Avoiding the Disguised Franchise

If you have a successful business you may get approached by others who are interested in "partnering with you" or "helping you expand." Partnering with an outsider, however, can mean giving up equity or losing operational control (or, worse still, tying yourself to the wrong person). A common alternative is to franchise your business. Unfortunately, that can be a complicated and drawn out process requiring outside legal counsel to navigate state and federal laws regulating the franchisor-franchisee relationship. As a result, some companies have turned to services agreements. The set-up is as follows: (1) the existing company (OldCo) helps the interested party create and operationalize a similar but new company (NewCo), and then (2) OldCo contracts with NewCo to provide NewCo management services for monthly payments (typically based on a percentage of NewCo's earnings). OldCo's services include helping NewCo with startup, and providing backend or management services to support NewCo's ongoing operations. The agreement may also include OldCo licensing its trademark to NewCo.

The above framework comes with risks, particularly if not managed carefully. NewCo will likely learn a lot about OldCo's confidential business practices. In some cases, NewCo may even gain access to OldCo's trade secrets (e.g., vendor lists, pricing lists, protocols, and so forth). As a result, the temptation is strong for NewCo to misappropriate OldCo's trade secrets and breach the service agreement -- thereby avoiding monthly payments under the service agreement. NewCo may also sue and allege that the service agreement (and the entire relationship between OldCo and NewCo) is a disguised franchise, entitling NewCo to rescind the service agreement. In other words, NewCo, after reaping the benefits from OldCo, would avoid the service agreement and avoid having to pay OldCo monthly payments.

There has been a rise in parties using the "disguised franchise" argument as a sword to rescind contracts. Under the Federal Trade Commission's (FTC) Franchise Rule, franchisors must provide all prospective franchisees with a disclosure document containing specific information about the offered franchise, its officers, and other franchisees. 16 CFR Parts 436, 437. To be covered under the Franchise Rule, the business arrangement must also satisfy three definitional elements of a "franchise": (1) the distribution of goods or services associated with the franchisor's trademark or trade name; (2) significant control of, or significant assistance to, the franchisee; and (3) a required payment of at least $500 within 6 months of signing an agreement. 16 C.F.R. § 436.2(a)(1)(i).

While the above regulations are helpful, parties seeking to rescind a service agreement cannot proceed under the FCT Franchise Rule because the Rule is not privately enforceable. Instead, they generally rely on state business opportunity disclosure laws or state consumer protection statutes, prohibiting unfair and deceptive trade practices. For instance, Utah's Business Opportunity Disclosure Act (UBODA) (Utah Code § 13-15-101, et seq.) regulates the offer of "business opportunities" and is generally viewed as a consumer protection tool against unregistered business opportunities, including disguised franchises. UBODA section 13-15-302(1) provides that a "purchaser [of a business opportunity] may bring an action in a court of competent jurisdiction against a seller who does not comply with this chapter." It further provides that the purchaser of a business opportunity is entitled to rescission of the contract, attorneys' fees, and actual damages or $2,000, if a court finds that a seller of a business opportunity has violated Chapter 15 -- which generally means the alleged seller has failed to register the business opportunity and provide the required disclosures under UBODA. Utah Code § 13-15-302.

California provides for rescission directly under its franchise laws. California Corporations Code § 31300(a) provides that "[a]ny person who offers or sells a franchise in violation of [the relevant franchise laws] . . . shall be liable to the franchisee . . . who may sue for damages caused thereby, and if the violation is willful, the franchise may also sue for recission . . . ."

Although the above are generally considered consumer protection statutes, some sophisticated plaintiffs are using these laws to undo a business agreement (between sophisticated parties) only after NewCo has been successful and no longer needs OldCo. In response, companies can take steps to protect themselves against disguised franchise claims:

• Prepare a thorough and clear written agreement with balanced restrictive covenants. Because OldCo is opening its books to an outsider (i.e., the owners of NewCo), OldCo should insist on restrictive covenants that protect confidentiality, limits NewCo's ability to walk-away from the service agreement (typically through a non-solicitation provision), and prevent NewCo from competing against OldCo in certain markets.

• Consider allowing NewCo to use a different trademark. The fact that NewCo and OldCo share the same trademark -- even if licensed -- makes the relationship look like a franchise. Consider allowing NewCo to use a different trade name of its choice (and document your offer). If NewCo insists on using the same tradename as OldCo, document their request.

• Grant a high degree of operational control to NewCo. The more control OldCo exerts on NewCo, the greater the chance a court will declare the relationship a franchise. Let NewCo select its offices, its furniture, its personnel, and so forth. The more the relationship functions as a true service agreement, the less risk of a court finding a disguised franchise.

• Focus your efforts on documenting and protecting your trade secrets. Ultimately, even if NewCo is successful in rescinding the service agreement, OldCo's trade secrets belong to OldCo. If OldCo can document its trade secrets and show misappropriation by NewCo, OldCo may have a strong trade secret misappropriation claim.

• Document all the assistance that OldCo provides to NewCo. If NewCo is ultimately successful in rescinding the service agreement, OldCo may be able to rely on the equitable claim of unjust enrichment for relief. In other words, OldCo would argue it benefitted NewCo, and allowing NewCo to retain the benefits without compensating OldCo would be unjust.

• Make sure you get good counsel. Typically, parties who are seeking to rescind a service agreement plan are planning their actions well in advance of filing a lawsuit. This means when NewCo sues OldCo for a disguised franchise, NewCo has been planning it for months (usually with the advice of legal counsel). As a result, OldCo needs good counsel to immediately resist and defend against arguments of a disguised franchise.

If you're looking for legal counsel to assist you with a disguised franchise or claims that you violated business opportunity disclosure laws, contact SARG LAW.

Disclaimer: This article is for informational purposes only and does not constitute legal advice. Reading this article does not create an attorney-client relationship between you and SARG Law. You should consult a qualified attorney for advice regarding your individual situation.