Franchising in the United States: overview

A Q&A guide to franchising in United States.

The Q&A provides an overview of the main practical issues concerning local and international franchising, including: current market activity; franchising regulatory framework; contractual issues relating to franchising agreements (analysing pre-contract disclosure requirements, formalities, parties' rights and obligations, fees and payments, term of agreement and renewal, termination and choice of law and jurisdiction); Operations Manual; liability issues; intellectual property; real estate; competition law; employment issues; dispute resolution; exchange control and withholding; and proposals for reform.

To compare answers across multiple jurisdictions, visit the Franchising: Country Q&A tool.

This Q&A is part of the global guide to franchising law. For a full list of jurisdictional Q&As visit www.practicallaw.com/franchising-guide.

Contents

Market

1. What have been the main developments in the franchising market over the past 12 months?

The main developments in the franchising market over the past 12 months include the following:

  • Misclassification cases. These cases analyse whether franchisees should be classified as employees of the franchisor rather than as independent contractors (see Question 37).

  • Joint employer cases. These cases analyse whether franchisors exert the type and degree of control over franchisees' operations that would warrant a finding that the franchisor is a joint employer of the franchisee's employees.

  • In September 2014, the Franchise and Business Opportunity Project Group (Project Group) of the North American Securities Administrators Association (NASAA) adopted a Multi-Unit Commentary, which provides guidance on how multi-unit franchise arrangements (including master franchises, area development arrangements and area representation arrangements) must be disclosed.

  • In October 2015, the NASAA published for comment a Financial Performance Representation Commentary, which clarifies disclosure requirements for financial performance representations. The Project Group is evaluating the comments received.

 
2. What are the most commonly used methods of local and international franchising?

Local franchising

US franchisors typically use a base unit franchise structure in which the franchisor grants the franchisee one franchise agreement for each franchised unit. Franchisors can combine the unit franchise structure with a multi-unit structure, most typically an area development or area representation structure.

Under an area development arrangement, the franchisor enters into a development agreement with an "area developer", granting the area developer rights to open multiple units in a designated geographic area over a specified period of time in accordance with a development schedule. As each unit is developed, the area developer or its affiliates enter into separate unit franchise agreements with the franchisor. On expiration of the term or completion of the development schedule, the development agreement expires and the franchised units continue to be operated under the unit franchise agreements. The area developer typically pays a development fee, which can be credited against the initial franchise fee for the unit franchises.

Under an area representation arrangement, the franchisor enters into an area representation agreement with an "area representative," granting the area representative the right to solicit third parties to enter into unit franchise agreements directly with the franchisor. The area representation agreement typically requires the area representative to provide post-sale support to unit franchisees in the area representative's territory. The area representative:

  • Pays a separate fee to the franchisor.

  • Typically receives a portion of the fees paid by the unit franchisees in its territory for its services.

Area representation arrangements can be regulated as sub-franchises under certain state franchise laws, but true sub-franchise arrangements are rare domestically. In true sub-franchise arrangements (also called master franchise arrangements), the sub-franchisor can enter into unit franchise agreements directly with third party franchisees, and provides support to those unit franchisees. The sub-franchisor typically pays to the franchisor:

  • An initial fee to secure the sub-franchise rights.

  • A portion of the fees paid by the unit franchisees.

The lack of contractual privity between the franchisor and the unit franchisees is a weakness of this type of arrangement.

The offer of an area development arrangement can be combined with the offer of a unit franchise arrangement in one franchise disclosure document, and only one registration is required in states that have franchise registration laws (see Question 5). The area representation arrangement and the sub-franchise arrangement constitute offerings distinct from the unit franchise offering. They must be disclosed and registered separately from the unit franchise arrangement.

International franchising

A number of US franchisors use master franchise agreements when expanding internationally. They contract with a local entity (master franchisee) to develop the franchisor's brand in a particular geographic area according to an agreed schedule, through unit franchise agreements entered into between the master franchisee and its affiliates and/or third parties.

A US franchisor may enter into area development and/or unit franchise agreements directly with the local entity when either:

  • The international market is close to the US (for example, Canada or Mexico).

  • The unit investment is significant and unit operations are complex (for example, a hotel or casual dining restaurant).

Where the parties agree that it is appropriate for the franchisor to invest more significantly in the market, the franchisor or an affiliate and the local entity may form a joint venture entity. That entity then enters into franchise arrangements with the franchisor.

 
3. Are there any specific reasons for an overseas franchisor to use a separate entity for entering into a franchise agreement with a franchisee in your jurisdiction?

There is no prohibition on a non-US entity acting as a franchisor in the US. However, audited financial statements for the franchisor (or its affiliate or parent with a guarantee of the franchisor's obligations) that are prepared in accordance with US generally accepted accounting principles must be included in the franchisor's franchise disclosure document. Therefore, from a practical perspective, it is often easier for a non-US brand owner entering the US through franchising to form a US entity to act as the franchisor and provide audited financial statements for that entity.

 

Regulation of franchising

4. What is the legal definition of franchising and/or a franchise?

The Federal Trade Commission (FTC) defines a franchise as 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 (16 Code of Federal Regulations, §436.1(h) (2007)):

  • The franchisee will obtain the right to:

    • operate a business that is identified or associated with the franchisor's trade mark; or

    • offer, sell or distribute goods, services or commodities that are identified or associated with the franchisor's trade mark.

  • The franchisor will:

    • exert or have 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.

  • 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.

The state law definitions of a franchise are generally consistent with the definition above. However, instead of the "significant assistance/control" element, most state statutes require a marketing plan or system prescribed in substantial part by the franchisor.

A few state statutes substitute a "community of interest" element for the FTC Franchise Rule's "significant assistance/control" element. They require that the franchisor and franchisee have a community of interest in the marketing of the franchised business's goods or services.

New York's franchise law defines a franchise more broadly than any other state statute. In contrast to the other state franchise laws where all three elements discussed above (trade mark, marketing plan (or community of interest) and fee) must be present for a franchise to exist, in New York, either of the first two elements combined with the fee element will result in a franchise.

 
5. What are the laws regulating franchising?

Franchising in the US is regulated both federally and at the state level. The general rule in the US is that:

  • Franchisors must comply with both federal and state franchise laws.

  • The law that is the most protective of the franchisee prevails.

At the federal level, franchising is governed by the Federal Trade Commission's (FTC) trade regulation rule entitled Disclosure Requirements and Prohibitions Concerning Franchising (16 Code of Federal Regulations (CFR), Part 436 (2007)) (FTC Franchise Rule). Federal registration is not required. The FTC Franchise Rule applies in all 50 states and US territories and protectorates (including the District of Columbia, Puerto Rico, Guam and the US Virgin Islands).

The FTC Franchise Rule requires franchisors to make prescribed disclosures to prospective franchisees 14 calendar days before the prospective franchisee can either:

  • Sign a binding agreement relating to the franchise.

  • Pay any money to the franchisor or its affiliates.

The following states have franchise registration and disclosure laws that require franchisors to register the franchise before making an offer or sale:

  • California.

  • Illinois.

  • Indiana.

  • Maryland.

  • Michigan.

  • Minnesota.

  • New York.

  • North Dakota.

  • Rhode Island.

  • South Dakota.

  • Virginia.

  • Washington.

Hawaii and Wisconsin require that the franchise be registered before a sale. Oregon has a state franchise sales law but does not require registration.

These states also require pre-sale disclosure. While most have adopted the 14 calendar-day disclosure period required by the FTC Franchise Rule, the disclosure period differs in some states.

Another federal trade regulation rule (Disclosure Requirements and Prohibitions Concerning Business Opportunities (16 CFR Part 437)) regulates the offer and sale of business opportunities. 26 states also regulate the offer and sale of business opportunities.

A "business opportunity" is generally defined broadly enough to include traditional franchises. However, exemptions or exclusions from the application of most business opportunity laws will apply if a franchisor:

  • Complies with the FTC Franchise Rule.

  • Has a federally registered trade mark.

  • Does not offer money-back guarantees.

Filings must be made to perfect an exemption from the business opportunity laws of Connecticut, Florida, Kentucky, Nebraska, Texas and Utah. The Connecticut filing requirement applies if a federal trade mark registration is obtained on or after 1 October 1996.

The FTC Franchise Rule, state franchise registration and disclosure laws, and the business opportunity laws regulate the offer and sale of franchises.

Additionally, about 21 states also have "franchise relationship" laws. These laws regulate major relationship issues such as:

  • Termination.

  • Renewals.

  • Transfers.

  • Sourcing.

  • Other issues, including the prohibition of discrimination among similarly situated franchisees.

State relationship laws override provisions of a franchise agreement that are inconsistent with these laws.

 
6. What is the regulatory authority responsible for enforcing franchising laws and requirements in your jurisdiction?

The Federal Trade Commission regulates franchising at the federal level.

In addition, there are 15 states that have franchise registration and disclosure laws (see Question 5). The relevant regulatory authority in each state is responsible for the enforcement of that state's franchise laws.

 
7. Must the franchisor be registered with a professional or regulatory body before setting up a franchise system?

Certain states require registration of the franchise before offers or sales can be made (see Question 5).

There is no legal requirement to register the brand's trade mark before offering or selling a franchise, although registration is advisable. Franchisors may lose certain business opportunity law exemptions if they do not offer the franchise in conjunction with a federally registered trade mark.

 
8. Is there a code of ethics or other means of promoting ethical franchising in your jurisdiction?

The International Franchise Association (IFA) has a Code of Ethics that is intended to establish a framework for IFA members to implement best practices in franchise relationships. The IFA Code of Ethics is not legally binding, but it contains general guidelines relating to:

  • Mutual respect among franchisees and franchisors.

  • Compliance with the law.

  • Appropriate conflict resolution.

 
9. Do franchisees benefit from any laws designed to protect consumers or small businesses?

The Federal Trade Commission (FTC) Franchise Rule and state franchise laws are considered to be consumer protection laws. There is no private right of action under the FTC Franchise Rule. Only the FTC can initiate enforcement actions under that Rule.

State franchise registration and disclosure laws and state franchise relationship laws grant franchisees a private right of action. In addition to these laws, a number of states have enacted consumer protection laws (referred to as Little FTC Acts). These are modelled on section 5(a)(1) of the Federal Trade Commission Act (15 United States Code §45(a)(1)), which prohibits unfair or deceptive acts or practices. Franchisees may or may not have standing to bring claims under a state Little FTC Act.

 
10. Are there any other requirements which must be met before a business can sell a franchise?

There are no other requirements that must be met before a business can sell a franchise.

 

Franchise agreement

Pre-contract disclosure requirements

11. Is the franchisor subject to any general or formal pre-contract disclosure requirements?

Under the Federal Trade Commission's Franchise Rule (FTC Franchise Rule), franchisors must provide prospective franchisees a franchise disclosure document (FDD) 14 calendar days before the prospective franchisee either:

  • Signs a binding agreement relating to the franchise.

  • Pays any money to the franchisor or its affiliates.

The FDD must include 23 disclosure items, which cover the following matters:

  • A description of the franchisor, its parents, predecessors and affiliates and a description of the franchise opportunity.

  • Business experience of the franchisor's officers, directors and management personnel.

  • Material litigation and bankruptcy information.

  • Initial and ongoing fees.

  • Estimated initial investment to open a franchise.

  • Sourcing requirements and restrictions.

  • Terms of any financing offered by the franchisor.

  • Assistance provided by the franchisor, including site selection, manuals and training, point of sale and computer systems, and advertising.

  • Territorial protections and restrictions.

  • Trade marks, patents and copyright material to the franchise.

  • Franchisee's obligation to participate in the franchised business.

  • Restrictions on what the franchisee can sell.

  • Summary of the key franchise agreement terms in chart form.

  • Public figure participation.

  • Financial performance representations, if any.

  • Company-owned and franchised outlet information.

  • Franchisor's financial statements.

  • Franchise seller information.

  • Copies of the material agreements as exhibits.

State franchise laws may require additional information. Franchisors can use a single multi-jurisdictional FDD to satisfy both federal and state law disclosure requirements. Additional information required by state law is typically included in a state cover page and state-specific addenda to the FDD and franchise agreements.

The FTC Franchise Rule only applies to franchises to be operated in the US or its territories.

If an exemption applies, the FTC Franchise Rule does not require pre-sale disclosure, although disclosure may still be required under the applicable state law. The five main exemptions are the (FTC Franchise Rule):

  • Minimal payment exemption, which applies if the franchisee pays to the franchisor less than US$570 within the first six months of operation.

  • "Fractional franchise" exemption, which applies if:

    • the prospective franchisee has more than two years of experience in the same type of business; and

    • there is a reasonable basis for anticipating that sales from the franchise will not exceed 20% of the franchisee's total dollar volume in sales during the first year of operation.

  • Large investment exemption, which applies if an individual invests US$1,143,100 or more.

  • Large franchisee exemption, which applies if the franchisee has:

    • a net worth of at least US$5,715,500; and

    • at least five years of experience.

  • Insider exemption, which applies if one or more purchasers of at least a 50% interest in the franchise either:

    • within 60 days of the franchise purchase has been, for at least two years, an officer, director or general partner of the franchisor, or an 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 franchise purchase has been, for at least two years, an owner of at least a 25% interest in the franchisor.

The amounts listed above are as of 1 July 2016. The FTC can adjust these monetary thresholds every four years for inflation.

There are also exemptions for:

  • Petroleum marketers and resellers protected by the Petroleum Marketing Practices Act.

  • Leased departments.

  • Oral contracts.

Many of the state franchise registration and disclosure laws also include exemptions. These exemptions vary from state to state and from the exemptions under the FTC Franchise Rule. State exemptions can be:

  • Exemptions from registration and disclosure, or from registration only.

  • Based on the franchisor's experience and net worth, or on the characteristics of the franchisee or of the transaction.

There is no private right of action for disclosure violations under the FTC Franchise Rule. State franchise laws grant franchisees private rights of actions for violations of registration and disclosure requirements. Disclosure violations can also give rise to common law claims. The FTC and state franchise administrators can initiate enforcement proceedings. See also Question 9.

 
12. Must the franchisor disclose fairly and in good faith all facts material to the prospective franchisee's decision to enter into the arrangement, or must the prospective franchisee rely on its own due diligence?

Pre-sale (and at the state level, pre-offer) franchise disclosure must be made to all prospective franchisees (see Question 11).

Under the Federal Trade Commission's Franchise Rule (FTC Franchise Rule), the franchise disclosure document must include:

  • All information that must be disclosed under that Rule.

  • Only the information required or permitted to be disclosed by that Rule.

  • All information required/permitted under any state law that is not pre-empted by the FTC Franchise Rule.

There is no broad requirement to disclose "all material facts" under the FTC Franchise Rule. There is also no broad prohibition against misleading statements made in connection with the sale of a franchise, but franchise sellers cannot make claims or representations that contradict the information required to be disclosed.

Most state franchise laws have broad prohibitions against false statements, omissions of material facts and deceptive conduct. Additionally, at common law, even in non-registration states (see Question 5), a franchisor can be liable for misrepresentation or fraudulent inducement if it makes material misstatements or omits material facts during the franchise sales process.

Formalities

13. What are the formal contractual requirements to create a valid and binding franchise agreement?

There is no legal requirement for the franchise agreement to be in English, although that is the practice in the US. There are no notarisation or other formal contractual requirements.

Under the Federal Trade Commission's Franchise Rule, the franchise disclosure document must be in plain English.

A franchise agreement is considered to be a general commercial contract. However, most US franchise agreements include an express licence to use the brand's trade marks and other IP.

Parties' rights and obligations

14. Is there a general obligation to behave fairly, reasonably or in good faith to the other party during the term of the franchise agreement?

Obligations of the franchisee

The Federal Trade's Commission Franchise Rule does not impose a general good faith or similar obligation on either the franchisee or the franchisor. However, some state franchise relationship laws do. For example, the Hawaii franchise law requires both parties to deal with each other in good faith (section 482E-6(1)). The Washington Franchise Investment Protection Act includes an identical provision.

Obligations of the franchisor

In addition to the obligation of good faith imposed on both parties under certain state franchise relationship laws, some of these laws contain restrictions on the franchisor in relation to certain types of unfair or unreasonable behaviour. For example, Indiana's Deceptive Franchise Practices Act makes it unlawful for a franchisor to:

  • Compete unfairly with the franchisee within a reasonable area, if no exclusive territory is granted (section 2(4)).

  • Unreasonably fail or refuse to comply with the franchise agreement terms (section 2(5)).

The common law of many states includes an implied covenant of good faith and fair dealing. Although the applicability and scope of the implied covenants vary, they can be used in certain situations to limit the franchisor's contractual discretion by allowing a court to apply a "reasonableness" standard.

 
15. Does local law require that particular provisions must be expressly included in a franchise agreement?

A franchisor cannot disclaim, or require a prospective franchisee to waive reliance on, representations made in the franchise disclosure document (FDD), its exhibits or amendments (section 436.9(h), Federal Trade Commission's (FTC's) Franchise Rule).

The FTC's staff stated that a general release in a franchise agreement (or in any other document that a franchisee must sign as a condition of obtaining the franchise) violates that prohibition unless the release expressly excludes claims arising from representations in the FDD, its exhibits or amendments. See number 34 of the FTC's frequently asked questions at: www.ftc.gov/bcp/franchise/amended-rule-faqs.shtml.

 
16. Are exclusion and entire agreement clauses enforceable in your jurisdiction? If so, are they effective to protect the franchisor?

Entire agreement (or integration) provisions are generally enforceable. However, the Federal Trade Commission's Franchise Rule prohibits a franchisor from disclaiming, or requiring a prospective franchisee to waive reliance on, any representation made in the disclosure document or in its exhibits or amendments (see Question 15). Therefore, an integration clause in a franchise agreement cannot be used by a franchisor to limit liability based on incomplete or otherwise improper disclosure.

 
17. Can the franchisor impose product tying or other purchasing restrictions and non-compete obligations on the franchisee during the term of the agreement?

Restrictions on purchasing and product tying

A franchisor can require franchisees to buy products and services only from the franchisor or its designated or approved suppliers. Under the Federal Trade Commission's Franchise Rule and applicable state franchise laws, these sourcing requirements must be disclosed in the franchise disclosure document. Sourcing requirements are subject to certain limitations under:

  • Federal and state anti-trust laws.

  • State franchise relationship laws.

Franchisees can challenge a sourcing requirement as an illegal tie under the anti-trust laws. Under a tying arrangement, the seller conditions the sale of one product (tying product) on a requirement that the buyer also purchase another unwanted product (tied product) from the seller. In franchising, the tying product is typically alleged to be the franchise itself and the tied product is the item that the franchisor requires the franchisee to purchase.

A number of elements must be proved to establish an illegal tie. In recent years, cases have focused on the element that requires the franchisor to possess "market power" in the market for the tying product. In Eastman Kodak Co. v Image Tech. Servs., 504 U.S. 451 (1992), the US Supreme Court held that a market can consist of a single brand if the buyer is "locked in" to the seller, that is, it is both:

  • Unaware of, or unable to assess, the economic impact of the purchasing requirement at the beginning of the relationship.

  • Unable to make a change during the relationship because of the high cost of "switching".

The requirement under federal and state franchise laws to disclose sourcing requirements before the sale of a franchise have mitigated the impact of this type of decision on US franchisors.

Certain state franchise relationship laws also place limitations on sourcing requirements. Under the Hawaii law, it is an unfair or deceptive act or practice to require a franchisee to buy or lease goods or services from the franchisor (or from designated suppliers) unless the purchasing requirements are reasonably necessary for a lawful purpose justified on business grounds (Hawaii Rev. Stat. Title 26, Chapter 482E. section 482E-6(2)(B)). The Indiana Deceptive Franchise Practices Act and the Washington Franchise Investment Protection Act include similar provisions (Indiana Code Title 23, Article 2, Chapter 2.7, section 1(1); Washington Code, section 19.100.180(2)(b)).

Non-compete obligations and transfer restrictions

Non-compete obligations. The enforceability of non-compete obligations during the term of the franchise agreement is primarily governed by state statutes or the common law. The law that determines whether a covenant is enforceable is the law of the state where the franchise is located, not the law chosen to govern the interpretation of the franchise agreement.

Generally, to be enforceable, non-compete covenants must be:

  • Reasonable in duration, geographical scope and scope of activity that is restrained.

  • Only as broad as is necessary to protect the legitimate business interests of the beneficiary of the covenant.

Many states do not distinguish between in-term and post-term non-compete obligations, but some do. Subject to certain limited exceptions, post-term non-compete covenants are void in California. (sections 16600 et seq., California Business and Professions Code (1976)). However, in-term non-compete covenants are not void if they do not foreclose competition in a substantial share of a business, trade or market (Comedy Club, Inc. v Improv West Associates, 553 F.3d 1277 (9th Cir. 2009)).

Transfer restrictions. Certain state franchise relationship laws limit the ability to require the franchisee to obtain the franchisor's consent before transferring the franchised business or ownership interests in the franchisee entity. For example, under California's Franchise Relations Act, a franchisor cannot withhold its consent to a transfer unless either (section 20028):

  • The buyer fails to satisfy the franchisor's then-existing standards for new or renewing franchisees.

  • The selling franchisee and the buyer fail to comply with the conditions of transfer set out in the franchise agreement.

Fees and payments

18. What fees are usually payable by the franchisee? Are there any restrictions on the parties' freedom to set the fees and payments, or any other payment requirements?

Franchisors usually charge an initial franchise fee and an ongoing royalty (generally a percentage of gross sales). Franchisors often also require payment of an advertising fee or contribution (also often a percentage of gross sales) to the franchisor or to an advertising fund administered by the franchisor and/or a local advertising expenditure (paid to third parties).

Franchisees must often pay fees at certain points in the relationship (for example, a renewal fee on renewal and a transfer fee on transfer of the franchise). In some industries (for example, the hotel and car rental industries), franchisors charge a number of service-based fees, such as reservation system fees, revenue management fees and computer system fees.

Interest can be charged on late payments, subject to applicable usury laws.

Term of agreement and renewal

19. Are parties free to agree on the term of the franchise agreement? What is the typical term of a franchise agreement in your jurisdiction?

Franchisors and franchisees can agree on the term of the franchise agreement. No law imposes a specific minimum or maximum term.

While the terms vary, a ten-year initial term is not uncommon. Under current practice, it is rare to grant a franchise agreement with a term of more than 20 years or less than five years.

 
20. What rights of renewal are usually included in the franchise agreement? Are fees paid on renewal?

Commercial practice

The grant of renewal rights is typical in franchise agreements. Generally, the franchisee can renew the franchise agreement if certain conditions are met (including paying a renewal fee, signing the then-current form of franchise agreement, upgrading the franchised unit and signing a general release).

The franchisor can grant a right to one or more renewal terms for a specified number of years (for example, one ten-year renewal term or two five-year renewal terms).

Local law

Generally, franchisors are not required to grant the franchisee a right to renew. However, the position is different under certain states' franchise relationship laws (for example, New Jersey).

If renewal rights are included in a franchise agreement, state franchise relationship laws generally prevent the franchisor from refusing to renew without good cause. A franchisee's failure to meet the requirements for renewal set out in the franchise agreement is generally considered good cause.

Under California's amended franchise relationship law, which became effective in early 2016, a franchisor cannot (except under limited circumstances) refuse to renew a franchise agreement without both:

  • Giving the franchisee 180 days' prior written notice of non-renewal.

  • Allowing the franchisee to sell its business to a third party meeting the franchisor's requirements.

Termination

21. Are there any limitations on the right of a franchisor to terminate the agreement?

The franchise agreement determines the grounds on which a franchisor can terminate the agreement and the procedure for termination. Whether or not a franchisee can terminate the franchise agreement is primarily a matter of contract. This is subject to state franchise relationship laws, which may override the franchise agreement and limit the franchisor's right to terminate.

Many US franchise agreements do not include a contractual right for the franchisee to terminate, although some do.

State laws often prohibit termination by a franchisor absent good cause. "Good cause" is defined differently in the various state relationship statutes. For example, under the Washington Franchise Investment Protection Act, good cause includes, without limitation, the failure of the franchisee to comply with lawful material provisions of the franchise or other agreement between the franchisor and the franchisee, and to cure such default within the time period provided in the statute (section 19.100.180(2)(j)).

State statutes also typically require the franchisor to:

  • Provide written notice before termination.

  • Give the franchisee a right to cure any default, with statutory cure periods that are often longer than those included in franchise agreements.

Even if the termination is lawful, a franchise relationship statute may require the franchisor to compensate the franchisee for inventory, equipment or other supplies on termination (for example, see section 20022 of the California Franchise Relations Act).

Liquidated damages provisions are enforceable provided that they are a reasonable estimate of the losses that will be sustained, and not a penalty.

 
22. Are post-term restrictive covenants enforceable?

The enforceability of post-term non-compete covenants is determined by the law of the state in which the franchisee is located. Many states will enforce post-term non-compete covenants that are "reasonable" in time, geographical scope, and in relation to the scope of the activity that is restricted. However, certain states do not enforce post-term non-compete covenants (including California).

Reasonable post-term confidentiality covenants are generally enforceable in all states.

 
23. Can the franchisor or a replacement franchisee continue to sell to the former franchisee's customers?

There is typically no restriction on the right of a franchisor or replacement franchisee to sell to the former franchisee's customers without compensating the former franchisee. Franchise agreements in certain industries (for example, the hospitality industry) often recognise the franchisor's ownership of customer information.

Choice of law and jurisdiction

24. Will local courts recognise a choice of foreign law in a franchise agreement for a business operating in your jurisdiction?

In the US, the typical practice is to contractually designate the law of the state in which the franchisor is based to govern the franchise agreement (or sometimes the law of the state in which it is formed).

The courts of the various states and the federal courts routinely recognise the choice of another state's law in commercial contracts, including franchise agreements. State and federal courts may also recognise contractual clauses designating the law of a foreign country, but the practical implementation of such a provision in the context of a dispute may be cumbersome.

 
25. Will local courts recognise a choice of foreign jurisdiction in a franchise agreement for a business operating in your jurisdiction?

Local courts will uphold a forum selection clause designating a jurisdiction other than the franchisee's home state provided that the clause:

  • Was not fraudulently induced or coerced.

  • Is not overly burdensome.

  • Is not contrary to state public policy.

In Gregory Fowler v Cold Stone Creamery, Inc., the US District Court for Rhode Island upheld the forum selection clause despite the franchisee's claim that it was unconscionable, reasoning that the franchisee need not have entered into the franchise agreement.

However, enforceability may be limited by state franchise relationship laws. In Business Store, Inc. v Mail Boxes Etc., a New Jersey court found that the franchise agreement's designation of a forum outside New Jersey was contrary to public policy as expressed in the New Jersey Franchise Practices Act.

 

Operations Manual

26. How does the franchisor ensure that the franchisee complies with the business standards, systems and requirements?

Franchise agreements routinely contain provisions requiring the franchisee to comply with system standards and requirements. Franchisors monitor compliance by conducting inspections and audits of franchised outlets. Inspections can be either:

  • Formal and announced in advance.

  • Conducted by "secret shoppers" (that is, employees of the franchisor or of third parties who conduct unannounced/secret inspections).

Non-compliance with standards is typically an event of default for which the franchisor can terminate the franchise agreement after giving the franchisee notice and an opportunity to cure the default.

 
27. Can the franchisor change the Operations Manual unilaterally, as is usually required?

Franchisors can unilaterally change the Operations Manual to modify system standards. However, under common law theories and/or state franchise relationship laws, franchisees can challenge changes that either:

  • Are not reasonable under the circumstances.

  • Alter the fundamental rights and obligations of the parties.

 

Liability issues

28. What are the franchisee's remedies against the franchisor for deceptive or fraudulent selling practices?

There is no private right of action under the Franchise Rule of the Federal Trade Commission (FTC). Therefore, a franchisee cannot bring an action against the franchisor under this Rule for either failure to comply with the Rule's disclosure requirements or for deceptive or fraudulent selling practices.

However, aggrieved franchisees can bring claims for:

  • Fraudulent or deceptive franchise sales practices under applicable state franchise registration and disclosure laws.

  • In some states, acts or omissions that constitute violations of the FTC Franchise Rule under state deceptive trade practices acts or Little FTC Acts (see Question 9).

Remedies vary, but may include:

  • Monetary damages (in some cases treble damages).

  • Injunctive relief.

  • Rescission of the franchise agreement.

 
29. How can third-party claims against the franchisee be brought successfully against the franchisor?

Indemnity

US franchise agreements typically require the franchisee to indemnify the franchisor against third party claims arising from the franchisee's operation of the franchised business.

However, a third party injured by the franchisee's acts or omissions can bring a claim directly against the franchisor if it can show that either:

  • The franchisee was the franchisor's actual or apparent agent.

  • The franchisor exercised so much control over the franchisee's day-to-day operations that the franchisor should be held vicariously liable for the acts or omissions of the franchisee.

In recent years, franchisees' employees in certain franchise systems, or agencies acting on their behalf, have brought claims directly against the franchisor on the basis that the franchisor was a joint employer.

Precautions

To support the franchisee's independence from the franchisor, franchise agreements include provisions that:

  • Designate the franchisee as an independent contractor, rather than as an agent of the franchisor.

  • Require the franchisee to:

    • display notices of its separate legal status; and

    • conduct certain business operations (for example, employee relations) under its legal name, and not the franchised brand name.

Franchise agreements, manuals and other system documents should also limit the controls exercised by the franchisor to controls that are necessary to promote consistency of operations under the brand, and to protect the brand.

 

Intellectual property

30. What provisions are usually made in relation to intellectual property rights (IPRs), including know-how?

Franchisees are generally granted a non-exclusive licence to use the franchisor's designated trade marks and other IP solely for the purpose of operating the franchised business at the approved location for the term of the franchise agreement.

Franchisors typically reserve all rights with respect to IPRs, including the right to develop and operate, and license others to develop and operate, other outlets or other types of businesses under the trade marks, subject only to any territorial protections that may be expressly granted in favour of the franchisee.

Franchise agreements include:

  • Comprehensive provisions related to the franchisee's use of the franchisor's trade marks and other IP.

  • Acknowledgements by the franchisee regarding the franchisor's sole ownership of the trade marks and other IP, and the associated goodwill.

 
31. What are the registration requirements for licensing IPRs?

The licence to use the brand trade mark and the franchisor's other IPRs in the operation of the franchise is typically included in the franchise agreement. It is registered as a part of the franchise agreement, when registration is required by state franchise registration and disclosure laws.

Standalone licences of trade marks, copyright, patent rights and other IPRs generally need not be registered.

 

Real estate

32. Are consents from landlords difficult to obtain when transferring leases or granting subleases from a franchisor to a franchisee?

In the US, the majority of franchisors do not sublease the premises of the franchised outlet to the franchisee. It is more common for franchisees to lease the premises directly from a third party landlord. However, there are some very large franchise systems in which the franchisor owns or leases the premises and, in turn, leases or subleases these premises to franchisees.

Leases commonly require the landlord's consent to transfer the lease or grant subleases. Franchisors typically try to negotiate a right to transfer or sublease to qualified franchisees on notice to, but without consent of, the landlord. In either case, the franchisor can be required to:

  • Remain liable under the lease after a transfer.

  • Stay primarily liable under the master lease in a sublease scenario.

 
33. How can a franchisor prevent the franchisee from occupying the premises after the franchise agreement has ended?

If the franchisor subleases the franchised premises to the franchisee, termination or expiration of the franchise agreement triggers termination of the sublease and of the franchisee's right to occupy the premises.

If the franchisee enters into a lease for the premises directly with a third party landlord, the franchise agreement typically gives the franchisor an option to assume the lease on termination or expiration of the franchise agreement. These options generally need not be registered in order to be enforceable.

If a franchisee refuses to vacate the premises on exercise of the franchisor's option, the franchisor can seek judicial relief to compel the franchisee to vacate.

 
34. How can the franchisor effectively acquire the franchisee's premises at the end of the franchise relationship?

In addition to an option to assume the lease on termination or expiration of the franchise agreement, the agreement can also include a post-term option for the franchisor to purchase the assets of the franchised business at fair market value or based on a formula price. These options generally need not be registered in order to be enforceable.

There is generally no requirement that the franchisor pay for the goodwill associated with the business, although the parties can agree to allocate a portion of the purchase price to the goodwill of the business as a going concern.

 
35. If the franchisor leases or subleases its own site to its franchisee, can it pass on all related costs to the franchisee? Can the franchisor charge its franchisee tenant a rent expressed as a percentage of the franchisee's sales?

A franchisor that leases or subleases a site to the franchisee can freely set the commercial terms of the lease or sublease.

 

Competition law

36. What is the effect of competition law rules on franchising agreements? Are there any available exemptions?

Competition law

Federal and state anti-trust laws regulate vertical pricing and non-pricing restrictions. As a result of legal developments over the past few decades, the anti-trust laws do not impose material restrictions to the imposition of most vertical non-pricing restraints in the context of franchising.

Before 2007, minimum resale price maintenance (that is, the requirement that a franchisee charge no less than a certain amount for a product or service) was per se illegal in the US. In 2007, in the case of Leegin Creative Leather Products, Inc. v PSKS, Inc., the US Supreme Court held that minimum resale price maintenance was no longer per se illegal and that these arrangements would be judged under the "rule of reason". The ruling did not prevent states from continuing to prohibit minimum resale price maintenance under state anti-trust laws, and a number of states continue to do so (including California, New York and Illinois).

In 1997, in the case of State Oil v Khan, the US Supreme Court held that maximum resale price maintenance (that is, the requirement that a franchisee charge no more than a certain amount for a product or service) was no longer per se illegal and would be judged under the rule of reason. This ruling was viewed as pro-consumer, and maximum resale price maintenance is now generally accepted, subject to the rule of reason test.

Exemptions

There are no exemptions relevant to franchising.

Online/e-commerce restrictions

Franchisors can (and often do) prohibit franchisees from having their own website presence and from engaging in e-commerce.

 

Employment issues

37. Can a franchisee be regarded as an employee of the franchisor?

In recent years, US courts have held that a franchisee can be found to be an employee of the franchisor, rather than an independent contractor. These "misclassification" cases have focused on franchisees in the janitorial or commercial cleaning industry. The results in these cases differ and may turn, in part, on the test used to determine the franchisee's status. While the traditional test for determining employment status looks at the putative employer's right to control the person who claims to be an employee, other tests can be used depending on the jurisdiction and the claim at issue (for example, unemployment compensation).

Some states have enacted legislation in response to the misclassification cases. For example, Georgia (among other states) has passed legislation stating that individual parties to a franchise agreement are not employees (Georgia Code Ann. §34-9-1).

 

Dispute resolution

38. How are franchising disputes typically dealt with? What provisions for handling disputes are usually included in domestic franchise agreements?

Franchise agreements often provide that disputes (with some exceptions, such as claims for trade mark infringement) must first be submitted to non-binding mediation. If the parties are unable to resolve the dispute through mediation, the franchise agreement will provide for resolution of the dispute either through arbitration or litigation (usually before the courts of the jurisdiction where the franchisor is based).

 
39. How are foreign judgments or foreign arbitral awards enforced locally?

The US is a party to the Convention on the Recognition and Enforcement of Foreign Arbitral Awards 1958 (New York Convention). An arbitral award arising out of a commercial relationship (such as a franchise) and obtained in a country that is also a party to the New York Convention is enforceable by application to the US district courts, which have original jurisdiction to confirm the award.

The US is not a party to any judgment enforcement treaty. However, under the common law doctrine of comity and pursuant to the Uniform Foreign Country Money Judgment Recognition Act, federal and state courts regularly enforce foreign judgments. A list of non-exclusive grounds on which enforcement can be denied includes:

  • Lack of personal jurisdiction.

  • Lack of subject matter jurisdiction.

  • An agreement to resolve disputes in another forum.

  • Lack of notice.

  • Violation of public policy.

 

Exchange control and withholding

40. Are any exchange control or currency regulations applicable to payments to an overseas franchisor?

Other than the requirements of the Office of Foreign Asset Control (OFAC) (which may limit or prohibit payments to certain restricted persons or jurisdictions that are subject to economic or trade sanctions), there are generally no exchange control or currency regulations applicable to standard commercial cross-border remittances.

 
41. Is there a withholding obligation on payments made to an overseas franchisor?

Most types of US source income paid to foreign persons, including royalty payments, are subject to a withholding tax. The tax rate is 30% unless either:

  • An exemption applies.

  • The rate is reduced by a tax treaty between the US and the franchisor's country of residence.

The US is a party to many tax treaties, some of which reduce the withholding tax rate to 0%.

 

Reform

42. Are there any proposals to reform the laws affecting franchising?

The US Federal Trade Commission (FTC) will begin a new review process of the FTC Franchise Rule in 2017. The current FTC Franchise Rule became effective in 2007, after a rule-making process that lasted about ten years.

The franchise registration states can amend their franchise laws and regulations. New state franchise legislation is introduced from time to time. However, other than the state legislative efforts to mitigate the impact of the misclassification and joint employer cases (see Question 37), there are currently no widespread efforts to reform the laws affecting franchising in the US.

 

Contributor profiles

Will Woods, Partner

Baker & McKenzie LLP

T +1 214 978 3022
F +1 214 978 3099
E will.woods@bakermckenzie.com
W www.bakermckenzie.com

Professional qualifications. Texas, US, 1998

Areas of practice. Franchise law; international commerce.

Recent transactions

  • Represented a leading hotel company in the negotiation of a franchise agreement and related documentation for a 3,400-room resort property in the Bahamas.
  • Restructured a large luxury product retail chain's licensed boutique agreement.
  • Represented a large hotel company in the negotiation of a licence agreement and related documentation for a 3,000-room condominium hotel in Las Vegas.
  • Represented a private equity company in connection with the purchase of a large QSR franchise company with restaurants in the US and six other countries.

Languages. English

Professional associations/memberships. Dallas Bar Association; State Bar of Texas; American Bar Association.

Publications

  • Editor, "Fundamentals of International Franchising, Second Edition", American Bar Association Forum on Franchising.
  • Co-author, "Income Tax Considerations in Acquisitions and Combinations of Franchise Businesses, Mergers and Acquisitions of Franchise Companies", 2nd Edition, American Bar Association Forum on Franchising, 2014.
  • "The Dark Side of Master Franchising", International Journal of Franchising Law, Issue 5, 2013.

Ann Hurwitz, Partner

Baker & McKenzie LLP

T +1 214 978 3033
F +1 214 978 3099
E ann.hurwitz@bakermckenzie.com
W www.bakermckenzie.com

Professional qualifications. Texas, US, 1983; District of Columbia (inactive), 1981; North Carolina, US, 1980

Areas of practice. Franchise law; international commerce.

Recent transactions

  • Advised US companies, including brand leaders, on international expansion including into South Korea, the Philippines, Mexico, Canada and the Middle East.
  • Developed a US franchise programme for a large Israeli coffee shop franchise expanding into the US market
  • Provided strategic advice to a multinational car rental franchisor in connection with restructuring its franchise programme after a bankruptcy filing.

Languages. English

Professional associations/memberships. Dallas Bar Association; State Bar of Texas; American Bar Association.

Publications

  • Co-editor, The FTC Franchise Rule: Analysis and Commentary, American Bar Association Forum on Franchising, 2008 and 2012 (2nd Edition).
  • "The Dynamics of the Franchise Relationship in Today's Business & Regulatory Environment", International Franchise Association Legal Symposium, 2015.
  • "You Don't Want to be a Franchise? Structuring Business Systems Not To Qualify As Franchises", American Bar Association Forum on Franchising, 2011

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