Dealer conversion white paper 2012 by iFranchise Group

International Franchise Association 45th Annual Legal Symposium May 20-22, 2012 JW Marriott Hotel, Washington, DC

DE-FRANCHISE MY LICENSE PLEASE: CONVERTING FRANCHISES TO LICENSES AND VICE-VERSA

Moderator and Author: Gary R. Duvall, Partner Dorsey & Whitney LLP Seattle, WA duvall.gary@dorsey.com Authors: Mark Siebert, CEO The iFranchise Group, Inc Chicago, IL msiebert@ifranchise.net Christopher T. Feldmeir, Attorney at Law Greensfelder, Hemker & Gale, P.C. St. Louis, MO ctf@greensfelder.com Adam Ekberg, Director, Corporate Counsel Starbucks Corporation, Seattle's Best Coffee Division Seattle, WA AEkberg@starbucks.com

TABLE OF CONTENTS Page I.

WHEN IS A LICENSE OR DISTRIBUTORSHIP AGREEMENT ALSO A FRANCHISE? ....................................................................................................... 1 A. B. C. D.

II.

HOW A LICENSE OR DISTRIBUTORSHIP CAN AVOID FRANCHISE AND BUSINESS OPPORTUNITY LAWS USING EXEMPTIONS ........................ 8 A.

B. III.

Exemptions from the FTC Rule .................................................................. 9 1. Sophisticated Franchisee (or Large Franchisee) Exemption ........... 9 2. Fractional Franchise Exemption .................................................... 10 3. Other Exemptions from the FTC Rule ........................................... 11 Exemptions from State Franchise Laws................................................... 12

BUSINESS ISSUES IN CONVERTING A LICENSE OR DISTRIBUTORSHIP TO A FRANCHISE ............................................................ 13 A.

B. C. D. E. IV.

FTC Franchise Rule Law Definition ........................................................... 1 State Franchise Definitions ........................................................................ 3 State and Federal Business Opportunity Laws .......................................... 6 Conclusion: How a License or Distributorship Can Avoid Franchise Laws .......................................................................................................... 8

Advantages of Conversion ....................................................................... 14 1. Channel “Ownership” and Margin Maintenance ............................ 14 2. Operational Control ....................................................................... 15 3. Branding ........................................................................................ 15 4. Fees – Offsetting Support Costs ................................................... 16 The Challenges of Conversion ................................................................. 17 Incremental Value – A Seminal Question ................................................ 18 The Importance of Dealer Input ............................................................... 20 The Importance of Trust........................................................................... 22

LEGAL ISSUES IN CONVERTING A LICENSEE OR DEALER TO A FRANCHISEE .................................................................................................... 23 A. B. C. D. E.

Dealers or Licensees who Object; Generally ........................................... 23 Breach of Territorial and Exclusive Dealing Rights .................................. 23 Breach of Duty of Good Faith .................................................................. 24 Breach of Specific Dealer Laws ............................................................... 24 Franchise Law Claims.............................................................................. 24 1. Was it a Franchise or Otherwise Unlawful? .................................. 24

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2. V.

Self-Reporting and Offering Rescission ........................................ 25

DE-FRANCHISING – CONVERTING A FRANCHISE TO A LICENSE OR DISTRIBUTORSHIP ........................................................................................... 26 A.

Why Would a Franchisor Abandon Franchising? ..................................... 26 1. Advantages of Franchising ............................................................ 26 2. Disadvantages of Franchising ....................................................... 26 “50 Ways to Leave Your Franchise”: How to De-Franchise .................... 28 1. Conversion of Existing Franchisees. ............................................. 28 2. Starting a New Dealer or License System. .................................... 29

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De-Franchise My License Please: Converting Franchises to Licenses and Vice-Versa The starting point in deciding whether to convert to or from a franchise or nonfranchise distribution system is analysis of the relevant definitions (Section I below) and exemptions (Section II below). The business issues and pros and cons of franchise and non-franchise systems are discussed in Section III (converting to a franchise) and Section V.A (converting from a franchise). Legal issues in converting to a franchise are discussed in Section IV, and legal issues in converting from a franchise are discussed in Section V.B. I.

When is a License or Distributorship Agreement also a Franchise?

An agreement, whether called a license, distribution agreement or otherwise, that meets the definition of “franchise” under federal law or an applicable state franchise law, must comply with the disclosure, registration, advertising and related laws that regulate the franchise industry. For those licensors and dealers looking to avoid those regulations, the first step of analysis is typically to determine if the definition “franchise” even applies (and if it does, to figure out a way to eliminate one of the definitional elements). A.

FTC Franchise Rule Law Definition

The Federal Trade Commission (“FTC”) has promulgated what this paper refers to as the FTC Franchise Rule.1 The FTC Franchise Rule defines “franchise” as follows: Franchise means any continuing commercial relationship or arrangement, whatever it may be called, in which the terms of the offer or contract specify, or the franchise seller promises or represents, orally or in writing, that: (1) The franchisee will obtain the right to operate a business that is identified or associated with the franchisor's trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor's trademark; (2) The franchisor will exert or has authority to exert a significant degree of control over the franchisee's method of operation, or provide significant assistance in the franchisee's method of operation; and (3) As a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.2 Thus, an arrangement that possesses three elements: the trademark element, the control or assistance element and the fee element, is a franchise under federal law.

Disclosure Requirements and Prohibitions Concerning Franchising, 16 C.F.R. Part 436 (2007). 2 16 C.F.R. § 436.1(h) (2007). -1-

The FTC Franchise Rule Compliance Guide (the “Compliance Guide”)3 states that the intent of the FTC Franchise Rule is to cover relationships in which each of these elements are represented, either orally or in writing, and regardless of whether the representation is true or can be fulfilled, meaning that a licensor’s promise to deliver the right to use a trademark or significant assistance will satisfy the definitional element, even if the licensor cannot or does not deliver on that promise.4 With respect to the trademark element, the term “trademark” under the FTC Franchise Rule is to be read broadly to include not only trademarks, but also service marks, trade names and other commercial symbols.5 If the licensor or supplier grants to its licensee or distributor the right to operate its business under the licensor’s mark (e.g., the sign on the door is the licensor’s mark), or the right to sell goods or services identified with the licensor’s mark (e.g., the goods are branded with the licensor’s mark), then the trademark element is present. Unlike some state law definitions discussed below, the FTC Franchise Rule definition does not reference the substantiality of the association between the trademark and the operation of the business, and the trademark element is therefore relatively clear to establish or avoid. The Compliance Guide provides that, “[A] supplier can avoid [FTC Franchise] Rule coverage of a particular distribution arrangement by expressly prohibiting the distributor from using its mark.”6 On the other hand, the FTC Franchise Rule control or assistance element is more difficult to identify because of the subjective component of the definition. When does control or assistance become “significant”? The Compliance Guide provides detailed examples of what constitutes control or assistance, but not an exhaustive list. As a threshold matter, the control or assistance must relate to the franchisee’s overall method of operation, not merely a small part of the franchisee’s business. For example, though a supplier may provide sales training to a distributor with respect to the dealer’s product, no franchise will exist under the FTC Franchise Rule if that assistance has only a marginal effect on the distributor’s overall business operation.7 Likewise, controls exerted by a licensor over a licensee’s use of a trademark will not be “significant” if the controls are only the minimum necessary to protect the licensor’s legal ownership rights in the mark (such as the right to inspect the licensee’s 3

Available at http://business.ftc.gov/business-guidance/bus70-franchise-rulecompliance-guide (last visited on February 12, 2012). 4 Compliance Guide at 1; see also FTC Franchise Rule Statement of Basis and Purpose, 72 FR 15444, 15459-15460 (Mar. 30, 2007). 5 Compliance Guide at 2. 6 Id. 7 See Id. at 4 (stating that promotional activities, such as furnishing point-of-sale displays and product samples, in the absence of additional forms of assistance, will not be deemed “significant”). But see Cal. Commissioner’s Release 3-F (Revised), infra at fn. 19 (finding a marketing plan may be prescribed, and thus satisfy the California definition marketing plan or system element, where a franchisor supplies sales aids or props). -2-

use of the mark).8 However, when a licensor controls the location, design or appearance of its licensee’s outlet or accounting practices, or when a dealer provides sales, repair or business training assistance, advises the distributor in the management or marketing of the business or furnishes a detailed business operations manual, significant control or assistance may be present. The Compliance Guide provides other examples of what constitutes significant control. “Significance” is also impacted by how much the licensee or distributor may rely on the control or assistance. With a less experienced licensee or a distributor undertaking a large financial risk, there is more likely to be a finding of significance with respect to the control or assistance being offered by the licensor or supplier. In Advisory Opinion 04-4,9 the FTC examined the degree of reliance members of an auto glass replacement network would reasonably place on the network operator providing controls and assistance to expand the member’s business. The FTC found that the network’s expertise and reputation were likely to be significant factors in why a member would join. Under the FTC Franchise Rule, the fee element is only met with the payment to the franchisor or any affiliate of at least $500 during the first six (6) months of commencing the operation of the franchised business. Payments under $500 or that are not made until after this six (6) month period do not satisfy this element. Required payments generally include any amount that is required by contract or practical necessity to be made to the franchisor or its affiliate, including any initial fee, training fee, deposit, rent, equipment purchases and continuing royalties. However, payments do not include the payment for a reasonable amount of inventory at bona fide wholesale prices.10 Thus, one method of avoiding the fee element under the FTC Franchise Rule is structuring a deferred payment arrangement, such as having the licensee deliver a promissory note payable after six (6) months of operating the business.11 As discussed below, however, state definition fee elements will not be as easily avoided. B.

State Franchise Definitions

Licensors and supplier who operate or contract with third parties in certain states may also have to contend with state specific franchise laws. This paper focuses on the fourteen (14) states that require the registration of a franchise offering, 12 but the reader

Id. Bus. Franchise Guide (CCH) ¶ 6524, Nov. 8, 2004. 10 Compliance Guide at 6. 11 Such a promissory note, however, cannot contain an acceleration clause in the event of default and they cannot eliminate any defenses to the payment obligation (whether by waiver in the note itself or by negotiating the note with a holder in due course). See, e.g., Informal Staff Advisory Opinion 98-3 (FTC, May 4, 1998). 12 California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin. 9

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should also consider whether the relationship laws found in twenty (20) states,13 as well as the District of Columbia and the territories of Puerto Rico and the U.S. Virgin Islands, have any applicability. Many of these relationship laws are broad enough to cover many dealers and agents, e.g. Wisconsin and New Jersey. In many states the business opportunity laws, discussed below, cover franchises unless a notice filing is made, or an exemption is available, e.g. Florida, Nebraska, Texas, Utah, and 10 other states. Generally, the state definitions of the fourteen (14) franchise registration states fall into two categories: those including a “prescribed marketing plan or system” definition;14 and those including a “community of interest” definition.15 Under those definitions that include a marketing plan or system prescribed by the franchisor, a franchise arrangement is present when, for a fee, a franchisee is granted the right to sell goods or services under a marketing plan or system substantially prescribed by the franchisor and that is associated with the franchisor’s trademark. Under those definitions that include a community of interest element, a franchise arrangement is present when, for a fee, the franchisee is granted the right to sell goods or services under a trademark in which the franchisor and franchisee share a community of interest in the operation of that business. A “community of interest” generally exists when there is a financial interest in the success of the business which is shared by the franchisor and franchisee (e.g., the franchisor sells products to the franchisee).16 New York, however, has a broader definition of franchise that deserves special mention. In that state, a “franchise” will exist when either of the following is present: (1) a fee is paid for the right to engage in a business of offering goods or services substantially associated with the franchisor’s trademark; or (2) a fee is paid for the right to engage in a business of offering goods or services under a marketing plan or system prescribed in substantial part by the franchisor.17 In other words, the New York definition has only two elements: a fee and either a marketing plan or substantial association with a trademark. Thus, many license relationships that do not involve substantial association with a trademark could be considered franchises in New York.

Alaska, Arkansas, California, Connecticut, Delaware, Hawaii, Illinois, Indiana, Iowa, Michigan, Minnesota, Mississippi, Missouri, Nebraska, New Jersey, Rhode Island, Utah, Virginia, Washington, Wisconsin. 14 California, Illinois, Indiana, Maryland, Michigan, North Dakota, Rhode Island, South Dakota, Virginia and Washington. 15 Hawaii, Minnesota and Wisconsin. 16 For a more in depth discussion of the meaning of the “marketing plan or system” element and “community of interest” element, see “You Don’t Want to be a Franchise” Structuring Business Systems Not to Qualify as Franchisees” by Ann Hurwitz and David W. Oppenheim, American Bar Association 24th Annual Forum on Franchising, at 8-11 (October 19-21, 2011); and see John R.F. Baer, David A. Beyer and Scott P. Weber, When are Sales Representatives also Franchisees?, 27 FRANCHISE L. J. 151, 154-155 (2008) (containing an in depth discussion of the community of interest definition and, in particular, court interpretation of the Wisconsin Franchise Dealership Law). 17 N.Y. Gen. Bus. Law § 681.3 (2012). -4-

The trademark element under most registration state definitions requires that the marketing plan or system by substantially associated with the franchisor’s trademark, service mark, trade name, logotype, advertising or other commercial symbol.18 The California Department of Corporations measures “substantial association” in terms of the presentation of the business to customers and therefore creates “the appearance of a unified operation.”19 In other states, courts view merely selling a trademarked product, among many products offered for sale by the distributor under the distributor’s own name, as not enough to give rise to substantial association.20 Usually, a prescribed marketing plan or system will exist when a franchisor provides promotional or advertising materials, training regarding the promotion, operation or management of the business or other operational, managerial, technical or financial guidelines or assistance. In California, Illinois, Maryland and Wisconsin, however, even the mere suggestion of providing these sorts of operating procedures will give rise to a prescribed marketing plan or system.21 If, on the other hand, a distributor is left entirely free to operate the business according to its own plan or system, then no franchise should exist.22 The operative phrase in California is likely “entirely free”, as the State will (as mentioned above) find a marketing plan or system to be prescribed even if it is not required in the agreement that the procedure be adopted by the franchisee.23 The test in each of these states will depend on all the facts and circumstances of the arrangement. A “community of interest” generally has a broader reach than the prescribed marketing plan or system definition. The Wisconsin Supreme Court has identified two guideposts for when a community of interest is present: (1) when there is a continuing financial interest between the parties; and (2) when there is interdependence between the parties, such as cooperation and coordination of activities and shared common goals.24 The Court then identified a ten (10) factor test to determine the presence of these guideposts, including the length of time the parties have dealt with each other; the extent and nature of the obligations imposed on the parties by the agreement; the percentage of time or revenue the distributor devotes to the sale of the dealer’s products or services; the percentage of the gross proceeds or profits derived by the 18

See, e.g., California Franchise Investment Law, Cal. Corp. Code § 31005(a)(2) (2012). 19 Cal. Commissioner’s Release 3-F (Revised), When Does an Agreement Constitute a "Franchise" (June 22, 1994). 20 James v. Whirlpool Corp., 806 F.Supp. 835, 842 (E.D. Mo., Oct. 26, 1992) (interpreting the Michigan Franchise Investment Law). 21 See, e.g., Code of Maryland Reg. § 02.02.08.02.C (2011). 22 Cal. Commissioner’s Release 3-F, supra, at fn. 19. 23 Id. (stating, “[A] non-mandatory program ma attain the level of a ‘prescribed’ program,” but determining no prescribed marketing plan or system when an agreement merely “imposes upon the operator of a business procedures or techniques which are customarily observed in business relationships in the particular trade or industry”). 24 Baer et al., supra at fn. 16 (citing Ziegler Co. v. Rexnord, Inc., 407 N.W.2d 873, 878879 (Wis. 1987)). -5-

distributor from the sale of the dealer’s products or services; the extent and nature of any territory granted to the distributor; the extent and nature of the distributor’s use of the dealer’s trademarks; the extent and nature of the financial investment in inventory, facilities, and good will made by the distributor to operate the licensed business; the amount of personnel of the distributor who are devoted to the operation of the licensed business; the amount of advertising spend by the distributor to promote the dealer’s products or services; the extent and nature of any supplementary services provided by the distributor to consumers of the dealer’s products or services. 25 Each state definition contains a fee element, as under the FTC Franchise Rule. However, the state definitions are not uniform in the amount of fee required to satisfy the element (ranging from any fee paid to at least $500 paid), and no state limits the measurement period to only the first six (6) months of operating the business. For example, New York excludes from its fee element payments which do not exceed $500 on an annual basis.26 But like the FTC Franchise Rule fee element, there are exclusions in the various fee element definition for payments for the purchase of reasonable amounts of inventory at bona fide wholesale prices. Inventory amounts that cannot be sold in a reasonable amount of time will not satisfy the bona fide wholesale price exception.27 It is also important to recognize the distinction between inventory and raw materials.28 C.

State and Federal Business Opportunity Laws

Even if the licensor or supplier can successfully avoid the “franchise” definition, a review of whether the arrangement meets the definition of a “business opportunity” should be undertaken to ensure the relationship does not fall within the ambit of those registration and disclosure regulations. As with franchising, business opportunity laws are governed by both federal and state laws. The federal law exists in the FTC Business Opportunity Rule, the latest version of which was promulgated in 2011 and became effective March 1, 2012.29 Under the Federal Business Opportunity Law, a “business opportunity” is defined as follows:

Ziegler, 407 N.W.2d at 880 - 881. N.Y. Gen. Bus. Law § 681.7(e) (2012). 27 For instance, see Marathon Petroleum Co. v. LoBosco, 623 F.Supp. 129 (E.D. Ill. May 6, 1985) (suggesting that the requirement for a filling station operator to purchase 100,000 gallons of gasoline each month without regard to how much gasoline could be sold would constitute an indirect franchise fee under the Illinois Franchise Disclosure Act). 28 See the discussion by Hurwitz and Oppenheim, supra at fn. 16 (distinguishing between a yogurt franchisor selling product mixes used by franchisees to make the frozen yogurt ultimately sold to consumers, and therefore not wholesale inventory, from a licensor selling finished product to its licensee). 29 Disclosure Requirements and Prohibitions Concerning Business Opportunities, 16 C.F.R. Part 437 (2011). 26

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Business opportunity means a commercial arrangement in which: (1) A seller solicits a prospective purchaser to enter into a new business; and (2) The prospective purchaser makes a required payment; and (3) The seller, expressly or by implication, orally or in writing, represents that the seller or one or more designated persons will: (i) Provide locations for the use or operation of equipment, displays, vending machines, or similar devices, owned, leased, controlled, or paid for by the purchaser; or (ii) Provide outlets, accounts, or customers, including, but not limited to, Internet outlets, accounts, or customers, for the purchaser's goods or services; or (iii) Buy back any or all of the goods or services that the purchaser makes, produces, fabricates, grows, breeds, modifies, or provides, including but not limited to providing payment for such services as, for example, stuffing envelopes from the purchaser's home.30 The FTC business opportunity definition is therefore relatively limited to promises regarding locations, customers, and buy backs. Careful structuring is nevertheless required. There are twenty-six (26) states with business opportunity disclosure laws in effect. Business opportunity definitions in these states vary, but typically include the following elements: (a) a product sale element in which a person (the opportunity seller) or a person recommended by the opportunity seller will provide another (the opportunity buyer) with products, equipment, supplies or services that the opportunity buyer can use to start or operate a business; (b) a fee element in which the opportunity buyer is required to pay an initial fee (and unlike the franchise fee element, most states do not have a bona fide wholesale price exclusion); and (c) a representation element in which the opportunity seller makes any of the following representations (directly or indirectly) related to what the opportunity seller or a third party it recommends will do for the opportunity buyer: (i) that they will assist the opportunity buyer in finding outlets or accounts to sell the supplied products; (ii) that they will assist the opportunity buyer in finding locations for vending machines, racks, display cases or similar devices on premises neither owned nor leased by the opportunity buyer or the opportunity seller; (iii) that they will purchase any or all of the products made, produced, fabricated, etc. by the opportunity buyer; (iv) that they guarantee that the opportunity buyer will derive income from the business in excess of the price paid to the opportunity seller; (v) that they will refund all or part of the price paid, or will repurchase any of the products, equipment, supplies, etc. sold to the opportunity buyer; or (vi) that they will provide a marketing plan.32 31

16 C.F.R. ยง 437.1(c) (2011). Alabama, Alaska, California, Connecticut, Florida, Georgia, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maine, Maryland, Michigan, Minnesota, Nebraska, New Hampshire, North Carolina, Ohio, Oklahoma, South Carolina, South Dakota, Texas, Utah, Virginia and Washington. 32 Note that not all of these representations are present in the various state definitions. The one most likely to be absent is the representation that the opportunity seller will 31

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Avoiding both the FTC Business Opportunity Rule and applicable state business opportunity law definitions is generally more difficult than avoiding the franchise definition. The absence of the bona fide wholesale price exception makes it especially difficult for any money to exchange hands in the arrangement. Also, most of the business opportunity definitions are disjunctive (“or”) not conjunctive (“and”), so avoiding all of the definitional elements is required. Many states, including such large states as California, Florida, and Texas, have extremely broad definitions, which only require an investment by the buyer and a marketing plan provided by the seller, which are present in many dealer and license agreements. If avoiding a definitional element is not possible, then a licensor or supplier will need to look at the availability of exemptions or avoiding certain states. D.

Conclusion: How a License or Distributorship Can Avoid Franchise Laws

Because franchise laws apply only if the relationship in question satisfies the definition of “franchise”, a licensor or supplier can look to creatively structure its arrangements so as to eliminate one of the definitional elements and thereby avoid the requirement to comply with applicable franchise regulations. Normally, this boils down to a sacrifice on the part of the licensor or supplier to either relinquish control over its licensees and distributors, or giving up the ability to collect any fee in excess of bona fide wholesale prices. It may also require avoiding certain states, such as New York, whose franchise definition is so broad that it is difficult to structure an acceptable alternative to avoid the law. Business opportunity laws, summarized above, are less uniform and easier to trigger, and often therefore more critical for reducing compliance costs for license and distribution networks. II.

How a License or Distributorship Can Avoid Franchise and Business Opportunity Laws Using Exemptions

As discussed above, there are a variety of ways a licensor or supplier may avoid franchise regulations by structuring an arrangement to avoid the definition of a franchise under federal and state law. In instances where avoiding the definition is not possible or desired, avoiding application of franchise registration and disclosure laws may still be possible if the arrangement qualifies for an exemption. For each such arrangement, there must be an exemption from the disclosure obligations of the FTC Rule at a federal level, plus an exemption from registration and disclosure of any applicable states that regulate franchise sales. Franchisors should keep in mind that the risk of erroneously relying on an exemption falls solely to the franchisor, and potentially to its controlling provide a marketing plan. Cf. Florida Sale of Business Opportunities Act, F.S.A. § 559.801(1)(a) (including in the definition of “business opportunity” a representation by an opportunity seller that the seller “will provide a sales program or marketing program that will enable the purchaser to derive income from the business opportunity”), with Georgia Sale of Business Opportunities Act, Ga. Code § 10-1-410(2)(A) (containing no reference to a representation by the opportunity seller of providing a marketing program to the opportunity buyer). -8-

persons. If a franchisor relies on an exemption for which it does not qualify, that franchisor and its principals may face rescission of the franchise agreement, damages, injunctions, fines, and other potential civil and even criminal penalties. A.

Exemptions from the FTC Rule

A franchisor can avoid the disclosure obligations of the FTC Rule if it can establish that it meets one of several enumerated exemptions. Two exemptions that are particularly useful for franchisors with a nationwide system are the Sophisticated Franchisee and Fractional Franchise exemptions, because at least one of these exemptions (or a substantially similar form) exists in the majority of registration states. 1.

Sophisticated Franchisee (or Large Franchisee) Exemption

Offers and sales to large franchisees are exempt from the FTC Rule. Similar versions of this exemption exist in California, Indiana, Maryland, Rhode Island, South Dakota, and Washington. This exemption is available for arrangements in which the franchisee (or its parent or any affiliates) is an entity what has been in business for at least five years and has a net worth of at least $5 million.33 The net worth component may be established through the net worth of the franchisee (which may be an entity or an individual), or through the net worth of a parent company or commonly-owned affiliate; or by combining the net worth of multiple parents or commonly-owned affiliates. The time in existence requirement can be met by the franchisee, by a parent, or by a commonly-owned affiliate. One practical consideration when relying on this (or any) exemption is how best to document that the arrangement does in fact qualify as exempt. A best practice is to review the franchisee’s most recent balance sheet, and if net worth is based on the combination of multiple entities, to review either a consolidated balance sheet (that includes the multiple entities) or the balance sheets of each entity counted. If net worth is established based on multiple entities, it is also advised to review and understand the inter-corporate organizational chart indicating the relationship and ownership structure of the entities, and to verify the entity’s time in existence by checking online state incorporation records. It is important to note that while this exemption does not require that the large entity’s business experience be related to franchising or similar to the business to be operated, from a business perspective, it is important to evaluate the party’s understanding of franchise relationships and suitability for operating the business to be franchised. For instance, if the franchisee’s only prior business experience is in manufacturing semiconductors, shifting to operating a coffee franchise may be a significant stretch. Note that California has a similar exemption but requires that the financial statements be GAAP-compliant and no less than 90 days old at the date of contract execution.

16 C.F.R. 436.8(a) (5) (ii). (However, state laws vary on whether the franchisor can rely on parent/affiliate financials.) -9-

Fractional Franchise Exemption

The fractional franchise exemption is another option to avoid application of the FTC Rule and certain state franchise laws. To qualify as a fractional franchise there is a two prong test: 1) The franchisee, any of the franchisee’s current directors or officers, or any current directors or officers of a parent or affiliate, has more than two years of experience in the same type of business; and 2) The parties have a reasonable basis to anticipate that the sales arising from the relationship will not exceed 20% of the franchisee’s total dollar volume in sales during the first year of operation.34 Similar versions of the fractional franchise exemption exist in California, Michigan, Minnesota, New York, Oregon, South Dakota and Wisconsin. In Illinois, Indiana, and Virginia arrangements that qualify as fractional franchises are explicitly excluded from the definition of a franchise. What experience is required by the first prong? The FTC Rule requires that the franchisee have two years of experience in the “same type of business”. This is one of the potential drawbacks to the use of the fractional franchise exemption, as “same type of business” is inherently a subjective determination. The FTC Interpretive Guide provides that: “the required experience may be in the same business selling competitive goods, or in a business that would ordinarily be expected to sell the type of goods to be distributed under the franchise.”35 While in some instances the “same type of business” determination will be easy to make, in others there will be a judgment call, involving some risk. Does experience operating a mobile food truck with a limited menu come close enough to a franchise with a traditional sit-down restaurant concept with an expansive menu? Does operating an automotive quick-lube franchise qualify a franchisee to operate a tire sales and service franchise? Does operating a bagel franchise provide the necessary experience to operate a coffee shop? As a practical consideration, if your system involves operating a retail food and beverage location, you would want to have someone with similar experience, ideally having both financial and operational responsibility. Note that under California’s fractional franchise exemption, the person with experience must have been in the same position for the preceding 24month period. The person meeting the experience qualification can be an officer or director of the franchisee or a parent or commonly-owned affiliate of the franchisee. If the franchisee (or members of its corporate family) is a partnership or limited liability company, then a general partner or LLC manager would satisfy the experience requirement.36 How is the revenue component of the second prong determined? Note that different than the aggregation allowed in the large franchisee context, this test is based on the revenue of the franchisee entity only; the revenue of parents or commonly-owned affiliates is not counted. But see FTC Advisory Opinion 99-5. The franchisee’s overall 34

16 C.F.R. 436.8(a) (2). 44 Fed. Reg. 49,968 (Aug 5, 1980). 36 Informal Staff Advisory Op. 99-5 (Jul 2, 1999). 35

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revenue can include revenue from any business activities in any location, and not just at the site where the franchised business is to be located. See Compliance Guide page 8. Note, however, that to qualify for this exemption in California, the source of the franchisee’s total revenue for this equation is limited to the revenue the franchisee derives from the same location as the franchised business (e.g. the same grocery, department store or hospital). What type of documentation should you examine to determine qualification? To evaluate revenue, the franchisor should review the most recent income statement that identifies the revenue of the franchisee entity (without aggregating income of any parent or affiliate). Issues may arise if it is a new entity, such as a single-purpose entity formed to operate a hotel or grocery store. To evaluate experience, ask the franchisee to identify the person with the relevant experience, including that person’s title, time in position, and nature of experience. If that person is not directly employed by the franchisee entity, request an inter-company organizational chart that shows the relationship and ownership between the two entities. 3.

Other Exemptions from the FTC Rule

Large Initial Investment Exemption:37 If the franchisee’s initial investment, excluding any financing received from the franchisor or an affiliate and excluding the cost of unimproved land, totals at least $1 million, the arrangement may be excluded from the FTC Rule. In such a case the franchisee also must sign an acknowledgement verifying the grounds for the exemption. Insider Exemption:38 Offers and sales to insiders of the franchisor are exempt where: one or more of the purchasers of at least a 50% ownership interest in the franchise; within 60 days of the sale, has been, for at least two years, an officer, director, general partner, individual with management responsibility for the offer and sale of the franchisor’s franchises or the administrator of the franchised network; or within 60 days of the sale, has been for at least two years, an owner of at least a 25% interest in the franchisor. Leased Departments:39 Leased departments are arrangements where an independent retailer sells their own goods or services from a space they have leased within a larger retailer’s location. The key to qualifying for this exemption is that the independent retailer is not required to purchase goods or services from the larger retailer or suppliers required by the larger retailer.

16 C.F.R. 436.8(a) (5) (i). 16 C.F.R. 436(8) (a) (6). 39 16 C.F.R. 436.8(a) (3). 38

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Petroleum Marketers:40 Petroleum marketers and resellers governed by the Petroleum Marketing Practices Act, 15 U.S.C. § 2801, are exempt from the FTC Rule. Therefore, most gas stations are exempt. Oral Agreements:41 Oral agreements are also exempt from the FTC Rule. An oral agreement arises where no material terms of a franchise arrangement have been put in writing. B.

Exemptions from State Franchise Laws

Ensuring your arrangement is exempt at the federal level is not the only hurdle. States with franchise registration and disclosure laws must be considered and also have a variety of exemptions that may be applicable. The available exemptions vary widely from state to state.42 As mentioned above, some state exemptions are similar to the FTC Rule exemptions, including: the Fractional Franchise Exemption: (CA, MI, MN, NY, OR, SD, WI); Sophisticated Franchisee Exemption (CA, IN, MD, RI, SD, WA, WI); Large Investment Exemption: (MD, MN, SD); Large Franchisee Exemption and Insider Exemption: (CA, RI, SD, WA). Other exemptions are unique to the states, including: Large Franchisor Exemption (based on the experience or net worth, or both, of the franchisor (or its parent company)); Institutional Franchisee Exemption (such as banks and other financial institutions); Single Franchise Exemption (where only one or a very few number of franchises are sold); Out of State Franchise Exemption (where the franchise is sold out of state to a nonresident); Nominal Franchise Fee Exemption (where only very nominal annual franchise fees will be paid); Sale By Judicial Officer (such as the sale of a franchise by a trustee in bankruptcy or an executor); Renewal, Extension, or Amendment of Franchise Agreement Exemption (non-material, no interruption in operation); Sale by Existing Franchisee Exemption (when a franchisee sells its franchise without the franchisor’s involvement); Sale By Franchisor to Existing Franchisee Exemption (sale of an additional franchise to a current franchisee). A significant impediment to using many state exemptions is that many are exemptions only from registration, not from disclosure or relationship rules. Since registration is not nearly as expensive or burdensome as disclosure, such exemptions are of little practical use.

16 C.F.R. 436.8(a) (4). 16 C.F.R. 436.8(a) (7). 42 For a more in depth discussion of available state exemptions and useful charts see “Navigating the Exemption/Exclusion Maze under the Amended FTC Rule and State Laws” by Earsa Jackson and Karen Satterlee, American Bar Association 31st Annual Forum on Franchising, October, 2008. 41

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Exemption by Order: Because of the inconsistencies and other limitations in state exemptions, many large national and international companies seek discretionary exemptions from state examiners. This may in some cases be the only available option if your arrangement does not qualify for any of the other available state exemptions, and particularly if the exemption only grants you exemption from registration, but not disclosure. While seeking a state order is far more expensive and time-consuming than registering in a single state, it may be the most practical option if you do not have and do not want to incur the time and expense of preparing an FDD. Exemptions by order are explicitly allowed in ten states (CA, HI, IL, IN, MD, MN, NY, ND, RI, WI), and are arguably available in any state that regulates franchising, implied from the powers given to the franchise regulators. The FTC has a procedure for an informal advisory opinion, and for a formal order, that can be used in appropriate cases. Key legal questions to ask when considering an exemption based transaction: Does an exemption from the FTC Rule apply? Does the arrangement considered fall under the jurisdiction of any state franchise laws? Does an exemption from applicable state law apply? When determining whether a particular state’s franchise laws apply, franchisors must consider not only where the franchised unit will be located, but also the franchisee’s state of incorporation and where their headquarters is located. Does the state exemption apply to registration or disclosure or both? How can we verify and document that the exemption we are relying on is valid? Key business considerations for exemption based franchising: Operating a nationwide system based on exemptions is administratively complex. Discipline and due diligence in evaluating each potential deal and each jurisdiction’s available exemptions is required. Also, in some instances recurring filings may be required to maintain exemptions and continuing qualification must be evaluated as the business changes over time. The business advantages of maintaining an exemption based system include avoiding the time and expense of preparing a franchise disclosure document and dealing with registrations, updates and the mechanics of disclosure. Also, some of the information required to be disclosed in an FDD – such as projected openings by state, as well as other information may be things you wish to remain confidential. III.

Business Issues in Converting a License or Distributorship to a Franchise

While it is not tracked in any meaningful way, a number of manufacturers have been converting existing channels of distribution such as dealer or distributor networks to franchising. These organizations are coming to franchising from different places. Some are non-branded dealers who carry both the manufacturer’s product line and the products offered by competitors. Others may be branded dealerships that have avoided franchising through the use of the bona fide wholesale price exclusion. Others still may be independent sales organizations or business opportunities.

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Regardless of the established channel, these companies are recognizing the advantages of franchising and are turning to this new channel with increasing regularity. A.

Advantages of Conversion

For these organizations, converting an existing channel of distribution to a franchised channel offers a number of significant advantages. Among the most prominent advantages are:    

Channel Ownership and Margin Maintenance Operational Control Branding The ability to collect fees which can be used to provide enhanced support services 1.

Channel “Ownership” and Margin Maintenance

In the vast majority of dealer organizations, the manufacturer’s ultimate goal is to sell more products. In most cases, this motivation far exceeds any desire on the part of the manufacturer to generate incremental revenues on fees and royalties – which are often insignificant in comparison to the margins generated on product sales. Given this motivation, the desire to “lock up” a channel of distribution by branding it and requiring a degree of product line exclusivity is often the primary driving force behind a manufacturer’s exploration of franchising. As the lawyers on the panel have described, because of franchise laws, nonfranchise dealer networks cannot pay fees to the supplier above a bona fide wholesale price for goods. In non-exclusive dealer channels, while the manufacturer will provide the products, the dealer will promote their own brand and carry competing product lines in order to “better serve” their consumers. In some instances, these competing products are carried because there is strong underlying demand for competing product lines. In others, the dealers carry these lines because they will realize better margins at retail, despite the fact that the product may be inferior. And in still other instances, the dealer will choose to carry inventory simply to create an environment in which the customer can choose from a wider assortment. Regardless of the underlying reason, in many cases, these multi-line dealers generally display little in the way of brand loyalty in the long term. All else being equal, the brand that gets promoted most heavily (or that receives premium “slots” in the store) is the one that offers the strongest margins or the best purchasing spiffs. This forces the manufacturer to either drive primary demand (through product innovation, increased advertising, or both), to provide an increased level of service and support, or to lower costs. And in each such instance, the manufacturer will need to bear the associated costs or reduced margins in order to achieve the desired brand loyalty – which will still be less than 100%.

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Operational Control

Because non-exclusive dealers operate under their own name, the manufacturer is less likely to exercise any meaningful, control over the dealer’s day-to-day operations. Also, as the lawyers on the panel have described, because of franchise laws even if a dealer or licensee is using the supplier’s brand, licensors can only impose limited controls on licensees. If the manufacturer refuses to sell product to a poorly performing dealer, they may well lose market share. And if they continue to supply an underperforming channel, then sub-standard installation, inaccurate product claims, poor service, and price gauging at the dealer level may be “blamed” on the manufacturer. At the same time, if a non-exclusive dealer channel is overrun by shoddy merchandising, dirty stores, and poor advertising, the manufacturer will also be at a significant disadvantage relative to any of their competitors who are able to distribute through an alternate channel of distribution that is not plagued by these inconsistencies (whether that channel be direct to consumer, company-owned stores, or franchises). This provides manufacturers with a significant opportunity to increase revenues if they can “persuade” their dealers to improve their marketing, merchandising, or sales techniques. By providing their channel with an understanding of how to systematically integrate marketing, sales, and services best practices, a manufacturer will be able to increase overall dealer revenues, and, in the process, improve their revenues per dealer. Case Study: For example, some years ago, a major floor coverings manufacturer wanted to institute a new, higher-control franchise channel of distribution to their network of over 6,000 retail stores. The reason behind the move was simple. Many of the retailers in their channel offered installation services along with the sale of the company’s tile. These services were often farmed out to independent contractors who were often untrained in the proper techniques for tile installation. When these installers would use too much or too little glue or fail to properly prepare the sub floor, the tiles would fail. And inevitably, the manufacturer – and not the installer – would be blamed as a result. The manufacturer understood that by controlling the installation component through a certification program, they could improve their overall brand image. But that service would require significant support and would only be available in the select dealerships that committed to the program. So in order to pay for this (and other incremental) support and to differentiate the channel, the manufacturer turned to franchising. 3.

Branding

Replacing a non-branded channel of distribution with a branded channel (and, perhaps in the process, creating a franchise relationship) can also have a number of advantages for many organizations. As the lawyers on the panel have described, because of franchise laws, some suppliers sell opportunities without a trademark

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license and some business opportunity sellers in some states must avoid a marketing plan. Ultimately, the reason that companies choose to use a brand is so they can differentiate themselves from their competition in the eyes of the consumer. From a business standpoint, this differentiation is designed to either develop a preferential purchasing behavior (brand loyalty), to allow for premium pricing, or both. And from a manufacturer’s point of view, these are all highly desirable outcomes. To the extent that the manufacturer has established a well-respected brand, they may be able to capitalize on that brand equity by branding their channel of distribution. And even without an established brand (or even if a new brand will be established), operating under a common brand has substantial advantages in the long term. And, of course, because the brand is now above the door, the manufacturer will be able to exercise greater control over day-to-day business operations – as the brand will carry a consumer expectation that the franchisor can and should police. 4.

Fees – Offsetting Support Costs

Since manufacturers and other suppliers are accustomed to generating revenue from product sales, it is not surprising that the ability to realize incremental revenue in the form of fees is often overlooked in the formation of many dealer organizations. After all, why raise a barrier to entry for those desirous of reselling a manufacturer’s products? And given this focus, the support that is typically provided to dealers is often minimal – especially at first. But over time, market forces may dictate that a manufacturer needs to provide additional services if they are to remain competitive in the marketplace. And dealers, who do not need to pay for these services (and who have the threat of defection as a hammer), will be clamoring for increased marketing and support. But the addition of every service to this mix will inevitably eat into a manufacturer’s wholesale margins. And without fees or increased revenue to offset these incremental expenses, profitability is bound to suffer. Simultaneously, manufacturers are increasingly looking at the dealer’s overall revenue mix and realizing that often, a significant portion of dealer revenues may be derived from installation, service, and support – all of which are revenue streams in which they do not participate. So whether it is out of a desire to offset incremental support costs or simply out of a desire to capture revenues on the service side that, at least in part, can be attributed to the manufacturer’s brand equity, fees are becoming increasingly important to some organizations. While the addition of a fee element to a dealer channel can offset support expenses and allow broader revenue participation, that same addition can create a franchise relationship if the dealer channel is already branded.

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The Challenges of Conversion

While the advantages of converting to a franchised channel are certainly compelling from the standpoint of many manufacturers, there are a number of significant concerns that should properly be addressed before determining if franchising is an appropriate channel of distribution. Since most manufacturers with dealer organizations will already have a significant dealer channel, the decision to franchise is far too important to make without thoroughly examining the implications of introducing this new strategy. One of the primary challenges to converting dealers or licensees to franchises, of course, is that some of the exact reasons that the franchisor wants to implement a franchise program may cause dealers to reject or resist it. Many dealers, accustomed to running their own show, will be reluctant to cede control of their day to day operations to a third party – even if that third party is known and trusted by the dealer (which often is not the case). Aside from the natural urge of an entrepreneur to bridle at the thought of outside control, the dealer is likely to believe that the manufacturer does not have the operational knowledge at the retail level to implement best practices (and, in many cases, they would be correct). Many dealers will have an emotional attachment to their own brand. In some instances, dealers may have been operating under their family name for multiple generations -- making re-branding the emotional equivalent of business patricide. Alternatively, they may be operating under a brand that they believe – rightly or wrongly – has stronger brand loyalty in their local market than the manufacturer’s national brand which in reality may have much stronger consumer acceptance. And, of course, no dealer wants to pay more in the way of fees – especially if those fees do not have a measurable impact on the dealer’s bottom line. Aside from the question of program acceptance, a prudent manufacturer must also explore the impact that the mere introduction of franchising as an alternative channel could have on the existing channels of distribution. If, for example, the introduction of franchising could create a significant number of dealer defections, the manufacturer would be well advised to carefully measure how this potential loss of dealers might affect the economic viability of the planned franchise strategy. Another important issue will be to decide which dealers the manufacturer is willing to convert and which it is not. Just like a start-up franchise program, the prudent manufacturer must be selective in the conversion process, as each converting dealer will be more closely associated with their brand, thus impacting consumer perception. In the typical conversion scenario, it is not unusual to find that there are a significant number of dealers that the manufacturer has no desire to convert – either because they are poor operators or because they are in markets that cannot be readily serviced. And in fact, it is often the best dealers in the network who will be leading the charge toward increased selectivity.

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As an integral part of this process, the manufacturer will also need to come to a conclusion as to the ultimate disposition of any remnants of the existing channel – including both those dealers that the manufacturer chooses not to convert and those targeted dealers who do not accept the franchise offer. In the vast majority of instances, manufacturers have opted to run two (or more) channels of distribution simultaneously, rather than run the risk of a “take-it-or-leave-it” approach to the introduction of the franchise. And, of course, assuming that two channels will be allowed to co-exist, the manufacturer will need to decide whether they will continue to award new dealerships after the introduction of the franchise channel or whether to rationalize the dealer channel over time through attrition (or through the substitution of franchises in territories in which carry-over dealers choose to remain). At this point, a number of legal and social issues must be answered. Does the manufacturer have the legal ability to terminate a dealership in favor of a franchise? If the introduction of the franchise channel is met without significant opposition, is the manufacturer willing to rock the boat a second time by indicating to non-converting dealers that they may be eliminated by franchisees in the future? And if they do, will the remnants of the dealer channel begin looking for alternative product lines as soon as the announcement is made? As a multi-channel distributor, the manufacturer will need to decide how to allocate territories when two or more qualified dealers are interested. And, of course, if a franchisee and a dealer are in close proximity, numerous additional issues will surface around the issue of preferential treatment. The branding issue will also need to be resolved early in the process. In a multichannel unbranded environment, the manufacturer may want to capitalize on its established brand equity, and may thus want to incorporate the brand into the DBA used by its franchisees. But if the existing channel is already branded, the manufacturer will again need to differentiate the franchise channel so that it is not confused with the branding done by the dealer channel (and so that franchisee advertising does not drive dealer business). Unfortunately, for most manufacturers, it is either impossible or unwise to develop an entirely new brand, leaving them in a quandary. Often, this is resolved through the creation of a “premium channel” designation, such as Hallmark’s Gold Crown stores. While branding almost invariably is a benefit to any channel (and the individual operators within that channel), the manufacturer must also understand that despite this fact, many dealers may not be willing to re-brand. In cases where dealers may have a significant emotional attachment to their names, a manufacturer may also need to consider “co-branding” franchised locations. C.

Incremental Value – A Seminal Question

In order to “sell” dealers on the prospect of conversion (especially if the dealer channel will remain intact), the most important question that must be addressed is whether the manufacturer can adequately differentiate the franchise channel from the

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dealer channel. Considering the increased control (and perhaps newly-imposed fees) that will be imposed on the franchisee, the manufacturer must gain an understanding of their ability to provide “incremental value” to the new channel. Whether this incremental value comes in the form of branding, best practices, financing, preferred access to product lines, protected territories, national accounts, purchasing discounts (or access to exclusive products), or some form of increased support, a manufacturer should attempt to compare how that incremental value will create incremental returns for converting dealers (after considering the incremental costs associated with franchising). Often, the fact that the dealer has a territory that can be transferred – allowing them to accrue equity in the business – is seen as a significant incremental benefit and should be accounted for in this calculation. Ultimately, if there is not significant incremental value associated with the franchise offer, there will not be adequate inducement for the dealer to give up the control that they will be offering the franchisor. Long term, it is also important to build in provisions for maintaining the exclusivity of this incremental value. In multi-channel concepts, one will often find that the dealer channel will co-opt elements of the franchise value proposition – a concept known as “channel bleed.” The reason for this migration is simple. Those responsible for the dealer channel are judged based on the results of that channel (and senior management is also motivated to improve revenues and profits). So seeing the improved results generated by newly implemented best practices in the franchise channel, there can be a strong motivation to migrate these programs to the (often larger) dealer channel where they will generate greater returns – especially in instances when compensation is tied to dealer performance or overall sales. Unfortunately, while this migration may well improve overall corporate performance in the short term, by “giving away” the franchisee’s value proposition without charge or control, these actions will sabotage the franchise program. On a going forward basis, it will be almost impossible to sell franchises (unless dealerships are no longer offered) and, of course, the franchisor will likely incur significant ill will on the part of the franchisees that have ceded control and fees in return for incremental value that is no longer incremental. With this in mind, it is critical in a multi-channel environment that the franchisor create internal controls to ensure that the franchise value proposition maintains its integrity. In making a decision to franchise, it is also important to account for the different nature of the franchise relationship. Part of the incremental value proposition will almost certainly involve creating channels of communication that do not exist in most dealer networks. And of course, it is important to resolve the issues of how this incremental value will be provided to the franchisee. Oftentimes, a dealer organization will not have the internal staff necessary to service the franchise network. And as a manufacturer, it may not have the knowledge of retail, sales, or service best practices at the customer-facing

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level that will allow it to develop best practices internally. So a vital part of the planning process must account for the development and provision of this value proposition. D.

The Importance of Dealer Input

Once the theoretical framework for the franchise offer is established, the next challenge will be to “sell” the new channel to the dealers that are targeted for conversion. Generally speaking, most manufacturers will not (and should not) jeopardize either their existing distribution channel (or their reputation) by introducing a program that flops. In an examination of dozens of attempts at dealer conversion over the last 20 years, one of the biggest factors impacting the potential success of a new franchise program is the degree to which it incorporates the opinions of targeted dealers in the design of the franchise program. As a first step, it is often useful to “test the waters” among those dealer’s targeted for conversion through the use of a broad-based survey of the entire network (or of the subset targeted for conversion). A well-crafted survey should allow the manufacturer to determine the level of interest exhibited by the dealers in obtaining additional support – along with an idea of the areas in which the dealer base believes the franchisor could add value. It can also provide insight as to dealer willingness to conform to standards and their willingness (or perhaps desire) to promote a common brand. Care must be taken in the drafting of such a survey to ensure that the questions do not elicit dealer bias. For example, the mere mention of the word “franchise” to some dealer organizations will be met with immediate and often emotional resistance, while in other organizations the dealer base may be positively inclined toward franchising. Ultimately, the goal is to judge the “salability” of a franchise offering, so manufacturers will want to avoid any potential bias. If initial indications are positive, a more formal process of obtaining dealeracceptance should be utilized before announcing the franchise program or finalizing on its structure. In the best of worlds, the manufacturer would attempt to obtain dealer commitment by conducting meetings with opinion leaders (perhaps members of a dealer council or perhaps a hand-selected group of highly-respected dealers targeted for conversion) to familiarize them with the concept, determine their willingness to explore an enhanced channel, and obtain their feedback on program design. These meetings are best conducted in a group setting, with the joint participation of dealers (a representative sample of top performers is best), management (excluding anyone with decision-making authority to avoid creating a negotiation), and a third party facilitator with the stated goal of “determining if the manufacturer can add incremental value to the dealer channel through a ‘win-win’ structure.” This structure gives the group “permission to fail,” ensuring that the manufacturer is not backed into a corner (as they would be if the program was simply announced by management) should the group fail to achieve consensus.

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Generally, there are several predictable instances at which dealers will find themselves in conflict with Management on structure. In these areas, it is important to structure the roles so that the facilitator is seen as the party looking for more aggressive solutions, while Management is seen as being the group willing to compromise. Often, these more sensitive issues are best solved in a second meeting – after the dealers have begun to visualize the benefits that they will be receiving. Studies indicate that the major factors affecting dealer acceptance of a new structure are: 

Dealer involvement in the process of structuring the new program before it is introduced



Avoiding “zero-sum” negotiations in favor of a “win-win” creative building format



Use of a “team” approach (where dealers and the “franchisor” work for a common goal)



The use of an outside third party to act as the “lightening rod” for sensitive issues (such as adding fees) and as the “bad cop” when enforcing “predetermined” positions



Focusing on a value proposition that is “additive” in nature (unless the goal of the new program also involves shrinking the total size of the dealer base)



Maintaining clear distinctions between channels when multiple channels are envisioned for the end structure



Positioning the new offering as a “premier” channel

Ultimately, for dealers to enthusiastically support a franchise offering, they must believe that it was, at least in part, a program of their own creation (regardless of whether some of the desired outcomes were hatched or even predetermined in the planning stage). Thus, the goal of these meetings will be for the Opinion Leaders to take ownership of the program so that they will ultimately help promote this to other dealers. Since management will participate side-by-side with the Opinion Leaders in the development of the ultimate value proposition and franchise structure, an experienced facilitator should have little difficulty ensuring that the group ultimately develops a structure that mirrors the initial plan – assuming, of course, that the initial plan was realistic and additive in nature. Finally, should the group develop the skeleton of a franchise channel that is enthusiastically supported by all; a skilled facilitator will help ease the implementation of the franchise program by recruiting the Opinion Leaders to help “sell” the new structure to select members of the dealer network. Depending on the size of the dealer network,

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the manufacturer may introduce the franchise program at a national meeting or in a series of regional meetings. But by using the Opinion Leaders as an integral part of the introduction of the franchise program (and by giving them the lion’s share of the credit for its development), the manufacturer will gain significant credibility in the sales process and will avoid much of the “us vs. them” mentality that plagues many new program introductions. Case Study: A manufacturer in the automotive aftermarket sold its products through a branded dealer channel that was largely exclusive. Over the years, the manufacturer added numerous support services to the channel at the request of its dealers, all of which were provided at no cost. Some dealers took better advantage of these services than others, and in doing so, saw significant improvements in the sale of the manufacturer’s products. Ultimately, the manufacturer realized that if it could exercise more control over dealer operations, they could improve system-wide performance by providing these services more consistently across the network. In order to do so, the manufacturer felt it would need to collect some minimal fees to offset these costs. But when the manufacturer met with dealers to discuss this new channel, they were not willing to pay for services that they could already access for free. Fortunately, by using the Opinion Leader format, the manufacturer was able to add improvements to the dealer program without the embarrassment of announcing a franchise channel that failed to gain acceptance in the marketplace. E.

The Importance of Trust

The ultimate acceptance of any conversion strategy within an existing dealer organization often comes down to the level of trust dealers have for the ownership and senior management team. Within many older dealer organizations, dealers have experienced a history of their manufacturer’s inability to successfully implement new programs and change in the system. Perhaps they’ve seen the manufacturer introduce the “latest and greatest” innovation every few years, only to discover that few of these events have advanced their business forward. Or perhaps the manufacturer has inundated the market with competitive dealers to the point where there is no feeling of loyalty or support. In a system where trust does not exist, dealers will be highly skeptical of a manufacturer’s claim that the franchise strategy is a positive solution for their business. Case Study: A manufacturer for several decades sold its products through multiple channels of distribution. As part of their distribution strategy, they maintained a dealer-owned retail channel of nearly 400 stores. The decision to convert the dealerowned stores was driven by the company’s desire to provide enhanced support services. Because the company had maintained a strong relationship with its dealers over the years and dealers trusted their leadership, dealer interest in the franchise program was extremely strong. After developing a well thought out program and involving franchisees in the process, more than 98% of the existing dealers converted to franchisees.

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IV.

Legal Issues in Converting a Licensee or Dealer to a Franchisee

Many franchisors, especially smaller ones, started growing their distribution channels with dealers or licensees. The discussion in Section III above has covered thoroughly the business issues that arise when a franchisor offers dealers or licensees the opportunity to convert to a franchise. This Section IV deals with the legal issues. A.

Dealers or Licensees who Object; Generally

Assuming that dealers and licensees are not bound by their contract or forced by circumstances to convert, the franchisor must make them an offer that gives them enough benefits for them to accept the opportunity to become a franchisee. Sometimes dealers and licensees are bound by their contract or forced by circumstances to convert. For example, a dealer agreement might expire, with a covenant not to compete, so that if a dealer wants to stay in business, it must become a franchisee. Even then, the franchisor wants to avoid legal and business problems in the conversion. Assuming that dealers and licensees are bound by their contract or forced by circumstances to convert, there are still adverse consequences possible, both business and legal. For example, as to the business issues, franchisors who convert dealers will want to avoid: 1.

Recruiting dealers who are too independent or otherwise unwilling to follow the franchisorâ&#x20AC;&#x2122;s system;

Recruiting dealers who are unable to pay the franchise fees;

Setting up conflicts between legacy dealers and new franchisees, particularly seeming to favor franchisees over remaining dealers;

Causing customer confusion if the customer experience is different or not clearly defined.

Legal issues that might arise are discussed below. B.

Breach of Territorial and Exclusive Dealing Rights

The starting point for the legal analysis of the conversion of a dealer to a franchisee is the dealer agreement. The dealer may have been given exclusivity, geographically or as to products or markets. It is important that the franchisor not violate such rights. There are many cases involving territorial encroachment between

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franchisees and non-franchise distribution channels of the franchisor and its affiliates. 43 . C.

Breach of Duty of Good Faith

Dealers who are unhappy about the conversion to a franchise system may also complain the conversion violates the implied duty of good faith and fair dealing that is a part of every contract, under common law, the UCC, and various franchise and dealer laws. Courts generally hold that the covenant of good faith cannot be used to vary the specific terms of the agreement. 44However, occasionally courts have held that unfair encroachment or competition is a violation of the implied duty of good faith. 45 D.

Breach of Specific Dealer Laws

There are many state and federal laws protecting particular types of dealers. Federal laws cover petroleum dealers and auto dealers and others. State laws cover dealerships including as motor vehicle, motorcycle, recreational vehicle, farm implement, boat dealers, soft drink, alcohol, wine, beer, and tobacco, petroleum product and gasoline dealers, and others. These are generally relationship laws that provide protections when dealer is terminated or not renewed, a transfer is denied, or a new dealer is located or re-located. These laws should be consulted before conversion of a dealer program to a franchise program in a regulated industry. E.

Franchise Law Claims 1.

Was it a Franchise or Otherwise Unlawful?

A dealer concerned about a conversion process might seek a lawyer to review the relationship for the first time. Often the so-called “distributorship”, “dealership”, or “license” borders on being a non-compliant franchise or might have been sold in possible violation of the business opportunity laws. The dealer may want to use these laws for leverage in the negotiations. The discussion in Sections I and II above covers the definitions in these issues in detail. In addition to the franchise and registration and disclosure laws and the business opportunity laws discussed above, a disgruntled legacy dealer may turn to the state 43

BJM v. Norrell Services, Inc., 855 F. Supp 1481 (E.D. Ky. 1994), Business Franchise Guide ¶ 10,485, (franchisor violated franchise agreement by providing management services through an affiliate); Sandhill Motors, Inc. v. American Motors Sales Corp., 667 F.2d 1112 (CA-4 1981), Business Franchise Guide ¶ 7761 44 Rado-Mat Holdings v. Holiday Inns, (N.Y. S. Ct. 1991), Business Franchise Guide ¶ 9975 (hotel franchise agreement permitted hotel company to locate a second branded hotel two blocks from the first). 45 Scheck v. Burger King, 798 F. Supp 692 (S.D. Fla. 1992) Business Franchise Guide ¶ 7761 (fast food franchisor might have violated good faith by opening a nearby restaurant). -24-

franchise relationship statutes. Many of these relationship laws are broad enough to cover many dealers and agents, e.g. Arkansas, New Jersey, Puerto Rico, and Wisconsin. 2.

Self-Reporting and Offering Rescission

Assume that your client comes to you and says, “I sold 20 license agreements, and have been told that they are franchises; what should I do?” It depends. First gather the facts and research the law, as follows: a. Review the agreements and sales material. Were these sold in violation of franchise or business opportunity laws? The definitions discussed above in Section I are often subjective. For example, was the business “substantially” associated with the trademark (the test in some state franchise laws), or was the control or assistance “substantial”? For some state business opportunity laws, the test is whether a representation or guarantee of income or profit was made. For all of these reasons, you will need to explore the entire facts and circumstances. b.

Was there an exemption available? See Section II of this

paper. c. What are the possible claims and defenses? For example, there are cases in some states holding that a claim for rescission is subject to a laches claim, and therefore has to be made promptly after discovering the relevant facts underlying the claim. 46 d. claims might be made?

Has the applicable statute of limitations run for whatever

e. Are the dealers happy and successful, and how likely are they to choose rescission, termination, or conversion? f. Will franchises be offered in registration states? If so the questions above need to be asked separately for each state. If franchises will be offered in registration states, the regulators will have an opportunity to make their own assessment and impose their own penalties. How this will be presented to the state regulators may vary depending on the answers to the questions above. For example, in a case of a clear violation of franchise laws with no obvious defenses, a franchisor may want to inform the regulators in the cover letter with the registration application, and propose an appropriate remedy, e.g. a rescission offer. Often however, there may be an argument that these were not franchises, or there may be other applicable defenses, that would dictate another strategy.

Harb v. Norrell Services, (D.C. Washington 1991, 1993), Business Franchise Guide ¶¶ 9921, 10,185. -25-

In addition to the question of what to tell the regulators is the question of how to present the dealers or licensees in the FDD. Disclosure needs to be considered in Item 1 (history and business of the franchisor and affiliates and competition), Item 12 (territory and franchisor’s reserved rights) and Item 20 (franchises, company units, and “similar” businesses). In addition, state franchise laws may require full disclosure of all material facts. It is important to be accurate and complete in the new FDD, so as not to compound any mistakes that have been made in the past. V.

De-Franchising – Converting a Franchise to a License or Distributorship A.

Why Would a Franchisor Abandon Franchising?

Section III above describes some of the advantages of franchising over other distribution methods. However, there are pros and cons of franchising vis-à-vis other methods of distribution, including: 1.

Advantages of Franchising

a. More revenue sources to franchisor, initial fees and royalties, than dealers or agents (who generally avoid franchising by not collecting initial fees, royalties or ad fees) b. Franchisees are more motivated, because of larger investment, profit motive, and hopefully larger equity build-up; c. Enhancement of goodwill in trademark due to contributions to license of the trademark (versus business opportunity sellers and non-exclusive dealers), use of advertising fees to fuel faster growth (versus dealers and agents who don’t pay ad fees); d. More significant assistance to franchisees (versus licensees); more significant control to franchisor (versus licensor). e. Arguably sharing of risk between franchisor and franchisee results in reduction of failure rates, although the statistics are tricky. 2.

Disadvantages of Franchising

a. As to the franchisor, the cost of franchise legal compliance, including legal fees, audit costs, state filing fees, internal administrative time and expense; b. As to the franchisor, more legal restrictions, e.g. impound or deferral of initial fees, relationship laws governing termination and renewal, etc. (though some dealerships are subject to relationship laws in some industries and in some states)

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c. As to the franchisee, the loss of independences (versus licensors and business opportunity sellers with fewer controls); d.

As to the franchisee, additional costs of initial fees, royalties

and ad fees. 3.

Specific Pros and Cons of Dealer and Distributor Structure

a. Con: Dealers do not pay initial fees and royalties, so there is less potential revenue to support initial and ongoing training and support. b. Pro: If the products are expensive or high volume, e.g. cars or gasoline, or the required training and support is minimal, the supplier can still make adequate profit without charging a fee other than a bona fide wholesale price for goods. Use: with a product distribution system of high margin or expensive goods, to avoid franchise compliance costs and complexities. But be aware that many industry-specific dealer laws exist. Also, be aware that suppliers must ensure to not charge fees for ancillary services and products, such as marketing fees, software and technology fees, training fees, etc. 4.

Specific Pros and Cons of License Structure

a. Con: Non-franchise licenses do not receive significant control or assistance or (in some states) a marketing plan or have (in some states) a community of interest. b. Pro: If the licensee is large, sophisticated, or experienced, it may not need or expect control or assistance, e.g. a clothing or technology manufacturer who merely licenses designs or software to be incorporated in its products. Use: with a licensee that is large, sophisticated and experienced, and is not relying on training or a turn-key business system. Also use if franchise exemptions might be available. 5.

Specific Pros and Cons of Agency Structure

a. Con: Non-franchise agencies, like dealers and distributors, do not pay initial fees and royalties, so there is less potential revenue to support initial and ongoing training and support. b. Pro: If the products or services are normally provided directly to the customer by the principal, e.g. insurance or real estate listings, the principal can still make adequate revenue, and pay an adequate commission to the agent, without charging a fee.

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Use: with distribution of products or services that are normally provided directly to the customer by the principal. However, principals must ensure to not charge agents for ancillary services and products, such as marketing fees, software and technology fees, training fees, etc. 6.

Specific Pros and Cons of Business Opportunities

a. Con: Non-franchise business opportunities do not allow the purchaser to use a trademark, so there are no economies of scale of marketing a unified brand. b. Pro: If the business does not rely on a unified trademark, e.g. direct person to person sales, e.g. legal compliance costs may be reduced if the business opportunity is not highly regulated. Use: for distribution of products where a unified trademark is not essential, e.g. low cost direct marketing programs like Tupperware and Amway. However, compliance with business opportunity registration and disclosure laws and multi-level marketing laws may be required, which is beyond the scope of this paper. B.

â&#x20AC;&#x153;50 Ways to Leave Your Franchiseâ&#x20AC;?: How to De-Franchise

There are many types of conversion away from franchising. The conversion will presumably always affect future licensees or dealers. However, existing franchisees may be converted to licenses, dealers, or other independent status, or may be left as is. As the discussion in Section III states with respect to conversions the other direction, it is possible that both a franchise and a non-franchise distribution channel will be supported going forward. This must be done with care to not cause system conflicts and encroachment issues. 1.

Conversion of Existing Franchisees.

The starting place is the franchise agreement. Franchisees will likely be concerned with such a program of de-franchising, because it may take away one or more of the advantages that are described above, and for which they have paid. Franchisees often expect that franchisors will grow the system, although franchisors may not be legally required to do so. Franchisees will normally need to be given significant consideration, such as a royalty reduction, to approve an amendment to their agreement. Franchisors and concerned franchisees may point to the following sections of their franchise agreements or other legal issues: a. Term and Renewal Rights. Many franchise agreements give the franchisor the right to change the system and agreement upon renewal, and some condition renewal rights on the franchisor still franchising in the state or region. b. Option to Purchase. Many franchise agreements grant the franchisor the right to buy out a franchisee at a predetermined price at a predetermined time. -28-

c. Affirmative Obligation of Franchisor to Grow and Support. If the franchisorâ&#x20AC;&#x2122;s plans threaten support or assistance to existing franchisees, there will certainly be issues. d. Territory and Exclusivity Provisions. The franchisor may or may not have limited itself as to what it can do with dealers, licensees, and franchisor sales in franchisee territories. e. Duty of Good Faith. As with conversion the other direction, a franchisee who feels threatened by a change may allege a violation of the implied covenant of good faith and fair dealing. Many franchisee law suits have alleged that a franchisor had a duty to grow the system, but I am not aware of any case so holding. Franchisors should refrain from making such promises to prospective franchisees. 2.

Starting a New Dealer or License System.

The franchisor may want to run a parallel franchise and non-franchise distribution system. Franchisees will be concerned with the affect on their businesses. Franchisors may want to offer the dealership or license agreement to franchisees first, in order to reduce resistance to the new program. As stated above, existing franchisees may have significant protection in their franchise agreement and under some state franchise relationship laws against competition from dealers, licensees, and against franchisor sales in franchisee territories. A broad territorial grant clause may therefore bar a franchisor from starting a competing dealer or license program. Forward-looking franchisors are well-advised to carve out broad reserved rights when granting territories to give themselves flexibility in the future. These carve-outs should include (and are also occasions to consider establishing a non-franchise channel of distribution), when a franchisor wants to: a. competing businesses;

Purchase or be purchased by, or merge or combine with,

b. Establish or license a business in another geographic territory, region, or country; c.

Sell dissimilar goods or services;

Serve dissimilar customers, such as national accounts;

e. Sell in other distribution channels, including the Internet, wholesale, electronic media, etc; f. Use different trademarks for goods and services that are similar but at different quality or price levels;

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g. Distribute to different dealers or licensees that may be exempt from franchise laws, such as large or sophisticated entities, schools and colleges, entertainment and sports complexes, airports, military bases and government facilities, a licensed department retail and hotel chains, etc. Even if franchisors have the legal right to run dual distribution systems, as discussed above in Sections III and IV, franchisors should structure the dual systems to not cannibalize one another or cause customer confusion. There may be issues as to whether the dealer or license system is covered by the franchise laws, or is exempt from them, as discussed in Sections I and II above. If the dealer or license agreement is being offered to existing franchisees, this may assist with such issues. As to existing franchisees, the definition of franchise may not be implicated, because it may be considered just an additional part of the existing business, not a new business, under relevant definitions. Or exemptions might apply, such as the fractional franchise or sophisticated investor exemptions discussed in Section II above. Even if such exemptions donâ&#x20AC;&#x2122;t exist in some states, state regulators may be persuaded to grant discretionary exemptions if the offer will only be made to experienced franchisees exempt under the FTC Rule. SUMMARY In deciding whether to convert to or from a franchise or non-franchise distribution system, each business has unique business and legal considerations. This paper has hopefully addressed those business and legal issues, and therefore can be used as a checklist to assist in covering the relevant issues. Some businesses do better under a dealership model (e.g. car dealers and gas stations), and others under a franchise model (e.g. restaurants and convenience stores). Others are more mixed, or can find exemptions from the franchise laws that allow many of the same benefits (e.g. coffee retail cafes). We lawyers must explain to credulous clients that when a business wants a business structure that involves all of the definitional elements of a franchise and exemptions are not available, franchise compliance must occur. Our clients want us to find creative solutions that will allow franchise compliance to be avoided, but we must explain that doing so must involve changing the business model, in reality as well as in the contracts. Once a decision is made as to a franchise or non-franchise distribution system, there may also be business and legal issues in the conversion process of one to the other, discussed in detail above.

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