Is This Business a Franchise or Not?

“Franchise” means...?
A brief look at what the definition in Ontario’s Franchise Disclosure Act might mean.

Introduction

As most readers will know, Ontario now has franchise-specific legislation entitled the Arthur Wishart (Franchise Disclosure) Act, 2000 (the “Act”). The first portions of the Act, dealing with fair dealing and the right of franchisees to associate, were proclaimed in force on July 1, 2000. The disclosure portions of the Act will come into force on January 31, 2001.
Section 2 of the Act deals with its application. By virtue of subsection 2(1), the Act applies with respect to a “franchise agreement”. Section subsection 1(1) of the Act in turn defines a “franchise agreement” to mean “...any agreement that relates to a franchise...”. Hence the seminal importance of the definition of this word.

Lawyers who wish to advise their clients on means to structure their affairs must review the Act carefully. Arrangements which at first glance appear to be outside the definition of a franchise may, upon closer scrutiny, fall within the definition. For example, in the United States, arrangements such as taxicab businesses or branch offices of law firms have been found to be franchises. Given the significant consequences of a finding that a franchise exists, which include liability of the franchisor, its associates, officers and directors for the losses sustained by a franchisee, considerable caution is warranted.

This article will review the definition of “franchise” in the Act in order to provide some context for determining whether a particular arrangement constitutes a franchise. Given that, as of today, there is no case law examining the definition of franchise under the Franchises Act (Alberta), this paper focuses on a discussion of applicable American materials.

Definition of “franchise” under the Act

To paraphrase, the Act defines “franchise” in subsection 1(1) as:
_ a right to engage in a business where the franchisee is required to make a payment to the franchisor, whether direct or indirect and,
(a) in which,
_ the franchisor grants the franchisee the right to sell goods or services that are substantially associated with the franchisor’s trade–mark, and
_ the franchisor exercises significant control over, or offers significant assistance in, the franchisee’s method of operation, or
(b) in which,
_ the franchisor grants the franchisee rights, whether or not a trade–mark is involved, to sell goods or services supplied by the franchisor or a supplier designated by the franchisor, and
_ the franchisor provides assistance locating or securing locations for product sales displays used by the franchisee.
Please note that a close reading of the wording is required for anyone called upon to either opine upon or to persuade a court as to the existence or not of a franchise. Although the intended scope of the definition is probably the same as the definition used by other jurisdictions, unfortunately the definition itself does not closely resemble the wording used in Alberta or U.S. jurisdictions.

Requirement for Consideration

To constitute a “franchise” under part (a) or part (b), some kind of consideration must be payable in return for the right to engage in the franchised business. Consideration may either be in the form of a “payment” (presumably a single payment is intended) or in the form of “continuing payments”. The consideration may be “required”(which presumably means that the consideration has in fact been paid)or “a commitment to make such payment or payments” must exist (which presumably means is some future contractual obligation).

Numerous other jurisdictions, in dealing with the notion of the consideration payable by franchisees to franchisors, use the phrase “continuing financial obligation”. Such legislation will also frequently include a definition of “franchise fee” which excludes the purchase of a reasonable amount of goods or services at reasonable bona fide wholesale prices. The Act, however, uses the phrase “continuing payments” and contains no such definition of the phrase “franchise fee” (and in fact does not in employ the term). Consider also that the Interpretative Guide issued by the FTC in connection with its Franchise Rule excludes from the definition of continuing financial obligation a reasonable purchase of inventory at bona fide wholesale prices. I suggest that a “continuing payment” requires the finding of some form of distinct and discernible payment and represents a higher threshold of financial connection than the more subtle term “continuing financial obligation”. As a result, certain systems may attempt to avoid application of the Act by avoiding the concept of royalty payments and simply building their ongoing compensation into the sale price of their products (or services). The question of whether the amount charged by the “supplier” to the “purchaser” is greater then a “bona fide wholesale price” will be difficult to prove and would likely require a comparison of franchised and nonfranchised distribution schemes of the same product or services in order to establish a benchmark bona fide wholesale price.

Business Format Systems

Clause (b) of the definition deals with what are commonly referred to as “business format” systems. In these systems, a trademark is generally licensed along with use of a particular business format which permits the franchisee to conduct a specified type of business. Generally, the franchisee is required to comply strictly with the franchisor’s guidelines concerning the operation of the business and the appearance of the business location. The quality of the products and services provided by the franchisee are also controlled by the franchisor. Examples of business format franchises include restaurants, fast food establishments and real estate businesses.

The goods or services being sold, offered for sale or distributed must be substantially associated with the franchisor’s trademark. Use of the word “substantial” presumes situations where use is made of the franchisor’s trademarks or of its advertising which does not cross the threshold requirement of the Act.

The test in paragraph (ii) is satisfied if the franchisor exercises significant control over the franchisee’s method of operation, or offers significant assistance in the franchisee’s method of operation. There is no requirement that the control or assistance be either ongoing or active. Provision of initial training or even where manuals, videos or instructional or operational software is provided at the outset may satisfy this requirement. Of course, the word “control” is not meant in the sense of ownership. Rather, it means that the franchisor must have effective control over the franchisee’s methods of operation and, therefore, a factual examination of the elements of control is warranted.

Specific examples of the franchisee’s methods of operation that will be considered in determining the significance of the franchisor’s control or assistance are provided, and include building design and furnishings, locations, business organization, marketing techniques or training. In the U.S., “Significant control or assistance” has been defined by the FTC in their interpretative guide to include franchisor involvement in site approval, hours of operation, production techniques, personnel policies, accounting practices, advertising and promotion campaigns and location or sales area restrictions.

Product Distribution Systems

Product distribution systems consist of the grant of a right to distribute another’s products within a specified territory or at a specified location, generally using the manufacturer’s trademark. These systems include automobile, gasoline and farm equipment distributorships. In contrast to a pure “dealership” arrangement, a product distribution franchisee generally involves a detailed marketing plan and use of the franchisors trademark.

Part (b) of the definition is clearly intended to include such product distribution schemes. Such a clear intention is manifested by the removal of any requirement that the system involve use of the franchisor’s trademark, or be subject to significant control or assistance from the franchisor.
In order for a product distribution franchise to be found, the test in clause (b)(i) must also be satisfied. This test requires that the franchisor, the franchisor’s associate, or a third person designated by the franchisor, must provide location assistance to the franchisee. Location assistance includes either the securing of retail outlets or accounts by the franchisor on behalf of the franchisee, or the securing of an locations for the placement of some form of product sales display which will be used by the franchisee.

Exemptions

In order to structure a relationship that falls outside the definition, a party can: prohibit the use of its trademarks; refrain from providing marketing assistance or exerting any control over the other party; or, refrain from providing location assistance. As discussed above, the ability to avoid the definition simply by not collecting a franchise fee or royalties is suspect.
In addition to these contractual means to avoid application of the definition, the following continuing commercial relationships or arrangements are exempted by virtue of subsection 2 (3) of the Act:
_ employer-employee relationships;
_ partnerships;
_ cooperative associations;
_ certification and product testing services;
_ single license trademark arrangements;
_ leased department arrangements;
_ purely verbal agreements; and
_ arrangements with the Crown.

Conclusion

U.S. courts have for almost 30 years now been faced with the task of considering what kinds of payments will constitute a franchise fee, and what kind of arrangements will constitute a marketing plan. The definition of “franchise” in the Act has a good deal that is similar to legislation in other jurisdictions, and a good deal that is new. Lawyers advising clients in Ontario, and Ontario courts interpreting the Act, I now faced with the considerable challenge of not only assimilating a substantial body of existing case law, but developing and refining that case law to fit the uniquely “Ontario-an” bent of the Act.

Useful Caselaw: “Franchise”

Horner v. Tilton, 650 N.E. 2d 759 (Ind. Ct. App. 1995)
A mail services business was not a “franchise” under Indiana law where the business did not include a “marketing plan”. The operator was not subject to sales quotas nor did the seller have the right to control or oversee the purchaser’s business activities.
Metro All Snax Inc. v. All Snax Inc., C.C.H. Bus. Fran. Guide ¶10855 (Minn. D.C. 1996)
Under Minnesota law, the entitlement of a distributor to use the seller’s trademarks constituted the business a “franchise”, notwithstanding that the distributor never, in fact, used those trademarks.

Continental Basketball Assn. v. Ellenstein Enterprises Inc., 669 N.E. 2d 134 (Ind. S. Ct. 1996)
A professional basketball team was found to be a “franchise” under Indiana law where the owner was subject to compliance with the league’s requirements and operated in association with the league’s trademarks and advertising program.

Useful Caselaw: “Substantial Part”

Schauenburg Industries Ltd. v. Borowski (1979), 25 O.R. (2d) 737, 8 B.L.R. 164, 101 D.L.R. (3d) 701, 50 C.P.R. (2d) 69 (H.C.)

What constitutes a “substantial part” is determined by looking at the value of the part appropriated, its relative value to the work as a whole, and the purpose it serves. The case also addressed the question of whether “substantial” refers to quantity or quality, and determined that, in the circumstances of that case, it was both.

Useful Caselaw: “Control”

Sooke Forest Products and Lawford Cedar v. Toronto-Dominion Bank, [1985] B.C.L.R.B.D. No. 132
The British Columbia Labour Board found that the hiring of personnel, the adjustment of salaries, involvement in daily operations, sale and shipping of inventory, managing and review of production were sufficient to amount to operational control.

More information. For more information on franchising in Canada, the United States and internationally, please contact Peter Macrae Dillon, head of Siskinds Franchise Law Group. Peter is recognized expert in franchising. He is the author of the annotated Ontario Franchise Disclosure Act and the annotated Alberta Franchises Act and over 40 other publications on the subjects of franchising, licensing and distribution. He is licensed in Ontario and New York. Peter can be contacted at 800-816-9596 ext. 389 or by email at peter.dillon@siskinds.com. The information contained in this note is for general reference only, and should not be relied upon as constituting legal advice.

Is This Business a Franchise or Not? - To learn more about this author, visit Peter Macrae Dillon's Website.

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