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Avoiding Accidental Franchise Pitfalls

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Most people think they know a “franchise” when they see one—McDonald’s, Subway, 7-Eleven, Anytime Fitness, to name a few. However, there are some franchise relationships that are not so obvious. Many business relationships, including those in manufacturing and distribution, could easily become “accidental” franchises if companies are not careful. Becoming an accidental franchise can bring significant ramifications most manufacturers do not appreciate until it’s too late. For example, a manufacturer that terminates its distributor may find itself in court, defending against alleged violations of state franchise relationship laws. These manufacturer/distributor relationships can also sometimes unwittingly trigger administrative investigations, penalties, and fines from state franchise regulators. 

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The good news? These problems can be mitigated by understanding what a franchise is and what steps can be taken to avoid falling prey to an accidental franchise. 

Franchise Defined

The definition of a franchise boils down to three elements: (1) a marketing plan, (2) a substantial association with the franchisor’s trademark, and (3) the payment of a franchise fee.  Identifying these factors will help minimize the risk of an accidental franchise. Keep in mind; it is entirely irrelevant what the parties call their agreement or relationship. Substance prevails over form. 

This was certainly the case in Master Abrasives Corp. v. Williams, wherein the Indiana Court of Appeals held that a “distribution agreement” was really an accidental franchise.[1] The distributor in that case paid the manufacturer $3,000 for the selling rights to the manufacturer’s trademarked product, which triggered the second and third franchise elements. The court also determined the distribution agreement contained a “marketing plan,” based on the following items: (1) the state was divided into marketing areas; (2) the manufacturer had the right to establish sales quotas; (3) the manufacturer had the right to approve or disapprove of the distributor’s employees; (4) the distributor’s employees were required to attend sales training conducted by the manufacturer at which the employees were given quotation sheets, invoices, and other sales forms; (5) the manufacturer instructed the distributor’s employees as to what types of customers should be contacted; and (6) the manufacturer established a policy on giving sample products. Although subsequent cases acknowledge these factors are not exhaustive, this case demonstrates that accidental franchises can and do happen. 

Why Franchise Laws Matter

Federal law, including Federal Trade Commission (“FTC”) regulations, governs the sale of franchises in all 50 states and requires franchisors to provide a prospective franchisee with a Franchise Disclosure Document at least 14 days before it pays any fees or signs a franchise agreement. The Franchise Disclosure Document must contain certain information, and the list of required disclosures is extensive. Like the FTC, several states have their own specific laws governing the offer and sale of franchises. In Indiana, for example, prior to offering or selling a franchise, franchisors must first file and register their Federal Disclosure Documents with the Indiana Secretary of State, Securities Division. 

In addition to these mandatory disclosure and registration laws (prior to the sale of a franchise), several states also have laws governing the relationship between franchisors and franchisees, often imposing additional duties upon franchisors. The Indiana legislature, for example, has enacted the Indiana Deceptive Franchise Practice Act, which governs a franchisor’s ability to terminate a franchise agreement and bars certain acts and practices of the franchisor, such as discriminating between similar franchisees and unfair competition.

Manufacturers who inadvertently enter into distribution agreements with third parties, which the law would classify as a “franchise,” do not know these additional disclosure, registration, and relationship obligations exist. And yet the penalties for violating these laws can be severe, including civil penalties imposed by the government and/or civil damages pursued by the “franchisee.” These potential claims can also become ammunition for a distributor who is otherwise being terminated and wants to pursue its own claims against the manufacturer and/or wants to leverage a buyout of the distributor’s business under the threat of alerting other distributors (or state regulators) to the potential franchise-related claims. 

Avoiding an Accidental Franchise

It is possible for manufacturers to avoid application of the franchise laws, though it is admittedly sometimes easier said than done. Each state, for example, does not apply the same standard for establishing the elements of a franchise.   

Practically speaking, there is typically little dispute whether the distributor enjoys a substantial association with the manufacturer’s trademarks. Rather, manufacturers hoping to avoid the accidental franchise should pay particular attention to the “marketing plan” and “franchisee fee” elements. 

The existence of a marketing plan is a fact-specific inquiry where manufacturers can protect themselves with a proactive approach. To determine whether a marketing plan exists, Indiana courts have looked at whether the purported franchisee is able to make business and marketing decisions free of restrictions or consent of the purported franchisor, whether there are certain sales quotas that must be satisfied, and whether the purported franchisor mandates specific training. The less control the manufacturer retains, the less likely a “marketing plan” is established.  

Manufacturers should also be careful about the types and names of payments the distributors pay for the right to distribute products. Critically, Indiana (as well as other states) exclude from its definition of a “franchisee fee,” payments which do not exceed the bona fide wholesale price of goods—in other words, inventory purchased for resale. Thus, when a distributor’s only payment is for the bona fide wholesale price of goods, a distribution agreement is not a franchise, because there is no franchise fee involved. However, if the distributor is required to pay a separate fee for the right to sell the goods, in addition to purchasing inventory at the bona fide wholesale price, that additional fee could trigger the franchise element. 

At the end of the day, each business arrangement is different. The world of franchising can be complex; manufacturers should be careful not to cross the line. Otherwise, they could create an accidental franchise relationship, which can necessitate complex regulatory compliance and potentially result in costly fines and penalties for noncompliance and create unintended leverage for disgruntled or terminated distributors. 

For more information, contact Christina Fugate (317) 236-2374 or George Gasper (317) 236-2275.

 

[1] 469 N.E.2d 1196 (1984).   

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