Licensing or Franchising? A Fragile Balance

Licensing is ubiquitous in today’s marketplace.  Many companies are in the business of creating and licensing many forms of intellectual property, not just computer software, but also methods of business operations or service standards.  This can be a lucrative approach to growing a business and developing goodwill around your business name by granting others to use your proven method and recognized brand name.  However, when does controlling your intellectual property through licensing have unintended consequences?  Franchise law is broad and may capture the unwary licensor.  A licensing arrangement can fulfil the requirements of franchise law and become subject to onerous obligations and liabilities, whether the parties intended to or not.

This edition of The Battlefront considers the basics of franchise law and how a business can become a franchise without prior knowledge or intention of the parties.

What is a franchise?

Broadly speaking, a franchise is where one company (the franchisor) owns a business model and permits another company (the franchisee) to use the business model in exchange for a fee (or fees).  There are generally two types of franchise systems – the “business format” structure and the “product distribution” structure.

The “product distribution” structure is typically not as visible to consumers in today’s marketplace.  The licensor grants some form of representation or distribution rights (with or without the use of a trademark), and also provides some form of assistance in locating the business or its operations.  These arrangements tend to be in the business-to-business industries.  While the focus of this article is on the “business format” of franchise, the consequences of establishing a “product distribution” franchise are the same.

The “business format” is common and numerous today.  This usually involves a licensor granting the use of a trademark that is easily recognizable and a similar look-and-feel throughout the operation of all locations.  Examples are restaurants, coffee shops, car dealerships, car rental agencies, etc.

However, the law has an expansive definition of a franchise.  A franchise includes any arrangement that satisfies the three required elements, which in simple terms are: (1) payment of any kind by licensee to licensor; (2) the business is substantially associated with a trademark; and (3) the licensor has substantial control or assistance over the business method of the licensee.

The first two elements are easy to comprehend.  Further, the courts have determined that most forms of payment by a licensee to operate the business will likely be captured, even if the payment is not called a “franchise fee”.  A licensing fees, royalty fees, etc. would certainly be included.  A strict interpretation of payment would also include any amounts paid by the licensee for product or inventory.

This leads to the third, and most problematic, element of franchising - significant control or assistance.  This frequently is a minefield for licensors.  Whether a licensor exercises significant control or significant assistance is a based on the facts of each case. 

Significant control can exist with a licensor requires certain criteria in a building design or location, or marketing techniques, or training or service standards, or products, or technology used.
Significant assistance can exist if the licensor advises on building location, construction, equipment, training, appearance or quality controls.

The purpose of franchise law is to protect the franchisees.  As such, the courts have taken an expansive view of factors that may satisfy this third element. 

The intention of the parties or name of the documents is not relevant.  Significant control or assistance can exist in a franchise agreement, but may also exist in a licence agreement, a service agreement, a distribution agreement, or even a management agreement.  Also, the constant acceleration of today’s marketplace with technology-based business models may also provide significant control or assistance that can satisfy this third element and create a franchise.

While the parties may have only intended a simple licensing arrangement, this third element of significant control or assistance may tread into the realm of franchise law.  If the control or assistance relates to the licensee’s method of operation (its business), the risk of a franchise arises.

Consequences of Becoming a Franchise

If a business arrangement is a franchise, the law protects the franchisees in three principal ways: (1) the parties have a duty of fair dealing; (2) the right of the franchisees to associate with each other; and (3) extensive disclosure obligations are imposed on the franchisor.  This last criteria is the time bomb for the unsophisticated licensor/franchisor.

Prior to the franchisee signing any agreement, the franchisor must deliver extensive written disclosure of all “material facts” regarding the business.  This obligation arises at the start of the relationship with a prospective franchisee, but there may be no immediate effect of non-compliance.  The franchisee may willingly enter into the franchise/licence/distribution/management agreement and invest heavily to set up and start its business; all without extensive review of the disclosure materials.  However, if the business falters or the franchisee’s expectations are not met, the franchisee can then later review the disclosure materials to determine if there was any material non-compliance by the franchisor prior to signing any agreements.

If the franchisor has failed to disclosure as required, the franchisee may have various remedies.  The broadest remedy is to seek rescission of the franchise agreement at any time within two years after signing the agreement.  The rescission remedy effectively voids the franchise/licence/distribution/management agreement (and all related agreements) as if it never existed. The franchisor becomes obligated to put the franchisee back in the same position as if it never signed the agreement.  This can include reimbursing the franchisee for all fees, royalties, capital investments, losses, etc. relating to the business while operated by the franchisee.  This can give rise to extensive liability on the franchisor, multiplied by the number of licensees/franchisees that may have signed within the previous two years.

Further, such liability extends to the franchisor associates, i.e. the key officers of the franchisor, who are also personally liable for any rescission claims.

No Opt Out

Another feature of franchise law is that a franchisee cannot opt out, or waive, any of its rights under franchise law.  The parties may not want a franchise relationship and may specifically enter into a licence or distribution or management agreement that confirms in writing that there is no franchise relationship.  However, any waiver of franchise rights is not enforceable and the franchisee will still be able to enforce its rights regardless of the terms of the principal agreement.

Thoughts to Take Away

Whenever a licensor exercises significant control or provides significant assistance, the risk of a franchise relationship exists.  Franchise law protects the licensee/franchisee who can wait until a problem arises before investigating any non-compliance with franchise law.  Franchise law also voids any attempt to get a licensee/franchisee to waive its rights.

If a licensing arrangement is structured in a way that becomes a franchise, the entire risk is borne by the licensor/franchisor and its associates.

Franchise law is not affected by the intentions of the parties or the form of the agreement signed.  If the three elements exist, a franchise exists.  “Significant control” or “significant assistance” are key elements that may capture the unwary or unsophisticated licensor/franchisor.  A licensee/franchisee cannot opt out, or waive, any of its rights under franchise law even if included in the written agreement.  The franchisor’s associates also attract personal liability for claims by licensees/franchisees.

Distinguishing a licence agreement or a distribution agreement from a franchise agreement is a complex task that is dependent upon the facts and circumstances of each situation.  A careful review is required to determine if an arrangement is captured by franchise law or whether any exemptions are available.  Intentions, forms and waivers are not enough.  The balance between licensing and franchising can be fragile and risky!

About Loopstra Nixon LLP

Loopstra Nixon is a full-service Canadian business and public law firm dedicated to serving clients involved in business and finance, litigation and dispute resolution, municipal, land use planning and development, and commercial real estate.  Major financial institutions, insurance companies, municipal governments, and real estate developers along with corporate organizations and individuals are among the wide range of clients we are proud to serve.

About The Battlefront

This article contains general information only.  The Battlefront is a brief canvasing of the topic presented and should not be relied upon as professional advice in making any personal or business decisions.  Always consult with a licenced legal professional before making any decisions regarding your own personal or business needs.  The author takes no responsibility to update any of the information presented in this article.  All rights reserved.  © Loopstra Nixon LLP 2018