March 2003

The Unintentional Franchise

by Howard R. Morrill

Unintended franchises are franchises nonetheless; it does not matter what the parties call their business arrangement. In Washington , there have been reported decisions finding franchises within, for example, a mini-market lease, a partnership agreement, a candy distributorship and an area directorship. As an Illinois appellate court noted in interpreting that state's franchise statute: "None of the criteria set forth in the statute make the subjective intent of the parties a determinative factor in identifying a franchise relation. Rather, by statutory definition, a franchise exists where an agreement meets three objective criteria."¹ Clearly this is an accurate statement of the law in Washington as well. The problems with unintended franchises, for franchisors at least, are the unintended consequences.

The Franchise Investment Protection Act

In Washington , franchises are governed by the Franchise Investment Protection Act (FIPA), Chapter 19.100 R.C.W. FIPA was one of the first and most comprehensive franchise statutes in the nation, regulating both the sale of franchises and the relationship of the franchisee and franchisor. Since 1991, the three definitional elements of a "franchise" under FIPA have been: (1) a franchise fee; (2) the grant of the right to enter into a business of distributing goods or services using the grantor's marketing plan; and (3) the substantial association of the franchisee's business with the grantor's name and marks.² As in Illinois, nothing in FIPA makes the subjective intent of the parties' determinative — a business arrangement is a franchise if the elements of a franchise are present.

When one refers to "unintended franchises," one is necessarily referring to franchises that are sold in violation of FIPA's registration and disclosure requirements. FIPA requires that franchise offerings be registered with the Department of Financial Institutions in Olympia, unless an exemption from registration applies.³ FIPA also requires full disclosure in connection with franchise sales.⁴ A franchise required to be registered must be sold using a mandatory disclosure document. ⁵ FIPA declares it "unlawful" to sell a franchise in violation of any of these statutory provisions.

 The Intended "Unintended" Franchise

So how are these unintended franchises created? In many cases, they are created with full knowledge that the particular relationship involved looks an awful lot like a franchise. It is very common in practice to see contracts that disclaim the existence of a franchise, and some of these agreements may even contain explicit waivers of any franchise statute's protections. Often it is readily apparent from the documents creating the relationship that the business arrangement is indeed a franchise, the disclaimers notwithstanding. In those cases, it is very clear that the franchise was "unintended" only in the sense that the franchisor did not intend to have FIPA apply — in all other respects the intent was to create a franchise. That franchisor may find itself in an especially difficult position, particularly if its franchisees ever become disgruntled.

FIPA provides that a franchisor and all that franchisor's management personnel may have personal civil and criminal liability. A franchisee may be able to obtain both rescission and damages.⁶ The state of Washington may seek fines and/or jail time.⁷ The personal liability of a franchisor's principals is not a matter of piercing any corporate veil; it is more proper to say that FIPA does not allow for the corporate veil to be present in the first place. It is a "person" who violates FIPA, and by broadly defining "person," FIPA casts a wide net. ⁸

FIPA also authorizes exemplary damages of as much as three times actual damages.⁹ In practice, although there are no reported decisions concerning an exemplary award under FIPA, it seems intuitively appealing that a judge might be persuaded to make such an award in the face of clear evidence that a franchisor considered the application of FIPA and simply chose an evasive course of action instead of compliance. (Every case in which this writer has convinced a trial court to make an exemplary award had evidence of some deliberate and considered evasion of FIPA.) Finally, the franchisee's purported contractual waiver of FIPA's protections is utterly unenforceable.¹⁰

However, many unintended franchises really were completely unintended, at least subjectively unintended. There are many "license agreements," "distributorships," "joint ventures" and "dealerships" that are clearly franchises, but were entered into without any apparent consideration of franchise law. Consider the following illustrative hypothetical, which is an amalgam of several real-life examples:

A "Family" Deal

Bob and Mary built a very successful Seattle area chain of four barbecue restaurants. They built the chain, location by location, over the course of about 15 years, and acted as general managers of the entire operation for another decade. Their son Mike and a longtime employee and family friend, Julie, worked in the restaurants during their high-school and college years. Eventually both Mike and Julie graduated and began managing individual restaurants in the chain. "Mary's Barbecue Hut" became well-known and popular throughout the community.

Much of the success of the restaurants was due to Bob's homemade barbecue sauces. Bob had been in and around restaurants his entire working life, and he had always been interested in tinkering with the recipes. He had developed several different barbecue sauces through simple trial and error and years of experimentation. Known only to Bob, the recipes had struck a responsive chord with the public. Bob and Mary promoted the restaurants chiefly through radio spots featuring Mary's comically off-key singing. Mary became something of a minor local celebrity in the process.

Although Bob and Mary had been approached many times about franchising Mary's Barbecue Hut, the idea had never appealed to them. Every franchise promoter they spoke to talked of incredible, rapid expansion. Bob and Mary were concerned about quality-control issues and the time commitments associated with multiple and near-simultaneous franchise openings scattered throughout the state and beyond. They felt uncomfortable with the vague platitudes they heard when they asked specific questions, so they rejected franchising and stuck with the business they knew best.

Recently, Bob and Mary decided they wanted to reduce their workload and enjoy some of their well-earned success. However, they did not want to completely retire. They devised a plan that would provide them a smaller but continuing role.

Their plan had a certain elegant simplicity. Mike and Julie, now seasoned veterans in the business, would each cease being employees of the chain and would instead take over operation of two of the restaurants, running them as their own under the Mary's Barbecue Hut banner for a 10-year term. Bob would continue to produce the sauces, and he and Mary would help train employees, and provide advice and consultation on an "as needed" basis to Mike and Julie for an hourly fee. Bob and Mary would also continue to own the recipes, the Mary's Barbecue Hut name and marks, and the radio spots. Mike and Julie would buy the sauces from Bob and Mary, and pay them two percent of restaurant sales as well. Mike and Julie would be entitled to place advertising using the library of existing radio commercials.

A simple "operating agreement" containing the features described above was created to put this arrangement into place. Mike and Julie each entered into separate operating agreements with Bob and Mary. The parties started doing business under the operating agreements, none of them ever considering whether these agreements were also franchises. 

On these facts, it seems clear that unintended franchises have been created. All three statutory elements — franchise fee, marketing plan and name — are present. First and foremost, there are parties doing business in "substantial association" with the "Mary's Barbecue Hut" name, a name that does not belong to them. Second, there is an explicit percentage charge based upon sales — a "franchise fee" by definition.¹¹ In addition, payments for consultation and advice — payments for services, in other words — are also franchise fees.¹² Finally, there are promotional radio spots, an obligation to provide training by Bob and Mary, proprietary recipes, and advice and consultation. Any one of these items standing alone might be sufficient to constitute Bob and Mary's "marketing plan"; together, they seem to weigh heavily in favor of finding that a marketing plan is present.¹³

At this point, it seems worth pointing out that certain facts in the hypothetical could be altered to make it harder to find particular franchise elements. For example, suppose Bob and Mary did not collect any direct fees based upon sales or for their advice and consultation, but instead continued to collect all the restaurants' revenues and to pay Mike and Julie "commissions" of some amount based upon sales. Would changing the direction of the cash flows in this way negate the franchise-fee element? The answer should be no, for at least two reasons. First, a franchise fee may still be present in the prices Mike and Julie pay for the barbecue sauces. This is referred to as a "hidden franchise fee" in the caselaw, and it is worth noting that the burden of proving a franchise fee is not present if the sauce prices should fall on Bob and Mary.¹⁴ Second, and more fundamental, as long as Mike and Julie still bear the risk of business loss and are not employees, the direction of the cash flow is not really determinative of the economic reality of the arrangement.

Why Does Any of This Matter?

But if everyone is happy with a business arrangement, why does anyone care whether it is also a franchise? Well, as discussed above, the fact that everyone is happy does not really change the fact that Washington state (or the FTC) could take action. But it is probably less likely that such action would be taken in the absence of any complaining franchisees. Therefore, some companies that discover they have franchised accidentally may take the attitude that all they really have to do is wait for a statute of limitations to run. Some may even make their franchisees aware of the potential violations, just in case a discovery rule might apply.

This strategy ignores a couple of things. One, as was pointed out above, is the underlying illegality of the transaction. A violation of FIPA is also a violation of the fundamental public policy of this state.¹⁵ Under longstanding illegality precedent, it should be difficult or impossible to bring any contract claim based upon what the unintentional franchisor now realizes is a franchise agreement. The affirmative defense of illegality is not affected by any statute of limitations. Second, even if the franchisees cannot bring claims in connection with the unlawful sale to them of their franchises, they do have the benefit of the "franchisee bill of rights" contained in RCW 19.100.180. They cannot therefore be terminated without good cause, charged more than a bona fide wholesale price for supplies, or restricted in their right to form an association — to name just three examples. It may prove impossible to treat the franchisees differently as well, due to FIPA's anti-discrimination provision.¹⁶ So, in our Mary's Barbecue Hut hypothetical, it may be impossible for Bob and Mary to prefer their son to their family friend in any material way.

 The $64 Question

If you discover that your client has unintentionally franchised, you have to decide what, if any, course of action to recommend. Many clients will be reluctant to do anything for the same reasons that caused them to reject intentional franchising in the first place — cost and effort. Still, the time to attempt to cure the problem is never likely to be better than while the franchisees are reasonably content. The cost of not taking some action may be significantly higher than the cost of even a belated attempt at compliance.

 Howard R. Morrill is a shareholder in the Seattle law firm Bundy & Morrill, Inc. PS. Formed in 1990, the firm's practice consists primarily of representing franchisees and franchisors. Mr. Morrill is a 1987 graduate of the University of Washington JD/MBA program.

 NOTES

1. Brenkman v. Belmont Marketing, Inc., 410 N.E.2d 500, 503 (Ill. App. 1980).

2. RCW 19.100.010(4).

3. RCW 19.100.020(1).

4. See RCW 19.100.170.

5. RCW 19.100.080.

6. RCW 19.100.190(2).

7. RCW 19.100.210.

8. See RCW 19.100.010(13).

9. RCW 19.100.190(3).

10. RCW 19.100.220(2).

11. See RCW 19.100.010(12).

12. Id.

13. See RCW 19.100.010(5).

14. See RCW 19.100.220(1).

15. See RCW 19.100.220(3).

16. See RCW 19.100.180(2)(c).