What is a Franchise Under California Law?
By Mulcahy LLP on November 27, 2013
On January 1, 1971, the California Franchise Investment Law (the “CFIL”) became law in California, making it the first franchise-specific law in the country.
The CFIL, codified at Corporations Code sections 31000 through 31516, is designed to regulate franchisors’ dissemination of information to prospective franchisees, allowing the prospects to make informed decisions regarding their potential franchise investments. Both the registration and disclosure requirements under the CFIL closely mirror California’s Blue Sky Laws.
In short, the CFIL requires a franchisor to submit a franchise application and register a disclosure document with the Department of Business Oversight (formerly the Department of Corporations) before selling or offering to sell a franchised business in California. The comprehensive presale disclosure document must contain information regarding the franchisor's business activities, operating history, management qualifications, litigation and bankruptcy histories, cost of the franchise investment, royalty fee structure, restrictions on business activities, financing arrangements, intellectual property rights, and the financial condition of the franchisor, among other things. The franchisor is only allowed to start selling franchises in the state after the Department of Business Oversight approves of the franchisor’s application and disclosure document.
So, who is subject to these rigorous conditions, and what exactly is a franchise? Many licensors and manufacturers have found themselves in hot water after learning that their so-called “licenses” or “distribution systems” were really franchises. After all, a horse by any other name is still a horse. Failure to properly identify a business as a franchise – and comply with the CFIL’s registration and disclosure requirements – likely will result in the disruption of business operations, hefty fines, civil liability and even jail time.
The potential harsh consequences for failing to comply with the CFIL make it imperative that a business owner be able to identify whether or not the business model is a franchise.
I. The CFIL’s Definition of a Franchise
The CFIL expressly defines a franchise as:
- [A] contract or agreement, either expressed or implied, whether oral or written, between two or more persons by which:
- A franchisee is granted the right to engage in a business of offering, selling or distributing goods or services under a marketing plan or system prescribed in substantial part by a franchisor; and
- The operation of the franchisee's business pursuant to such plan or system is substantially associated with the franchisor's trademark, service mark, trade name, logotype, advertising or other commercial symbol designating the franchisor or its affiliate; and
- The franchisee is required to pay, directly or indirectly, a franchise fee.
This definition – added to the CFIL in 1974 – leaves much to be desired and provides little assistance to the business person trying to determine whether or not the business model is a franchise. Clearly, some further explanation was needed.
II. Commissioner’s Release 3-F’s Definition of a Franchise
In June 1994, the Commissioner of the then Department of Corporations, appreciating the need for better guidance for this complex issue, issued Commissioner’s Release 3-F (the “Release”) in an attempt to assist business owners and legal practitioners in determining whether an agreement constitutes a franchise. The Release sets forth certain elements of a franchise and then provides a detailed analysis of each element.
According to the Release, the four following elements must be present for an agreement to be a "franchise":
A. Granted Right to Engage in the Business
The franchisee must be granted a right “to engage in the business of offering, selling or distributing goods or services.” Thus, a person who is given the right to participate in the profits of a business, but who is given no right to operate or participate in the operation of the business, is not a franchisee. In this scenario, the relationship may be another type of legal arrangement that is subject to securities laws.
B. Operate Under Specified Marketing Plan or System
The franchisee must be given the right to operate the business “under a marketing plan or system prescribed in substantial part by the franchisor.” A franchisor’s system is one of the most important elements of the franchise – creating the centralized management and uniform standards needed to support a successful brand and, in turn, be attractive to both potential customers and prospective franchisees. If the business owner is left entirely free to operate his or her business according to the owner’s own marketing plan or system, the agreement is not likely a franchise.
According to the Release, if a franchisor reserves control over the essential operations of the business – such as, payment by customers, credit practices, warranties and representations in dealing with customers, implementation of a uniform marketing plan, required approval of site selection, use of trade names, signs and sales pitches, sources of supply, and direction over the appearance of the franchisee’s business premises – a franchise relationship likely exists.
Further, a comprehensive advertising program of the franchisor, with or without an obligation by the franchisee to participate, is indicative of a marketing plan subscribed by the franchisor, thus satisfying the second element in defining a “franchise.”
Alternatively, the Release provides that obligations imposed upon distributors to use their “best efforts” in making sales of the licensor’s product “is too general a requirement to amount to a marketing plan or system.” Where a business is merely licensing the use of a trade name for its operation without the imposition of any other marketing plan or system, a franchise does not exist. Also, a manufacturer's imposition of requirements upon a distributor that merely reflects the prevailing industry standards may not be indicative of a system or marketing plan.
While any one of the above examples may not amount to a marketing plan or system by itself, combining it with other restrictions may be sufficient to constitute the requisite marketing plan or system.
It is also worth mentioning, a marketing plan does not need to be fully developed at the time the business relationship is created. However, if a marketing plan is developed and imposed during the relationship, a franchise will have been created.
C. Use of Franchisor’s Marks
The third element of a franchise requires a franchisee’s business to be “substantially associated” with the franchisor’s commercial symbols – such as the trademark, service mark, trade name or logotype of the franchisor. For the business to be substantially associated with the franchisor’s symbol, this symbol must be communicated to the customers. It is not enough for the business to use the symbol with its vendors but not its customers. Once the symbol is communicated to the customers, a uniform operation in the form of a franchise is present.
D. Payment of a Franchise Fee
The fourth and final element that must be present for a franchise to exist is the payment, directly or indirectly, of a fee or charge from the franchisee to the franchisor for the right to enter into the business. This payment is considered a “franchise fee.”
Once again, the CFIL provides some guidance on this topic by defining a “franchise fee” to mean:
- Any fee or charge that a franchisee or subfranchisor is required to pay or agrees to pay for the right to enter into a business under a franchise agreement, including, but not limited to, any such payment for such goods or services.
Unfortunately, once again, the CFIL’s broad definition provides little assistance in unwrapping the complexities that must be considered to properly evaluate the existence of a franchise fee. The Release, however, proves to be a much better resource in this analysis.
According to the Release, a franchise fee may be payable in installments or in a single payment and may be a fixed rate or a percent of gross revenues or net income. Thus, a franchise fee may be found when calculating the difference between the wholesale price of a good sold to the franchisor, and the franchisor’s profit on selling that same good to the franchisee.
Payments made to certain affiliates of the franchisor, on behalf of the franchisor, may also constitute franchise fees. It makes no difference whether payments for goods or services are required to be made to the franchisor or to a third-party so long as the payment benefits the franchisor.
The Release provides the following examples of payments that have been found to be “franchise fees”:
- i. Performance guarantee or deposit;
- ii. Deposit of money;
- iii. Initial set-up fee;
- iv. Advertising fees;
- v. Nonrefundable bookkeeping charges;
- vi. Payments for training and school expenses;
- vii. Royalty or percentage of gross receipts;
- viii. Charges for any “kits, brochures, programs, forms, decals, shirts, displays and announcements”;
- ix. Rental or lease fees; and
- x. Payments for consultant or management services.
The Release provides some clarity into the complex issues that arise when attempting to define a franchise. While the Release is a significant improvement over the plain language of the CFIL, it does not replace the knowledge and experience of a franchise law attorney.
Disclaimer: While every effort has been made to ensure the accuracy of this article, it is not intended to provide legal advice as individual situations will differ and should be discussed with an experienced franchise lawyer. For specific technical or legal advice on the information provided and related topics, please contact Mulcahy LLP.