Distributorship Arrangements in Light of U.S. Franchise Laws
The German Practice Alert
August 6, 2013
A number of German businesses distribute their products in the United States through a network of distributors under individually negotiated distribution agreements. These often provide for the mutual ability to terminate the relationship at any time without cause. However, when the day comes to terminate a distributor relationship in accordance with the provisions of the underlying agreement, distributors sometimes invoke the protections of U.S. franchise laws. Careful structuring of the distributor relationship will help to avoid such unpleasant and costly surprises.
Franchising law is a complex web of statutes and regulations, including (i) rules of the Federal Trade Commission, (ii) State franchise laws that require registration and the provision of disclosure documents, (iii) State franchise laws that restrict the ability to terminate a franchise, and (iv) industry specific regulations.
What is a Franchise?
Although the definition of what a franchise is may vary depending on the applicable legal regime and also from State to State, generally a franchise is an agreement whereby:
- The operation of the franchisee’s business is substantially associated with a trademark or other commercial symbol of the franchisor;
- The franchisee is granted the right to engage in the business of distributing goods or services under a marketing system prescribed or suggested in substantial part by the franchisor; and
- The franchisee is required to pay a franchise fee.
A distribution arrangement can be characterized as a franchise even if the parties did not intend to be subject to the franchise laws. Additionally, a franchisee’s rights under the franchise laws cannot be waived.
A distribution relationship will often meet the first element (substantial association with trademark) because courts have found it to be sufficient that the distributor merely sells trademarked goods.
With respect to the marketing system requirement, it can be sufficient that the franchisor provide advertising/marketing plans, or control price determinations, payment/credit terms, contractual representations/warranties or the appearance of the business. Accordingly, more often than not the second requirement will also be met.
The third requirement, the franchising fee, is the trickiest part of the test. However, courts have been very liberal in this regard, holding for instance that the purchase of manuals or other materials over several years can constitute a payment of a fee. In fact, any payment by the distributor that is not directly related to the purchase of the goods to be distributed can arguably constitute a franchise fee.
Accordingly, a German company using a distributor in the U.S. may learn to its surprise that the distributor may have a good case to invoke the protections of U.S. franchise laws even though neither party really thought about a franchise when they initially entered into the distributorship agreement.
Basic Franchise Laws
If there is any, even remote, risk that a distributorship relation could be deemed a franchise under the above criteria, a careful State by State analysis is advisable. The following is a very general conceptual overview of the effects of a characterization as a franchise under State franchise laws:
Under some State franchise statutes (and also federal rules), comprehensive disclosure documents about the franchisor, its management, the franchise agreement, financial burdens, risks etc. are required. Under those States’ laws (but not the federal rules), such disclosure documents need to be filed with, and will be reviewed by, State regulatory authorities. The authorities often issue comment letters that can result in substantial modifications to the franchise arrangement.
Other States (and also some of the above first set of States) regulate the relation between the franchisee and franchisor. Under such States’ franchise laws, a franchisee is protected from termination or non-renewal by the franchisor except for “good cause,” the definition of which may, however, vary from State to State under applicable case law. The franchisor must usually first send a notice designating any violations of the agreement by the franchisee and give the franchisee the opportunity to remedy such violations.
Finally, a number of States have no franchise laws. In those states, a termination of the distributorship agreement simply needs to comply with the contractual terms. However, even in these States, federal disclosure requirements must be observed.
Before entering into a distribution agreement in the United States, it is wise to pause for a minute to reflect on whether U.S. franchise laws might be implicated. If such a risk exists, a careful analysis of the franchise laws in the States in question should be undertaken. If as a result of that analysis it is determined that franchise laws apply, depending on business considerations, possibilities may exist to restructure the relationship to avoid franchise laws. Going through such a legal evaluation process may eventually save your business a lot of headache and money.