When Does Trademark Licensing Become Franchising?

When Does Trademark Licensing Become Franchising?
Intellectual Property Section – Maryland State Bar Association
Published Fall 2009
By: David L. Cahn & Jeffrey S. Fabian

An issue that we often confront is determining whether a trademark license that a client wants to offer will be considered a franchise. Because franchising is a method of business expansion regulated by the Federal Trade Commission (“FTC”) and numerous states, including Maryland, whether a trademark license is, in fact, a franchise is of substantial importance in terms of the legal and accounting expenses required to offer the license. Only a careful and methodical analysis of a trademark licensing relationship’s structure, goals, and flexibility can determine whether it will constitute a franchise. While it is relatively easy to avoid the franchise definition in structuring a license for the sale of goods, including computer software, it is difficult to do so in licensing service marks.

The definition of a “franchise” varies from state to state; however, most definitions include three common elements, which appear in the Maryland Franchise Registration and Disclosure Law:

“Franchise” means an . . . agreement in which: (i) a purchaser is granted the right to engage in the business of offering, selling, or distributing goods or services under a marketing plan or system prescribed in substantial part by the franchisor; (ii) the operation of the business under the marketing plan or system is associated substantially with the trademark, service mark, trade name, logotype, advertising, or other commercial symbol that designates the franchisor or its affiliate; and (iii) the purchaser must pay, directly or indirectly, a franchise fee. Md. Bus. Reg. § 14-201(e)(1).

Unless all three elements are present, the relationship will not be deemed a franchise under Maryland law, and the benefits and protections of the disclosure and relationship laws will not apply. However, it is important to note that in a small minority of states, including New York, only two of the elements are required for a relationship to be deemed a franchise.

The first element of the franchise definition requires that the franchisee be “prescribed” a “marketing plan” by the franchisor. Elements suggesting the existence of a marketing plan include: “(1) [p]rice specification . . . or discount plans; (2) Sales or display equipment or merchandising devises; (3) Sales techniques; (4) Promotional or advertising . . . ; [and] (5) Training regarding the promotion, operation, or management of the business . . . .” COMAR § In addition, the FTC has specified that, “restrictions on customers” and “location or sales area restrictions” are hallmarks of a franchise. FTC Informal Staff Advisory Opinion 98-4, Bus. Fran. Guide (CCH) ¶ 6493 (June 8, 1998); see also Franchise Rule Compliance Guide, 16 C.F.R. Part 436 (2008) at 2–3.

The analysis of prescription considers whether the parties’ agreement or the licensor’s representations suggest or require: (1) that the franchisee follow an operating plan or training manual; (2) that the franchisee purchase a substantial portion of its inventory or equipment solely from designated or approved suppliers; or (3) that the franchisee is limited as to the “type, quantity, or quality” of the products or services it sells. COMAR §

The second element of the franchise definition requires that the franchisee’s business be substantially associated with the franchisor’s trademark. A business that identifies itself using a licensor’s trademark is clearly substantially associated with that mark. See Grand Light & Supply Co., Inc. v. Honeywell, Inc., 771 F.2d 672, 677 (2d Cir. 1985); Wright-Moore Corp. v. Ricoh Corp., 980 F.2d 432, 436 (7th Cir. 1992). However, if the licensee is not dependent on the licensor’s trademark for a substantial portion of its business, no franchise will exist. Compare Hartford Electric Supply Co. v. Allen-Bradley Co., Bus. Fran. Guide (CCH) ¶ 11,685 (Conn. Sup. Ct. 1999) (substantial association found) with Rudel Machinery Co. v. Giddings & Lewis, Inc., Bus. Fran. Guide (CCH) ¶ 11,716 (D. Conn. 1999) (substantial association not found).

The third element is payment of a franchise fee. Maryland defines a franchise fee as any payment “required or agree[d] to . . . for the right to enter into a business.” Md. Bus. Reg. § 14-201(f)(1). The timing, method, number and classification of payments are virtually irrelevant. See COMAR §; see also To-Am Equipment Co. v. Mitsubishi Caterpillar Forklift America, Inc., Bus. Fran. Guide (CCH) ¶ 11,456 (7th Cir. 1998) (purchase of $1,600 in sales and service manuals over many years constituted a franchise fee). Indirect or “hidden” franchise fees may be found to exist where the franchisor charges the franchisee above fair market value for equipment or inventory. Bucciarelli v. Nationwide Mutual Insurance Co., Bus. Fran. Guide (CCH) ¶ 14,200 (E.D. Mich. 2009). However, payments amounting only to ordinary business expenses will not trigger the franchise definition. Jon K. Morrison, Inc. v. Avis Rent-A-Car Systems, Inc., Bus. Fran. Guide (CCH) ¶ 12,701 (W.D. Wash. 2003).

Common questions considered in determining whether a payment constitutes a franchise fee include: (1) whether the payment is for an “unrecoverable investment”; and (2) whether the franchisee must put its own money at risk. Adees Corp. v. Avis-Rent-A-Car System, Inc., Bus. Fran. Guide (CCH) ¶ 12,702 (C.D. Cal. 2003) citing Wright-Moore Corp. v. Ricoh Corp., 980 F.2d 432, 436 (7th Cir. 1992) (grantor’s deduction from independent salesperson’s commission is not a franchise fee); compare Lobdell v. Sugar ‘n’ Spice, Inc., 33 Wash. App. 881, 891–92, 658 P.2d 1267 (1983) (initial charges to a sales agent intended to recover training and marketing expenses constitute a franchise fee).

If these three elements are satisfied, the parties’ relationship constitutes a franchise, and it is governed by the FTC’s Revised Franchise Rule and any applicable state relationship and disclosure laws. The broad definition of a “franchise” is intended to encompass the vast majority of “business format” licenses, and those who attempt to skirt the franchise definition are treading on dangerous and uncertain ground. However, in appropriate circumstances, careful drafting and clear delineation of the parties’ rights and obligations in a proposed relationship can help manufacturers and licensors steer clear of the franchise realm.

David L. Cahn is founder of and partner at Cahn & Rifkin, LLC, t/a Franchise & Business Law Group.

Jeffrey S. Fabian is an associate at Cahn & Rifkin, LLC, t/a Franchise & Business Law Group.