FTC Franchise Rule Coverage

Whether the FTC Franchise Rule applies to a particular business relationship depends upon whether the relationship meets the Franchise Rule’s definition of a “franchise” and whether an exemption or exclusion applies.

What types of relationships are covered?

The amended Franchise Rule covers the offer and sale of franchises. As under the original Rule, a commercial business arrangement is a “franchise” if it satisfies three definitional elements. Specifically, the franchisor must:
  • Promise to provide a trademark or other commercial symbol
  • Promise to exercise significant control or provide significant assistance in the operation of the business; and
  • Require a minimum payment of at least $500 during the first six months of operations.
Like the original Rule, the amended Rule covers business format and product franchises. The name given to the business arrangement is irrelevant in determining whether it is covered by the amended Rule. A business arrangement described as a “franchise” will not be covered unless it meets the three definitional elements in the amended Rule. In the same vein, a self-described “distributorship” will be covered by the amended Rule only if the three definitional elements are satisfied.
Further, the amended Rule covers relationships that are represented either orally or in writing as having the characteristics specified in the amended Rule’s definition of “franchise,” regardless of whether the representations are, in fact, true or can be fulfilled. Accordingly, if a seller of a business arrangement represents that it licenses its trademark, promises to provide significant assistance in the buyer’s business operations, and charges a minimum payment of at least $500, the arrangement will be covered by the Rule even if, for example, the seller, in fact, has no trademark or has no means to provide any assistance to buyers.

The “Trademark” Element

A franchise entails 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.” The term “trademark” is intended to be read broadly to cover not only trademarks, but any service mark, trade name, or other advertising or commercial symbol. This is generally referred to as the “trademark” or “mark” element. The franchisor need not own the mark itself, but at the very least must have the right to license the use of the mark to others. Indeed, the right to use the franchisor’s mark in the operation of the business – either by selling goods or performing services identified with the mark or by using the mark, in whole or in part, in the business’ name – is an integral part of franchising. In fact, a supplier can avoid Rule coverage of a particular distribution arrangement by expressly prohibiting the distributor from using its mark.

The “Significant Control or Assistance” Element

The amended Rule covers business arrangements where the franchisor “will exert or has the 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.”

When is control or assistance significant?

The more franchisees reasonably rely upon the franchisor’s control or assistance, the more likely the control or assistance will be considered “significant.” Franchisees’ reliance is likely to be great when they are relatively inexperienced in the business being offered for sale or when they undertake a large financial risk. Similarly, franchisees are likely to reasonably rely on the franchisor’s control or assistance if the control or assistance is unique to that specific franchisor, as opposed to a typical practice employed by all businesses in the same industry.
Further, to be deemed “significant,” the control or assistance must relate to the franchisee’s overall method of operation – not a small part of the franchisee’s business. Control or assistance involving the sale of a specific product that has, at most, a marginal effect on a franchisee’s method of operating the overall business will not be considered in determining whether control or assistance is “significant.”

Types of Control

Significant types of control include:

- Site approval for unestablished businesses
- Site design or appearance requirements
- Hours of operation
- Production techniques
- Accounting practices
- Personnel policies
- Promotional campaigns requiring franchisee participation or financial contribution
- Restrictions on customers
- Locale or area of operation

Types of Assistance

Significant types of assistance include:

- Formal sales, repair, or business training programs
- Establishing accounting systems
- Furnishing management, marketing, or personnel advice
- Selecting site locations
- Furnishing system-wide networks and website
- Furnishing a detailed operating manual

Factors to Consider

To a lesser extent, the following factors will be considered when determining whether significant control or assistance is present in a relationship:

- A requirement that a franchisee service or repair a product (except warranty work)
- Inventory controls
- Required displays of goods
- On-the-job assistance with sales or repairs

What activities do not constitute significant control or assistance?

Promotional activities, in the absence of additional forms of assistance, will not be deemed “significant.” This includes furnishing a distributor with point-of sale advertising displays, sales kits, product samples, and other promotional materials intended to help the distributor in making sales. It also includes providing advertising in such media as radio and television, whether provided solely by the franchisor or on a cooperative basis with franchisees.
In addition, the following items do not constitute significant control or assistance, as a matter of Commission policy1:
  • Trademark controls designed solely to protect the trademark owner’s legal ownership rights in the mark under state or federal trademark laws (such as display of the mark or right of inspection)
  • Health or safety restrictions required by federal or state law or regulations
  • Agreements between a bank credit interchange organization and retailers or member banks for the provision of credit cards or credit services
  • Assisting distributors in obtaining financing to be able to transact business

The “Required Payment” Element

The last of the three definitional elements of a franchise covered by the amended Rule is that purchasers of the business arrangement must be required to pay to the franchisor (or to an affiliate), as a condition of obtaining a franchise or starting operations, a sum of at least $500 at any time prior to or within the first six months of the commencement of operations of the franchised business.

What types of payments constitute “required payments?”

“Payment” is intended to be read broadly, capturing all sources of revenue that a franchisee must pay to a franchisor or its affiliate for the right to associate with the franchisor, market its goods or services, and begin operation of the business. Often, required payments go beyond a simple franchisee fee, entailing other payments that the franchisee must pay to the franchisor or an affiliate by contract – including the franchise agreement or any companion contract.
Payments which, by practical necessity, a franchisee must make to the franchisor or affiliate also count toward the required payment. A common example of a payment made by practical necessity is a charge for equipment that can only be obtained from the franchisor or its affiliate and no other source.

Required Payments

Required payments may include:

- Initial franchise fee
- Rent
- Advertising assistance
- Equipment and supplies (including such purchases from third parties if the franchisor or its affiliate receives payment as a result of the purchase)
- Training
- Security deposits
- Escrow deposits
- Non-refundable bookkeeping charges
- Promotional literature
- Equipment rental
- Continuing royalties on sales

What types of payments do not constitute “required payments?”

The “payment” element of the franchise definition does not include “payments for the purchase of reasonable amounts of inventory at bona fide wholesale prices for resale or lease.2
”Reasonable amounts” means amounts not in excess of those that a reasonable businessperson normally would purchase for a starting inventory or supply, or to maintain an ongoing inventory or supply. This “inventory exemption” also includes goods intended to be furnished to the public through lease. Thus, franchisees – such as those in the auto or furniture rental business – can take advantage of this inventory exemption. The inventory exemption, however, does not include goods that a franchisee must purchase for its own use in the operation of the business, such as equipment or ordinary business supplies.
Source: FTC Franchise Rule
1 See Original Interpretive Guides, 44 Fed. Reg. 49,966, at 49,967 (Aug. 24, 1979).
2 For background information on the reasons for the inventory exemption, see Original Interpretive Guides, 44 Fed. Reg. at 49,967.