Beware the Unintended Franchise

We all are familiar with well-known? franchises, such as McDonald’s restaurants. What many people do not realize, however, is that a trademark license agreement, if it has certain characteristics, can be considered a franchise agreement under state or federal law, creating huge potential liabilities for the unwary licensor.

In California, Corporations Code Section 31005(a) says that a franchise exists if three elements are satisfied:

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.

The second and third elements (the right to use a mark, and the obligation to pay a fee) are routine components of trademark license agreements. The first element – the franchisor’s “marketing plan or system” – thus is what distinguishes a franchise.

I was reminded of this point, recently, when a prospective trademark-licensee client showed me the licensor’s proposed Trademark License Agreement. The agreement included an obligation for the licensee to operate its business “in compliance with” the licensor’s “policies, specifications, procedures, and instructions”. To me, that looks like a “system prescribed…by a franchisor” as specified in the statute.

The good news for the prospective licensee is that the penalties for failure to comply with franchise laws are directed toward the franchisor (licensor) rather than the franchisee (licensee).? Nevertheless, any investigation or action related to franchise laws could be disruptive to the licensee, so I consider it appropriate for the licensor to agree to indemnify the licensee against any resulting costs or liabilities.

Lesson: If you are a trademark licensor, be careful about whether and how you control the licensee’s management of its business.

Photo credit: stock.xchng

This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact an attorney directly.