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January 15, 2013 Vol. 68 No. 1 Back to Bulletin Main Page

Avoiding an “Accidental” Franchise in U.S. Trademark Licensing

Trademark owners frequently license their trademarks to expand the scope and geographic reach of their brands and to maximize their revenue. Although it is crucial to have a fundamental understanding of trademark licensing to counsel clients and manage trademark portfolios effectively, it is equally important to understand the boundaries and potential overlap between trademark licensing and franchise law in the United States. The failure to do so may thrust an attorney’s client inadvertently into the highly regulated realm of franchising with unwanted, unexpected and costly consequences. This article provides general guidelines to help U.S. trademark attorneys not only recognize a franchise but also avoid common mistakes that could lead to the unintentional creation of a franchise by the trademark owner—a situation often referred to as “the accidental franchisor.”

Franchising Fundamentals
A unique feature of franchising is that franchise regulations apply regardless of whether the contracting parties actually meant to enter into a franchise relationship. Accordingly, it is essential for an attorney to understand the fundamentals of franchising when drafting a traditional trademark license agreement—if an agreement meets all the definitional elements of a franchise, it will be treated as a franchise no matter what the client’s intent is or what the agreement calls the relationship.

There are two main types of franchise laws and regulations. One addresses the franchise sales process, while the other addresses problems in the franchise relationship, such as early franchise terminations, nonrenewals and franchise transfers, to name only a few.

Franchise sales regulation consists of regulation at both the federal and the state level. Depending on the applicable statute or regulation, failure to comply can result in fines of thousands of dollars per day, damages awards, injunctive relief and even criminal penalties.

The purpose of franchise disclosure law is to ensure fair dealing by franchisors; to prevent misrepresentation or nondisclosure of business information; and to enable potential franchisees to make informed decisions before entering into an often complex, long-term and intertwined business relationship with a franchisor.

Although there is no uniform definition of a franchise at the federal and state levels, the United States Federal Trade Commission (FTC) definition, found in 16 C.F.R. § 436.1(h), is the baseline upon which states are free to elaborate or adopt more specific requirements, as long as the state’s additional requirements increase the level of protection afforded to the franchisee. The FTC defines a franchise as any continuing commercial relationship or arrangement that contains three separate elements:

  1. Right to use a trademark. The franchisor must give the franchisee permission to identify or associate with the franchisor’s trademark, or to offer, sell or distribute goods or services using that trademark.
  2. Payment. The agreement must require that the franchisee pay royalties or fees to the franchisor/trademark owner or an affiliate.
  3. Control. The franchisor must either impose significant controls over, or offer significant assistance in, the franchisee’s method of operating the business using the trademark.
State regulations may incorporate additional requirements and limitations for franchisors, including regulations on exclusive rights to operate in a given territory, requirements that the franchisee purchase or sell a specified quantity of the franchisor’s goods or services, or requirements that the franchisee use the franchisor’s trademark to identify the franchisee’s business. An attorney drafting a trademark license agreement must determine, among other things, which states’ regulations might apply to the agreement and tailor the agreement to avoid falling within each state’s definition of a franchise. Although federal and state laws and regulations have various exceptions and exemptions from their definition of a franchise, generally there is no consistency between or among them.

Differences Between Trademark Licenses and Franchises
The best way to avoid unintentionally creating a franchise relationship is to draft a license agreement with these three foregoing elements in mind. The difficulty, however, is that the essential elements of a franchise often closely coincide at least conceptually with non-franchise trademark license agreements. For example, in addition to the terms surrounding the trademark itself, trademark license agreements typically address some form of royalty or compensation and quality control. Each basic element is considered in turn below.

Trademark Requirement
Like trademark licenses, franchise agreements must grant the franchisee the right to use the franchisor’s trademark. Proper use of a well-known and well-respected trademark in a franchise system encourages consumers to trust the quality of the product, service or brand regardless of the particular franchisee controlling that establishment. But unlike some trademark licenses, franchises often involve the franchisee using the franchisor’s trademark in the name of its business.

For example, collegiate institutions often license their trademarks to apparel manufacturers for the production of licensed apparel bearing collegiate trademarks. In most cases, these agreements do not result in the creation of a franchise, partly because the manufacturers do not use the collegiate trademarks to hold themselves out as the institutions. Consumers who purchase the licensed apparel generally understand that it was not the collegiate institution itself that manufactured the product. Conversely, consumers tend to identify franchised chain restaurants by a franchisor’s trademarks and may not recognize that each location may be individually owned and operated.

Payment Requirement
Most trademark licenses include some sort of compensation provision. With franchises, however, there must be a compensation element for the relationship to be classified as a franchise. There are various ways that a trademark licensor can be compensated for use of its mark that may qualify the license as a franchise, such as advertising fees, training fees, rent and purchases of mandatory equipment or of inventory. For example, in arrangements where the licensee purchases some inventory for resale or lease directly from the licensor, such as in some distribution agreements, requiring the licensee to purchase these products at more than a bona fide wholesale price will result in the fee requirement’s having been met and in the existence of a franchise arrangement if the other definitional requirements are also met.

Control Requirement
One of the most pronounced differences between a traditional trademark license agreement and a franchise agreement is the level of control the licensor seeks to exercise over the licensee’s use of the trademark and other methods of business operations. A trademark owner who fails to exercise reasonable control over the use of the trademark may see it cease to function as a symbol of quality and a controlled source, leading to the involuntary loss of trademark rights. Accordingly, well-drafted trademark license agreements include some quality control provisions, although the amount of control required will vary.

Importantly, in terms of franchises, the FTC has articulated that it will not deem as “significant” control or assistance trademark controls designed solely to protect the trademark owner’s goodwill in the mark. Thus, it is generally acceptable to include clauses allowing the licensor to inspect the goods and services offered by the licensee under the mark; to be involved in the design process for the product; to approve packaging and advertising to ensure that the mark is used properly and conforms to the licensor’s guidelines; and to require access to the licensee’s facilities to monitor adherence to the licensor’s quality standards without the arrangement’s being classified as a franchise.

The problem occurs when licensors begin to exercise too much control over other aspects of the licensee’s business operations. Examples of requirements that are the hallmarks of franchise agreements include requiring the licensee/franchisee to follow site design or appearance requirements; to adopt specific hours of operation, production techniques, accounting practices, personnel policies and practices; or to undertake specific promotional or marketing campaigns for those products using the licensed trademark. In addition, providing significant assistance, such as training programs for personnel, sales or business methods and procedures; selecting site locations or sources for raw materials; and furnishing detailed operating manuals, all point to a franchise relationship.

Best Practices to Avoid Creating a Franchise Agreement
Armed with an understanding of the main differences between basic trademark license agreements and franchise agreements, an attorney should keep in mind several best practices in drafting license agreements to avoid having them construed as franchise agreements.

  • Keep the elements of a franchise close at hand. Because each element is essential to the definition of a franchise, negating one element is the most effective way to prevent the creation of an unintentional franchise agreement.
  • State in the agreement the intent of the parties—though not dispositive, it is helpful for a reviewing court to understand whether the parties intended to create a franchise relationship.
  • The agreement should clearly state the scope of permissible use of the licensor’s trademark. For example, what are the specific goods and services with which the licensee is permitted to use the trademark? Is the licensee permitted to advertise using the trademark? Will the licensee identify itself exclusively using the trademark or use a separate name or mark that consumers will use to identify the licensee’s business?
  • Any license agreements that are royalty-free should state this explicitly, as noted above, to eliminate the compensation element that is required for a franchise to exist, although other required payments may nevertheless make the arrangement a franchise.
  • If the licensor intends to provide the licensee with inventory or supplies for resale or lease, the agreement should state that these items will be purchased only at bona fide wholesale prices and only in quantities that are reasonable for starting or ongoing inventory or supply.
  • Be aware of the level of control given to the licensor over the licensee’s business operations. Ask whether this control provision is strictly necessary to protect the trademark owner’s rights in the mark or whether it goes further and seeks to control the licensee’s day-to-day business operations.
  • If all factors point to the arrangement’s being a franchise, investigate whether there may be an applicable exemption or exception. Keep in mind, however, that an exemption from federal law may not be applicable in any state that regulates franchise sales, and vice versa.

Being aware of the basic elements of franchising often is the most important first step to avoid subjecting a client to the rules and regulations applied to franchising. Carefully thought-out agreements designed to eliminate at least one of the basic elements of franchise can help to minimize the risk of an “accidental franchise.” Where a reasonable argument can be made that all three elements are present in a license agreement, the drafting attorney would do well to seek the guidance of fellow attorneys experienced in the nuances of franchise law to help assess whether the franchise line has been crossed.

Although every effort has been made to verify the accuracy of items in the INTA Bulletin, readers are urged to check independently on matters of specific concern or interest.

© 2013 International Trademark Association