New York State Bar Association Corporate Counsel & Business Law Sections' Joint Fall Program Doing Business in New York State: Challenges & Opportunities
October 14, 2016 You Don't Know What You Don't Know: Challenges of Doing Business in New York State
THE INADVERTENT FRANCHISOR By
Thomas M. Pitegoff LeClairRyan New York, NY 212-34-5032
Franchise sales are regulated by both federal and state laws. The definition of a "franchise" differs somewhat among these laws. But New York has the distinction of having the franchise sales law with the broadest scope. As such it is not difficult to imagine licensors, suppliers and others being shocked to learn that their distribution systems might be deemed to be franchises under New York law.1 Both federal and state franchise sales laws require franchisors to deliver a franchise disclosure document (FDD) to each prospective franchisee. Franchise sales laws in New York and several other states require registration before the franchisor may sell franchises in the state. State examiners can require extensive changes in proposed FDDs to bring them into compliance with state regulations. The Federal Trade Commission (the "FTC") requires presale franchise disclosures throughout the U.S. under the FTC's trade regulation rule on franchising (the "FTC Rule") but does not require registration. The FTC Rule requires franchisors to make extensive pre-sale disclosures to prospective franchisees.2 Compliance with both the FTC Rule and state franchise sales laws requires, among other things, timely delivery of a disclosure document to all prospective franchisees, timely amendments of disclosure
1 See The Inadvertent Franchisor, New York State Bar Association Business Law Section, September 2011, available at https://www.leclairryan.com/files/Uploads/Documents/Inadvertent-Franchisor-2011-09-Pitegoff.pdf. See also Franchising in New York After the Revised FTC Rule, New York State Bar Association Business Law Journal, Fall 2007, available at https://www.leclairryan.com/files/Uploads/Documents/PitegoffBusLawJFall07-2.pdf. 2 Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures, 16 CFR pt. 436 (1979), Bus. Franchise Guide (CCH) 6080.
documents, and annual audited financials. In the states with franchise sales laws, compliance also requires a franchisor to amend and renewal its franchise registration periodically. Definition of a Franchise The FTC Rule defines the term "franchise" to include 4 elements:3
(1) a continuing commercial relationship (2) a trademark (3) a fee (4) significant control or assistance The definitions of a "franchise" under the state franchise sales laws are similar to the FTC definition of a "franchise".4 These definitions commonly contain the following elements: (1) the grant of a right to engage in a business (2) under a trademark (3) for a fee (4) in conjunction with a marketing plan prescribed in substantial part by the franchisor The trademark and fee elements of the state laws are parallel to the FTC Rule. However, instead of "control or assistance," the state laws generally refer to a "marketing plan or system prescribed in substantial part by a franchisor ...." Under most of these laws, all of the elements must be present in order for the arrangement to constitute a franchise. The California Franchise Investment Law definition is typical of most state franchise sales laws.5 The FTC Rule and the state franchise laws have a number of exemptions and exclusions that are not discussed in this paper.6 The New York Definition of a Franchise Of all the state franchise disclosure laws, the one with the broadest definition of a franchise is New York. The definition of a franchise in New York includes a required fee and either a trademark or a marketing plan element, but not both.7 In New York, elimination of either the marketing plan element or the trademark element will not suffice to avoid application of the New York franchise sales law. Put another way, the New York definition of a franchise has just two elements. Under the New York Franchise Sales Act ("NYFSA"), one element in the definition of a franchise is a fee. The second element is either a trademark or a marketing plan prescribed in substantial part by the franchisor.
3 See Schedule A for the FTC Rule definition of a "franchise". 4 A typical example of a franchise disclosure law franchise definition is found in the California Franchise Investment Law. See Schedule B. 5 See http://www.leginfo.ca.gov/cgi-bin/displaycode?section=corp&group=30001-31000&file=31000-31019. 6 The American Bar Association's Forum on Franchising will soon publish a book entitled Exemptions and Exclusions under Federal and State Franchise Laws. 7 Section 681 of the New York General Business Law (GBL). See Schedule B.
Both prongs of the NYFSA's definition of a franchise raise issues. Starting with the first prong, what does it mean to grant "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 a franchisor" without a trademark? A marketing consultant may provide a marketing plan to a client to enable that client to launch a business. Certainly the client will pay a fee. The arrangement meets the fee element and the marketing plan element of a franchise. Is this a franchise? When does such an arrangement constitute a "grant" of the "right" to engage in a business? The statute is not at all clear on what type of arrangement this prong of the definition is intended to cover. The second prong is easier to understand but is extremely broad. The plain language of the statute covers many license and distribution arrangements that would not be considered franchises in other states. Any trademark license granting someone a right to engage in a business in consideration for a royalty would fall within the definition of a franchise under the NYFSA. This is not the type of business arrangement that anyone unfamiliar with New York law would expect to be a franchise. Brand owners commonly license parts of their product lines or create brand extensions through licensing. But few know that the NYFSA can apply to a business arrangement that would not be viewed as a franchise in any other state. A person who sells a franchise in violation of the NYFSA is liable to the purchaser for damages. If the violation is willful and material, the buyer has the right to rescind and collect attorney's fees and costs.8 Officers and directors can be personally liable for violations of the NYFSA.9 The Department of Law can prosecute a violation of the NYFSA as a criminal offense and can seek restitution for fraudulent practices.10 In short, the NYFSA is a trap for the unwary. Most people would not think of consulting with a franchise lawyer before entering into a trademark license agreement or a marketing agreement. Yet failure to comply with the NYFSA can give rise to litigation between contract parties or prosecution by the Attorney General's office. Impediment to Business in New York For licensors who do receive proper advice, this broad definition can be an impediment to doing business in the state of New York or with a person or business located in New York. A franchisor is required to prepare a detailed franchise disclosure document that includes audited financials and to register the offering with the state Attorney General's Office. The franchisor must then make the required disclosures and wait 10 business days (or 14 calendar days in other states) before entering into the agreement or accepting any payment. These are costly and time-consuming requirements that can easily kill a deal. The broad scope of the New York law creates risk and imposes a degree of uncertainty. Why would a licensor choose to be subject to the extensive registration and disclosure requirements imposed on franchisors in New York when the company can avoid these requirements by going to any other state?
8 GBL 691(1). 9 GBL 691(3). 10 GBL 692.
Most business owners want to comply with applicable laws. If by chance or good fortune they happen to consult with a franchise lawyer before they enter into a trademark license agreement or a market consulting agreement, they may be advised either to seek a discretionary exemption or to locate the business outside the state of New York and not to enter into the contract with anyone who is located in New York. Prosecutorial Discretion The good news is that the New York State Department of Law exercises prosecutorial discretion and seldom prosecutes companies that would not be viewed as franchisors in other states. But a future New York State Attorney General might take a different view. An overly broad law is not a good law. The sparse enforcement of the NYFSA does not change the fact that the threat is always there. An enforcer can arbitrarily decide one day to enforce it. Similarly, in practice, relatively few licensees or others raise the issue of noncompliance with the NYFSA against trademark licensors or marketing consultants for violations of the NYFSA in litigation. Arguably, the fact that the Attorney General's Office does not apply the law to arrangements that are not commonly understood to be franchises may indicate that the Attorney General's Office does not view the broad definition as a necessity. Therefore, cutting back the definition so that it conforms to the laws of other states is not likely to change the enforcement activity at the Attorney General's Office. Nor would it change the way private litigants behave. No Problem for Traditional Franchisors or Franchisees Companies that offer traditional franchises have no issue with the broad definition of a franchise under the NYFSA. Franchisors prepare franchise disclosure documents in accordance with the FTC Rule and the franchise laws of New York and other states. Franchisors register their franchise offerings in New York as they do in other states and they make the required disclosures to prospective franchisees. For franchisors, then, the broad definition of a franchise in New York is a non-issue. The broad definition of a franchise under the NYFSA also does not adversely affect franchisees or prospective franchisees who expect to enter into a franchise arrangement. They receive the required disclosures from their franchisors regardless of the law's definition of a franchise. The "terrifying"11 aspects of the New York definition apply only to those who would not be considered franchisors under federal law or the laws of any other state. Narrowing New York's broad definition of a "franchise" to conform to the definition in other states would have no effect one way or another on franchisors or franchisees as those terms are commonly understood. It is likely that the Attorney General's Office seldom prosecutes business arrangements that are not commonly understood to be franchises because these business arrangements do not require the protections that the NYFSA affords to prospective franchisees.
Jurisdictional Scope of the NYFSA Unlike most state franchise sales laws, the NYFSA law can apply extraterritorially. The New York franchise law applies if the offer merely originates from New York or is accepted in the state, regardless of where the franchisee or the franchised business is located. Most other state franchise sales laws apply only to franchise offerings made to prospective franchisees within the state. The NYFSA specifically states that an offer to sell is made in the state "when the offer either originated from this state or is directed by the offeror to this state and received at the place to which it is directed." The extraterritorial application of the Act was upheld in at least one case, Mon-Shore Management v. Family Media,12 where the court applied the NYFSA when the offer merely originated in New York, even though the offerees and the franchised businesses were outside the state. In other words, a franchisor based in New York should not offer franchises in any state unless the offering is registered in New York.
12 584 F. Supp. 186 (S.D.N.Y. 1984), Bus. Franchise Guide 8150.
FTC DEFINITION OF "FRANCHISE"
16 CFR Section 436.1(h) 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.
Example Definitions of a "Franchise" under State Franchise Sales Laws
California Corporations Code 31005(a) "Franchise" means a contract or agreement, either expressed or implied, whether oral or written,
between two or more persons by which: (1) A franchisee 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 a franchisor; and (2) 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
(3) The franchisee is required to pay, directly or indirectly, a franchise fee.
New York General Business Law 681 "Franchise" means a contract or agreement, either expressed or implied, whether oral or written,
between two or more persons by which: (a) A franchisee 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 a franchisor, and the franchisee is required to pay, directly or indirectly, a franchise fee, or
(b) A franchisee is granted the right to engage in the business of offering, selling, or distributing goods or services 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 franchisee fee. Single Sale Exemption GBL 684(3)(c)
There shall be exempted from the registration provisions of section six hundred eighty-three of this article the offer and sale of a franchise if: ... (c) The transaction is pursuant to an offer directed by the franchisor to not more than two persons, other than persons specified in this subdivision, if the franchisor does not grant the franchisee the right to offer franchises to others, a commission or other remuneration is not paid directly or indirectly for soliciting a prospective franchisee in this state, and the franchisor is domiciled in this state or has filed with the department of law its consent to service of process on the form prescribed by the department.