— Karen Brennan, Attorney
Too often, trademark owners that seek to exploit their brands through various licensing arrangements inadvertently fall into the trap of an unintended franchise. Such disguised franchises can lurk in a variety of agreements and relationships, including reseller, distribution, and independent contractor agreements that include a trademark license with a fee along with very detailed quality control requirements. Sometimes those requirements are more a reflection of the licensor’s intent to control the business activities of the licensee than merely to ensure the products and services meet certain quality control standards. When the licensor exerts too much control over the day to day activities of the licensee, the relationship can evolve from a licensor/licensee relationship to a franchise with serious implications.
Several states have a “three prong test” to determine if a franchise exists. Those requirements generally include: (i) a license to use a trademark; (ii) the payment of a franchise fee for use of the mark; and (iii) significant control exerted by the licensor/ franchisor or significant assistance given by the franchisor or assistance by the licensor. The control required to create a franchise relationship can be established by training programs, operation manuals, and established business or marketing plans or methods of operation.
It is the element of control that often creates a dilemma for the trademark licensor. On the one hand, the law requires that the trademark licensor exercise quality control to avoid loss of rights in the mark, see prior blog post. However, if the licensor exercises too much control, the relationship may become a franchise. If the relationship is a franchise, the franchisor/licensor must register and file-specific franchise disclosure documents as required by particular states. Failing to comply with such requirements can have serious consequences, including a claim of damages by the franchisee/licensee and in some instances, criminal penalties and fines. The consequence of this dilemma can also expose the licensor to claims by the licensee. For example, a licensee that continues to use the mark after termination of the license may counterclaim that a franchise was created due to the level of control and the license was terminated in violation of the franchise laws. If the relationship was in fact a franchise and not a licensor/licensee relationship, the licensor could be liable for damages and be required to refund all money that has been paid by the licensee and offer the licensee to cancel the license. On the other hand, failing to exercise quality control could invite an infringer to claim the licensor failed to impose sufficient quality controls on the licensee resulting in an “abandonment” of the mark and loss of rights to enforce the trademark.
In the event the licensor determines the licensor/licensee relationship is a franchise, the licensor/franchisor must decide whether to take the necessary steps to become a lawful franchise or change the license model to avoid franchise status. Such change can be especially difficult and merely labeling the relationship as licensor/licensee does not prevent the relationship from being a franchise since it is the actual relationship between the parties that is relevant not declarations of what the relationship is supposed to be. If the licensor elects to convert to a franchise model, there is a possibility that the licensees will claim that they were entitled to the protections of the relevant franchise laws all along, especially if the business relationship is an unhappy one. Also, the conversion to a franchise can be costly especially if there are numerous licensees in several states that have franchise laws.
Given the consequences of being an illegal franchise, the trademark licensor must exercise great caution to be sure that the minimum level of quality control exercised under a trademark license does not create a relationship that violates federal and state franchise laws. Such consequences underscore the importance of the legal, business, and marketing groups collaborating to develop a strategy that ensures the proper arrangement is chosen to exploit the mark either through a license with appropriate quality control or in the form of a franchise relationship.