Franchising in the USA

Gray Plant Mooty - Mark Kirsch, Julia C. Colarusso and Karli B. Hussey

Franchising is interwoven into the fabric of the US economy. Based on data from research firm FRANdata and the International Franchise Association (IFA), franchising represents or accounts for the following.

	2016	2017 (forecast)
Number of outlets	732,800	744,400
Number of employees	7.64 million	7.89 million
Output	$674 billion	$710 billion
Gross domestic product	$405 billion	$426 billion

These figures are forecast to increase in 2017 and 2018.

Franchised businesses operate in over 75 business sectors or industries, ranging from retail to service businesses to restaurants. While restaurants and other food service operations account for approximately one-third of all franchise establishments, franchising is well represented in many sectors, such as automotive services, hotels, retail products and business and residential services. There has been a significant increase in healthcare-related franchises (eg, elder care and home care services, medical services) in the past 10 years. Due to well-established financial and lending markets, real estate practices and legal systems, franchising has flourished in the United States.

Regulation

Are there any franchising-specific laws in your jurisdiction? What other legal regimes apply?

Franchise laws and regulations exist at both the federal (nationwide) and state levels. However, not all states have franchise laws and the federal laws do not address some of the issues that are covered by the state laws. Therefore, when considering entering the US market with a franchise concept (or with a business concept and the objective of not being subject to the franchise laws), it is important to evaluate the laws and regulations at the federal level and at the state level in those states in which the business will most likely operate.

The federal and state franchise laws and regulations are varied and include: 

• federal-level pre-sale franchise disclosure regulations;
• state-level pre‑sale franchise registration and disclosure laws; and
• state-level franchise ‘relationship’ laws which govern the ongoing relationships between franchisors and franchisees, as well as between manufacturers and dealers or distributors.

In addition, at both the federal and state levels, there are laws regulating the offer and sale of ‘business opportunities’ or ‘seller-assisted marketing plans’. A franchise arrangement may be covered by one of these laws.

Pre-sale disclosure and registration laws At the federal level, the US Federal Trade Commission (FTC) has implemented a trade regulation rule which is generally referred to as the ‘FTC Franchise Rule’ or ‘FTC Rule’. The FTC Rule requires a franchisor that will be operating anywhere in the United States to prepare a franchise disclosure document (FDD) and provide the FDD to prospective franchisees at least 14 days before signing a franchise agreement, or paying any consideration for the right to enter into a franchise relationship. The FDD includes 23 specific disclosure items and must include financial statements of the franchisor, copies of the forms of franchise agreement and other contracts that a franchisee will be required to sign, and contact information for all existing franchisees in the system.  

Fourteen states have pre-sale franchise disclosure laws. These states also require the pre-sale registration of the franchise offer and FDD with a specified government agency. The 14 states are  California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin. In these jurisdictions, a franchisor may not offer franchises in the state, or to that state’s residents, unless and until the FDD and franchise offering is registered by the state.

Franchise relationship laws Twenty-five states and territories have enacted franchise relationship laws that generally govern the manner and procedure in which a franchisor may terminate, not renew or consent to a transfer of a franchise.  For example, most franchise relationship laws require that a franchisor have ‘good cause’ to terminate a franchise, and impose certain time periods in which a franchisee may cure defaults to avoid termination. Some of these laws are more limited and address narrow issues, such as voiding venue selection clauses that force a franchisee to appear in court outside its home state.

Business opportunity laws If a commercial arrangement is not a ‘franchise’ under federal or state laws, or even if it is structured intentionally to avoid a definitional element of a ‘franchise’, other regulatory schemes may still ensnare an unsuspecting entrepreneur.

For example, laws regulating the sale of business opportunity ventures, also known as seller-assisted marketing plans, exist in almost half of the states and at the federal level through the FTC. The FTC Business Opportunity Rule applies to commercial arrangements where a seller solicits a prospective buyer to enter into a new business, the prospective purchaser makes a required payment and the seller – expressly or by implication – makes certain claims or representations. A seller of a business opportunity most provide a short disclosure document to the buyer.

At the state level, if an enterprise is subject to a business opportunity law, generally the seller must prepare a disclosure document, file and register that disclosure document with the applicable state agency and receive approval from the state agency, among other requirements, before the offer of a business opportunity to a purchaser. 

Industry-specific laws In addition, franchise-related laws govern certain industries or protect dealers or distributors in certain industries. For example, the Petroleum Marketing Practices Act addresses issues in the petroleum industry and affects gasoline retailers, dealers, distributors and jobbers. Also, many states have laws pertaining to motor vehicle dealerships, retailers and distributors of beer, wine and spirits, and farm equipment dealers.

Is there a legal definition of ‘franchise’?

While federal and state jurisdictions share common definitional approaches, there is no universal definition of a ‘franchise’. Moreover, each jurisdiction has its own mix of definitional exclusions and exemptions. 

Generally, a franchise is defined by the coexistence of three elements:

• a grant of rights to use another’s trademark to offer, sell or distribute goods or services;
• significant assistance to, or control over, the grantee’s (franchisee’s) business, which may take the form of a prescribed marketing plan; and
• payment of a required fee.

If these three elements exist, the business arrangement is a ‘franchise’ and the franchisor must comply with the applicable federal and state law.

Are there any specific regulatory implications for foreign franchisors seeking to expand into your jurisdiction?

US franchise laws pertain to any person or entity offering or selling franchises to be operated in the United States. Therefore, foreign franchisors are subject to the same laws and regulations as US-based franchisors. One aspect of the US franchise disclosure laws, and one of the requirements of FDDs, that may affect foreign franchisors relates to financial statements. A franchisor must include in its FDD its audited financial statements (for the three most recent fiscal years, with certain adjustments for start-ups), prepared in accordance with US Generally Accepted Accounting Principles (US GAAP). Therefore, if a foreign entity is franchising in the United States, it must prepare its financial statements under US GAAP or include detailed conversions from international standards to US GAAP. An alternative would be to create a new US entity to be the franchisor and start with new financial statements, prepared in accordance with US GAAP.

A second critical implication for foreign franchisors pertains to the trademark of the franchise brand. Because the trademark (or service mark) is a central element of a franchise relationship, it is highly recommended that a foreign franchisor seek US trademark registration for its principal marks before offering franchises in the United States.

Are any regulatory reforms envisaged or underway that affect franchises?

While there is no franchise-specific legislation pending in Congress (other than the joint employer legislation discussed below) or pending regulatory changes at the FTC, regulatory reforms in the areas of employment, immigration and menu labelling are under continuing discussion:

• Joint employer – in the last several years, labour unions, the Department of Labour, the National Labour Relations Board and certain state agencies have issued advisory or policy statements, or regulatory adjudications, that hold or suggest that the franchisor’s control over the brand operations at the franchised outlet means that the franchisor controls the franchisee’s employees, and therefore that the franchisor is a joint employer of those employees along with the franchisee. The implication of these actions is that the franchisor would become liable for all wage and hour, employment, discrimination and other aspects of all franchisee operations. Such an outcome would place a great economic and oversight burden on franchisors, and would increase insurance and supervisory costs to the franchisor. It also might spur franchisors to provide less training, decrease the independence of the franchisee (which is a hallmark of operating a small business) and make it easier for unions to unionise all workers operating at different, independent franchised outlets, with different owners, simply because they operate under the same brand. Some states have enacted legislation to counter this trend, by specifically legislating that franchisors are not joint employers and spelling out the demarcation line of employee control versus non-control. Also, on July 27 2017 proposed legislation was introduced in Congress to define more clearly an employment relationship and to establish that franchisors are generally not joint employers with their franchisees. This legislation is pending at the time of writing.
• Minimum wage – federal, state and many city, county and other jurisdictional laws set the minimum wage at which all workers must be paid. There has been a push at all governmental levels to increase the minimum wage. These increases vary from state to state and jurisdiction to jurisdiction. Most of these laws apply to all, or many, businesses and industries, and do not single out franchising. However, because a significant number of lower-wage workers are employed in certain sectors that are prevalent in franchising (eg, restaurants and hospitality), these laws may have a significant impact on franchising in general, and in certain sectors in particular.
• Immigration – US immigration policy is set at the federal level, and there is ongoing debate and legislative and executive branch efforts to minimise or curtail immigration, and enforce current immigration laws. The outcome of the immigration policies and potential legislative changes may affect the labour market generally and have a more significant impact in certain sectors, including those in which some franchise systems operate.
• Menu labelling – the Food and Drug Administration recently prepared rules requiring establishments selling food to disclose calories on their menus. Enforcement of such rules has been delayed until May 7 2018. While menu labelling laws are not franchise-specific, due to the large number of franchised restaurant chains and because many of the laws and regulations apply to chains with a specified minimum number of outlets, these laws will have a significant impact on this sector.

Franchise models

Which models and company forms are commonly used for franchises in your jurisdiction? Are there any restrictions or requirements as to which models and forms may be used?

Franchises in the United States can generally be categorised as either product distribution franchises or business format franchises. Product distribution franchises tend to involve a franchisor or manufacturer which sells its trademarked products through franchisees and distributors which operate using the franchisor/manufacturer’s trademarks and follow the franchisor’s system. Examples include equipment and tool distributors, automobile franchises, gasoline dealers and various retail and consumer products, such as cosmetics. Business format franchises tend to be in the restaurant, hospitality and service sectors, where the franchisor grants the right to operate a business using the franchisor’s system and method of operation. Both of these methods, as well as hybrids, exist in abundance in the United States, and a foreign franchisor could introduce its brand and system in any format.

Regardless of the type of franchise system that is being offered, a franchisor may implement one or more methods to grant those rights. Four common methods, with variations, are used in the United States:

• Direct unit franchising – this involves a grant of franchise rights from the franchisor to the franchisee for the operation of one outlet (a store, unit or business) pursuant to a franchise agreement.
• Area development franchising – this involves a grant of franchise rights from the franchisor to the franchisee/developer for the operation of multiple franchised outlets in a prescribed territory according to a development schedule.
• Area representative franchising – under this model, the franchisor grants the area representative the right (and obligation) to provide certain franchise sales and support services to franchisees in a prescribed territory. While each franchisee and franchised outlet has a direct contractual relationship with the franchisor, many of the franchisor’s duties are outsourced to the area representative.
• Master franchising, or sub-franchising – this model typically involves the grant of a larger geographic territory within which a master franchisee can develop or sub-franchise others to develop multiple units under separate sub-franchise agreements pursuant to a development schedule. The franchisor and master franchisee generally execute a master franchise agreement, which typically requires the master franchisee to serve in a franchisor role for each unit to be developed, and establishes the terms under which the franchisor and master franchisee will share fees payable by sub-franchisees. The master franchisee and each sub-franchisee then execute a separate sub-franchise agreement to govern each individual unit. Few franchisors employ this model in the United States, given the complications created by US franchise laws.

Industry associations

Are there any national or regional franchising associations? If so, is membership mandatory and what operational codes and guidelines apply?

The most prominent franchise association in the United States is the IFA, which was founded in 1960. It represents franchise companies in over 300 business format categories, has over 1,300 franchisor members, over 13,500 franchisee members and over 675 supplier members. The IFA’s mission is to protect, enhance and promote franchising (see www.franchise.org). Membership of the IFA is not mandatory for franchisors or franchisees. The IFA has adopted a Code of Ethics, which is intended to establish a framework for the implementation of best practices in the franchise relationship of IFA members. The IFA Code of Ethics has no force of law.

There are, and have been, other organisations and associations related to franchising in the United States. Some of these have developed to address certain issues or subgroups (eg, the American Association of Franchisees and Dealers). There are also industry-specific franchise-related associations (eg, the National Auto Dealers Association and the Asian America Hotel Owners Association). 

Franchise agreements

Common features and contractual requirements

What are the common elements of franchise agreements in your jurisdiction? Do any requirements or restrictions on contractual provisions apply?

The franchise agreement details the respective rights and obligations of the franchisor and the franchisee. It establishes the general terms of the franchise relationship, including:

• the length of the initial term and any renewal terms;
• identification of the franchised location;
• any territorial rights or territorial protections granted to the franchisee;
• conditions applicable to renewal and transfer;
• the parties’ respective rights to terminate the agreement;
• covenants against competition during the term of and following the expiration of the franchise agreement; and
• other applicable post-termination obligations. 

The franchise agreement should describe the franchisee’s obligations applicable to the development and operation of the business and all fees payable by the franchisee. Other significant operational requirements that are often described in franchise agreements include:

• advertising;
• initial and ongoing training and support;
• site selection;
• technology and computer systems;
• accounting and reporting; and
• insurance.

More specific details regarding the franchisor’s required standards and specifications are often included in the franchisor’s operations manual. The franchise agreement will also address dispute resolution (eg, the use of mediation, arbitration or litigation), governing law and other dispute resolution processes and costs. Many franchise agreements include a personal guaranty that must be signed by one or more owners of the franchisee entity.

The parties are generally free to establish the terms of the agreement. However, certain state franchise laws may prohibit franchisors from requiring a franchisee to waive application of the state’s franchise law, the right to a jury trial or certain types of damages, or from requiring consent to litigation in a forum outside the franchisee’s home state. Certain state laws may also affect or limit the enforceability of non-competition covenants and releases of claims. Many franchisors address these issues as necessary in state-specific addenda to the franchise agreement.

Are parties to a franchise agreement subject to an implied or explicit duty of good faith?

Courts have held that an implied duty of good faith applies to all contracts, including franchise agreements. The implied covenant of good faith and fair dealing, as applied by many courts, means that the parties must deal with each other honestly and fairly, and a party cannot act to deny the other party the benefit of the bargain reflected in the contract. However, the covenant of good faith and fair dealing cannot contradict the express terms of a contract or create rights and duties that are not provided in the contract. Many franchise agreements are explicit in their description of each party’s rights and responsibilities to reduce potential uncertainty regarding terms and conditions, and to minimise potential claims alleging a breach of this implied covenant.

Are franchise agreements subject to any formal or documentary requirements, including registration?

Franchise agreements generally must be in writing to be enforceable. There are no notarisation, seal or registration requirements. The form of franchise agreement that the franchisor intends to offer to, and execute with, a franchisee must be included in the franchise disclosure document (FDD).

Due diligence

What due diligence should both parties undertake before entering into a franchising agreement?

The FDD is, or should be, a critical but not exclusive part in the prospective franchisee’s evaluation of a franchise. Prospective franchisees should review the FDD, franchise agreement and related documents detailing the terms of the franchise relationship to understand the costs involved, the control exercised by the franchisor and the support services offered. The FDD includes a list of all operating franchisees and those franchisees which left the system in the most recent fiscal year. Prospective franchisees can and should speak to as many of these franchisees as possible. Prospective franchisees should evaluate competitive franchised brands and even franchises in other industries. Industry-specific trade associations also have information on businesses and operations, and these resources should be used by prospective franchisees. Prospective franchisees should evaluate whether the business model is an appropriate fit with their own business experience and whether there is a market need for the products or services offered by the franchised business in the franchisee’s ideal territory or location. Prospective franchisees should consider engaging financial and legal advisers to help assess the franchise opportunity.

Franchisors should establish criteria to assess each prospective franchisee. Such criteria should include:

• whether the franchisee is a good fit for the system;
• whether the franchisee has the appropriate experience to successfully operate the franchised business;
• whether the prospect meets minimum capital requirements;
• the availability of territory in the franchisee’s ideal market; and
• whether it makes sense for the franchisor to expand into that region.

Pre-contractual disclosure

Are franchisors subject to pre-contractual disclosure requirements? If so, do any exemptions apply? What remedies are available to franchisees in the event of breach of these requirements?

Generally, franchisors must give a prospective franchisee an FDD at least 14 calendar days before the prospect signs a binding agreement or pays any consideration to the franchisor or its affiliate. The FDD includes 23 specific disclosure items, including:

• information regarding the franchisor and its business experience;
• initial and ongoing fees payable by the franchisee;
• an estimate of the initial investment required to begin business operations;
• information regarding support provided by the franchisor before and after the business opens; and
• summaries of the key terms of the form franchise agreement.

The FDD also must include the franchisor’s financial statements, copies of the forms of franchise agreement and other contracts that a franchisee must sign and contact information for all existing franchisees in the system. 

On provision of the FDD, a franchisor must obtain from the prospective franchisee a signed and dated FDD ‘receipt’ page, which is the last page of the FDD. Franchisors must maintain a copy of all executed receipts as evidence of proper disclosure. 

A number of disclosure exemptions are available under the US Federal Trade Commission (FTC) Rule. Three of the most commonly used exemptions are the minimal franchise fee exemption, the large franchisee exemption and the large investment exemption. An exemption, if satisfied, means that the franchisor does not need to provide an FDD to the prospective franchisee. The minimal franchise fee exemption exempts franchise sales that require a franchisee to pay less than $570 in franchisee fees during its first six months of operation. The large franchisee exemption exempts franchise sales to franchisees with at least $5,715,000 in net worth and five years of prior business experience. The large investment exemption exempts franchise sales when the initial investment is $1,143,100 or more. The monetary thresholds applicable to the above exemptions are periodically updated for inflation by the FTC. 

If a franchisor wishes to avail itself of an exemption under the FTC Rule, it must also ensure that it is exempt at the state level. Not all FTC Rule exemptions are available under state laws and there are registration and disclosure exemptions at the state level that are not available under the FTC Rule. Exemption requirements vary from state to state. State exemptions are often limited to exemption from registration and therefore may require compliance with disclosure obligations.

There is no private right of action available to franchisees under the FTC Rule for failure to provide proper disclosure. Therefore, only the FTC may pursue a violation of the FTC Rule. In registration states, if a franchisor fails to provide proper disclosure or appropriately register, the franchisee may bring a claim under the applicable state law. Remedies available under state franchise laws may include rescission of the franchise agreement and damages. In addition, separate from any potential franchisee claims, if a state agency determines that a franchisor failed to comply with applicable state franchise law, the state may issue a cease and desist order, require payment of civil penalties and require the franchisor to include a disclosure related to the state franchise law violation in the FDD.

Choice of law

May the parties freely choose the governing law of the franchise agreement?

The parties are free to choose the governing law of the franchise agreement. However, since franchise agreements are drafted in the first instance by the franchisor, the franchisor often will choose the law of its home state as the governing law. In some situations, a franchisor may elect to have the law of the state in which the franchised business is located govern the agreement. If applicable, state franchise laws commonly prohibit franchisors from requiring franchisees to waive the protections granted under these laws.  

Fees

What fees are typically charged under a franchise agreement?

Franchisors commonly charge an initial franchise fee at the time of signing the franchise agreement. During the term of the agreement, franchisees are also generally required to pay an ongoing royalty fee, which is typically a percentage of gross sales. Franchisors also commonly require franchisees to contribute to a system marketing or advertising fund on a regular basis, which is typically intended for general promotion of the brand. Technology-related fees are sometimes charged if the franchisor has developed proprietary software or requires franchisees to maintain access to certain technology capabilities. Other common fees include renewal fees and transfer fees, which are payable only on renewal of the franchise rights or on transfer of the business.

Renewal

Do franchisees have a right of renewal?

Franchisees’ renewal rights are generally determined by the terms of the franchise agreement. Many (but not all) franchise agreements include a right or option to renew the agreement or to sign a new agreement for a renewal or successor period. However, certain state relationship laws prohibit franchisors from refusing to renew the franchise rights without good cause or without provision of advance notice.

On what grounds may a franchisor refuse to renew?

If a franchisee has not complied with the conditions for renewal that are established in the franchise agreement, the franchisor may generally refuse to renew the franchise agreement. If applicable, state relationship laws may impose certain restrictions on a franchisor’s refusal to renew or require the franchisor to comply with certain procedural requirements in order to refuse renewal. 

How are renewals of franchise agreements usually effected? Do any formal or substantive requirements apply?

The terms of the franchise agreement generally establish the renewal requirements. Common renewal conditions include:

• prior notice of the franchisee’s intent to renew;
• payment of a renewal fee;
• execution of a general release of claims against the franchisor and its affiliates;
• compliance with the current franchise agreement;
• remodel of the franchised business location; and
• execution of the franchisor’s then-current form of franchise agreement. 

Disclosure is generally required on renewal if the franchisee will be required to sign a materially different form of franchise agreement than the agreement under which it is operating. 

Termination

On what grounds may a franchisor terminate a franchise agreement? Are any remedies available to franchisees in this regard?

The terms of the franchise agreement establish the grounds on which a franchisor may terminate the franchise agreement. Common defaults include:

• insolvency or bankruptcy;
• abandonment of the franchised business;
• failure to pay amounts due to the franchisor or its affiliates;
• violations of health and safety laws;
• failure to comply with system standards; and
• any conduct that impairs the franchisor’s goodwill.

Franchise agreements commonly distinguish between curable and incurable defaults. If a franchisee has committed a curable default, the franchisor must allow the franchisee the opportunity to cure the default in accordance with the terms of the franchise agreement. On the occurrence of an incurable default, franchisors are generally permitted to terminate the franchise agreement immediately on notice. If applicable, state relationship laws may override the terms of a franchise agreement and require a franchisor to have ‘good cause’ for termination or provide for specific cure periods that must be afforded to the franchisee before termination.

Ongoing franchisor/franchisee relationship

Operational compliance

What mechanisms (formal and informal) are commonly used by franchisors to ensure franchisee compliance with the operational terms and standards of the agreement?

Franchisors generally reserve inspection and audit rights to monitor compliance with brand standards. Such inspections and audits may include formal or informal site visits by a representative of the franchisor, mystery shopper programmes or review of a franchisee’s business records through remote access to the franchised business’s computer or point-of-sale system. Franchisors generally issue formal written notices of default to notify franchisees of corrections required in the operation of their business. 

Amendment of operational terms

Can the franchisor unilaterally change operational terms and standards during the course of the agreement?

The franchisor is not permitted to unilaterally alter the terms of the franchise agreement. Franchisors commonly reserve the right to alter the operations manual in order to modify the brand standards to reflect trends in the marketplace or new marketing techniques, technologies and products and services. However, franchisors generally will not revise the system standards in such a way that would materially alter a franchisee’s rights under the franchise agreement.

Applicable laws

Do any specific laws affect the ongoing franchisor/franchisee relationship after they enter into the franchise agreement?

The parties are free to choose the governing law of the franchise agreement. Certain state relationship laws may also affect the parties’ relationship with regard to issues of termination, non-renewal and transfer. In particular, state relationship laws may override the terms of a franchise agreement and require a franchisor to have ‘good cause’ for termination or provide for specific cure periods that must be afforded to the franchisee before termination. Likewise, state relationship laws may impose certain restrictions on a franchisor’s refusal to renew a franchise or to approve the transfer of the franchise.

Ongoing disclosure

Do any ongoing disclosure requirements apply during the course of the agreement?

There are no ongoing disclosure requirements. However, disclosure is either required or recommended before renewing a franchise agreement.

Transfer and sale

Transfer and sale

What rules and procedures apply to the transfer and sale of a franchise business?

Franchisors will reserve the right to approve or disapprove a sale of the franchised business to a new franchisee and any change in ownership of the franchisee entity. The terms of the franchise agreement dictate the rules and processes applicable to the transfer and sale of a franchised business. Common transfer conditions include:

• prior notice of the intent to transfer;
• payment of a transfer fee;
• remodel of the franchised business location; and
• execution of a general release of claims against the franchisor and its affiliates. 

The transferee must also meet the franchisor’s standards for new franchisees, execute the franchisor’s then-current form of franchise agreement and complete any initial training required by the franchisor. Franchisors also commonly reserve a right of first refusal to acquire the franchised business if a franchisee desires to transfer.

Certain state-specific franchise relationship laws may also affect transfers. For example, the California Franchise Relations Act requires franchisors to provide to a transferring franchisee, on request, the standards they use to approve new and renewing franchisees, and to follow these standards in approving any requested transfer. 

Competition issues

Applicable laws

What competition laws apply to franchises, with particular regard to:

(a) Non-competes and other restrictive covenants?

Most modern franchise agreements used in the United States contain a non-compete provision. These provisions may apply during the term of the franchise agreement (an ‘in-term’ covenant), for a period following the end of the agreement (a ‘post-term’ covenant) or both. In-term non-compete clauses typically prohibit a franchisee from owning or maintaining an interest in a business that offers the same or similar goods or services as those offered by the franchise system during the course of the franchise agreement. Post-term non-compete provisions impose the same type of restrictions on the franchisee, but go into effect once the franchise agreement expires or terminates and continue for a limited duration thereafter. In-term non-competes may apply nationwide, but post-term non-competes tend to be more limited in geographic scope.

No federal law in the United States governs the use of non-compete covenants in the franchise context. The enforceability of covenants against competition is principally governed by state statutory or common law. Some states will not enforce a non-compete covenant as a matter of public policy. However, courts in many states will enforce a covenant against competition if it is reasonable in terms of its durational and geographic restrictions and is necessary to protect the franchisor’s legitimate business interests. 

(b) Exclusive geographical areas?

An exclusive or protected territory generally entails a promise that the franchisor will not operate in or grant another franchise in that territory. Territorial restrictions in franchise agreements are generally legal under US antitrust law as long as they are not the product of an agreement among competitors. Accordingly, state contract law typically governs the enforceability of a provision in a franchise agreement that grants to the franchisee an exclusive territory. 

In addition, some state franchise relationship statutes (eg, the Washington Franchise Investment Protection Act and the Iowa Franchise Act) include protections related to encroachment issues that may also apply. 

(c) Price fixing and mandatory product purchases?

Sourcing and price controls imposed by a franchisor are subject to certain limitations under federal and state antitrust laws and state franchise relationship laws.

A franchisor can require franchisees to buy products and services only from the franchisor or its designated or approved suppliers. These restrictions must be disclosed in the franchisor’s franchise disclosure document (FDD). While a franchisee may challenge those restrictions as an unlawful tying arrangement under federal and state antitrust laws, such claims rarely succeed. With some exceptions, as long as the sourcing requirements were disclosed through the FDD or other pre-sale communications with the franchisee, these arrangements do not usually expose franchisors to antitrust liability. However, certain state franchise relationship laws (eg, the Washington Franchise Investment Protection Act) place limitations on sourcing requirements.     

In addition, federal and state antitrust laws regulate pricing restrictions. Vertical agreements between franchisors and franchisees setting minimum or maximum resale prices are generally lawful under federal law. However, state law on this issue varies and must also be considered before a franchisor implements agreements that establish resale prices. 

(d) Online trading?

No laws govern restrictions on online trading. Franchise agreements can prohibit franchisees from having their own website presence and from selling products or services over the Internet, provided that the franchisor is not acting collectively with competing franchisors to impose those restrictions. At the same time, franchisors can, and commonly do, reserve for themselves the right to sell products or services over the Internet or through other alternative distribution channels. 

(e) Other?

Most franchise agreements used in the United States contain requirements and restrictions relating to the transfer of the franchised business. In particular, franchisors often require that the franchisee first obtain the franchisor’s prior approval before transferring the franchise. Certain state franchise relationship laws require that the franchisor’s refusal to approve a transfer not be arbitrary and that the franchisor have a reasonable basis to reject the proposed transferee.

Intellectual property

IP rights

How can franchisors protect their intellectual property (eg, trademarks and copyright)?

One of the principal means for franchisors to protect their intellectual property is through registration. Trademarks can be registered at the state and federal levels, although nationwide protection can be achieved only through federal registration. Unregistered rights in a trademark are governed by the common law and extend only to the geographic territory where the mark is actually used. At the federal level, registration with the US Patent and Trademark Office (USPTO) gives the franchisor a priority of rights in the trademark on a nationwide basis. Once a trademark is registered with the USPTO, there is a rebuttable presumption that the registrant is the owner of the mark, that the mark is valid and that the registrant has the exclusive right to use the mark. The trademark owner may license others to use the mark and to pursue enforcement of infringers. After five years, the registrant’s rights in the mark become ‘incontestable’, which shields the registrant from certain challenges to the validity of the mark. States also have trademark registration laws. However, state trademark registrations have limited value to a franchisor with regional or national expansion plans because the trademark protection is restricted to that state.

The US Copyright Office also has a system for registering copyrights. Under US law, a copyright attaches to an original work of authorship at the time that it is created. While registration with the Copyright Office is not required, if the owner of a copyright wishes to bring a lawsuit for copyright infringement, the owner must register the work before bringing a claim. 

Franchisors can take other practical steps to protect their intellectual property in the United States in addition to registration. For example, franchisors can ensure the continuing strength of their trademarks by using the marks consistently and avoiding changes in their appearance and presentation. Franchisors should also use trademark notices (eg, the ‘®’ symbol for federally registered marks and the ‘™’ symbol for all other marks) to demonstrate their ownership rights. Likewise, franchisors can include copyright notices and restrictive legends on their copyrighted works, which communicates to the public that the franchisor considers the work to be proprietary. 

Franchisors can further maintain the exclusivity and value of their intellectual property by monitoring the marketplace and taking action against infringers. In particular, there is a risk that a trademark may be deemed abandoned and lose protection under the federal law if a franchisor fails to prevent the unauthorised use of the mark or fails to maintain adequate quality controls in connection with the mark. Franchisors can also benefit from including strong, reasonably tailored in-term and post-term restrictive covenants in their franchise agreements designed to protect their intellectual property, and from enforcing those covenants as necessary.

Must IP licences be registered?

A franchisee’s licence to use the franchisor’s trademarks and other intellectual property in the operation of the franchised business is typically granted by the parties’ franchise agreement. That licence need not be registered with any government agency or other organisation.

Know-how

How can franchisors protect their know-how and trade secrets?

US law recognises the value in confidential methods and knowledge that rise to the level of ‘trade secrets’. A ‘trade secret’ is defined as any information in any form that derives independent economic value from not being generally known or readily ascertainable and that is the subject of reasonable efforts to maintain its secrecy. No government filing is required in order for information to be recognised as a trade secret.

In 2016 the federal government enacted a statute for the protection of trade secrets entitled the Defend Trade Secrets Act. Before enactment of this act, businesses obtained protection of their trade secrets on a state-by-state basis under state statutes. Forty-eight states have adopted the Uniform Trade Secrets Act. The Defend Trade Secrets Act does not pre-empt the Uniform Trade Secrets Act and claims can be brought under both federal and state law for the misappropriation of trade secrets. 

For information to retain its status as a trade secret, a franchisor must closely monitor the information and take measures to maintain its secrecy. Anyone who has access to the information (eg, employees, vendors and franchisees) should be subject to strict confidentiality obligations that are memorialised in written agreements. A franchisor should also:

• keep track of the individuals with access to the information;
• implement physical or electronic barriers to the information as appropriate; and
• make sure to retrieve any pertinent materials from franchisees and employees upon their separation from the system.

Breach

What are the consequences of a franchisee’s breach of the franchisor’s IP, know-how or trade secret rights and what remedies are available to the franchisor in this regard?

A franchisee’s breach of its obligations with respect to the franchisor’s intellectual property may result in a loss of the goodwill associated with that intellectual property, customer confusion and damage to the brand’s reputation. Generally, in response to a franchisee’s misappropriation of its intellectual property, a franchisor may:

• seek injunctive relief;
• file suit to seek monetary damages to compensate the franchisor for the breach; or
• if the breach occurs during the term of the franchise agreement, declare a default and terminate the franchise agreement if all other requirements for termination are satisfied. 

If successful on a trademark infringement claim, a franchisor can obtain injunctive relief, including an order that the infringing conduct be stopped. In addition, courts may award the trademark owner its actual damages, enhanced treble damages in appropriate cases, costs and attorneys’ fees in exceptional cases. Courts may also order other relief, such as the seizure and destruction of infringing goods.

With respect to trade secrets, remedies that may be available under the Defend Trade Secrets Act and the Uniform Trade Secrets Act include injunctive relief, monetary damages caused by the misappropriation, exemplary damages and an award of attorneys’ fees.

Real estate

Laws and considerations

What real estate laws and considerations should franchisors bear in mind where:

(a) The franchisor owns the premises on which the franchisee operates?

All US states and many cities and other jurisdictions have laws and regulations that address ownership, leasing, sub-leasing and transfers of real estate. These laws apply to all businesses and are not specific to franchising. However, there are real estate issues that a franchisor may wish to consider. Franchisors should take steps to exercise control over the premises of the franchised business so that on termination or expiration of the applicable franchise agreement they do not lose valuable customer exposure, the location or signage. Owning the franchised property and leasing it to the franchisee position the franchisor to more easily take possession of the site on termination or expiration, and operate there or grant a new franchise for the site. Many franchise agreements include provisions that address these issues and will reference the applicable lease provision, or include cross-defaults running between the franchise agreement and the lease and vice versa. While owning the property is a desirable method to control the site, it does involve significant financial expenditures, risks and effects on the franchisor’s financial statements.

(b) The franchisor sub-leases the premises to the franchisee?

Where a franchisor leases the premises on which the franchisee operates and then sub-leases the premises to the franchisee, the franchisor will want to position itself to take possession of the site on termination or expiration and operate there or grant a new franchise for the site. Many franchise agreements include provisions that address these issues and will reference the applicable sub-lease provision, and/or include cross-defaults running between the franchise agreement and the sub-lease and vice versa. While sub-leasing the property to the franchisee is a desirable method to control the site, it does involve significant financial expenditures and risks.

(c) The franchisee leases the premises from a third-party landlord?

Where a franchisee leases the franchised premises from a third-party landlord, a franchisor may want to require the franchisee to execute a conditional assignment of the lease. This is an agreement in which the franchisee and the lessor/landlord agree to assign the property to the franchisor on the termination or expiration of the lease/sub-lease or the franchise agreement. A variation of this method is to include in the franchise agreement certain lease/sub-lease terms that a franchisee is required to include in its lease/sublease, as part of the site approval and leasing process. Two challenges for franchisors are:

• not all landlords will agree to these provisions; and
• franchisors need the operational and administrative discipline to review carefully the lease/sublease of the franchisee and, if necessary, negotiate with the landlord. 

Many franchise agreements contain provisions that allow the franchisor to purchase the franchisee’s outlet or take an assignment of the lease/sublease on termination or expiration of the franchise agreement. This process usually includes a purchase at a pre-determined price or valuation formula, or at a price determined by an appraiser. While these provisions are enforceable, they may require extra judicial steps to be accomplished.

(d) The franchisee owns the premises?

Where the franchisee owns the premises on which it operates the franchised business, the franchisor may insist on an assignment of the property or a lease from the franchisee to the franchisor on termination or expiration of the franchise agreement. Such a provision is enforceable. However, as a practical matter, it is difficult for a franchisor to secure such an agreement.

Employment issues

Liability

Can franchisees or their employees be regarded as employees of the franchisor for liability purposes? If so, how can franchisors mitigate this risk?

Generally, franchisors and franchisees are not considered to be in an employer-employee relationship. Rather, franchisees are classified as ‘independent contractors’ and operate as separate legal entities. However, in recent years the courts have found that franchisees may be employees of their franchisor for purposes of labour, tax and other laws, where the franchisor exercises excessive controls over the activities of the franchisees. The results in these cases turn on the specific facts at issue and also on the state-specific test used to determine the franchisee’s status as an independent contractor, which can vary. Accordingly, franchisors can mitigate the risk of having their franchisees classified as employees by structuring and implementing the franchise relationship in a manner that is consistent with the independent contractor laws in the states in which each franchised business operates.

In addition, franchisors operating in the United States face an increasing risk that they may be regarded as joint employers of their franchisees’ employees. Factors that may lead to a finding of a joint employer relationship include the franchisor:

• having the authority to hire and fire the franchisee’s employees, promulgate work rules and assignments, and set conditions of employment (eg, compensation, benefits and hours);
• maintaining day-to-day supervision of the employees, including the ability to discipline employees; and
• maintaining control over employee records, including payroll, insurance and tax records.

Franchisors can mitigate the risk of joint employment by making certain changes to their disclosure documents, franchise agreements and operations manuals to emphasise the franchisee’s status as an independent contractor. In particular, the franchise agreement should make explicit that the franchisee is solely responsible for all employment-related decisions and for compliance with all state and federal labour and employment laws. In addition, franchisors can limit their exposure by providing only voluntary recommendations for franchisees with respect to employment issues and eliminating or limiting any contractual provision that gives the franchisor the right to train, advise or approve the franchisee’s employees or to set grooming or appearance standards for those employees. To further protect themselves, franchisors should limit the use of their trademarks on the franchisee’s paystubs or in the franchisee’s corporate name so that employees of the franchisee have a clear understanding of the entity that serves as their employer.

Tax and currency controls

Tax implications

What tax regimes apply to the franchisor/franchisee relationship?

Taxes are imposed in the United States by federal, state and local governments. A foreign franchisor will be subject to the tax laws of the jurisdictions in which it operates. If the foreign franchisor establishes a US-based subsidiary as the franchisor, the US-based entity will be subject to the tax laws. Franchisors will be subject to income taxes, which are generally assessed on revenues or income, after certain deductions and adjustments. The federal tax rate ranges from 10% to 39.6% of taxable income. State and local taxes vary from 0% to 13.3% of income. If the entity that is being taxed is a corporation, there is the possibility of double taxation, with income tax also imposed on the shareholders or owners. For certain entities (eg, limited liability companies and partnerships), the tax is ‘passed through’ to the owners of the entities. The typical revenue received by a franchisor – initial franchise fees and agency royalty fees – will be treated and taxed as ordinary income, and not at the lower capital gains rates.

A foreign franchisor will be taxed on its US sources of income, even if it does not have a physical place of business in the United States. Taxes will be assessed at the federal level and by some states. If the foreign franchisor operates in the United States or creates a US subsidiary, the state in which the headquarters is located or in which the entity is formed may assess taxes on that entity. In addition, more states are seeking to assess taxes from out-of-state entities that are doing business in the state, even if not physically located there. Therefore, some states are seeking to assess income tax on foreign entities that have franchises operating in that state. That means that an out-of-state franchisor may be subject to tax on the royalty income it receives from a franchisee located in a particular state. Out-of-state franchisors may be able to obtain credit on their home state taxes for taxes paid in other jurisdictions. It is important to understand whether a nexus exists with the taxing state and whether it is possible to challenge the claim of extraterritorial taxes.

Federal law also requires that the tax on royalties paid to a foreign entity be withheld at the source and paid to the Internal Revenue Service. However, certain tax payments may be reduced or exempted from withholding under some tax treaties with foreign countries.

Currency controls

Do any currency controls apply with respect to foreign franchisors?

Generally, the United States does not impose currency or exchange controls on the transfer of money by a US-based entity (eg, a US franchisee) to a foreign entity (unless the foreign entity’s home country is subject to US economic sanctions). However, IP-based payments to a foreign franchisor (eg, royalty payments) may be subject to a 30% withholding tax. If the United States and the foreign country are parties to an income tax treaty, the foreign franchisor may be entitled to a partial reduction or full exemption from the tax withholding.

Dispute resolution

Common disputes

What issues are typically the subject of disputes arising in the franchisor/franchisee relationship?

The most common issues raised by franchisors include the franchisee’s:

• failure to comply with the operational standards of the franchise system;
• failure to pay royalties and other contractual fees;
• violation of in-term or post-term covenants against competition; and
• unauthorised, continued use of the franchisor’s trademarks or trade secrets following the conclusion of the franchise agreement. 

Typical claims raised by franchisees include the franchisor’s:

• alleged misrepresentations during the franchise sales process, particularly with respect to the financial performance that the franchisee could expect to achieve in operating the business;
• noncompliance with franchise disclosure or registration requirements;
• violation of state relationship statutes;
• encroachment of the franchisee’s exclusive territory;
• wrongful termination of or refusal to renew the franchise agreement; and
• failure to provide training and support.

Venue

Which venues are empowered to hear franchising disputes in your jurisdiction? What considerations should be borne in mind when choosing a venue?

There is no mandatory venue for franchise disputes in the United States. Parties may litigate their dispute in a court of law, in which case they will need to choose between state or federal courts. Whether a franchisor or franchisee chooses to sue in a state or federal court depends on the nature of each party’s substantive claims and on where the parties reside. 

If both the franchisor and franchisee reside in the same state and the case does not concern a question of federal law, a federal court would lack subject-matter jurisdiction over the matter. In that scenario, the dispute would need to be litigated in state court. However, if the franchisor and franchisee reside in different states (or if either party resides in a foreign country) and the amount at issue exceeds $75,000 exclusive of costs and interest, a federal court would have subject-matter jurisdiction over the case based on diversity of citizenship. 

Many franchise agreements also contain forum selection clauses that designate a particular forum for disputes arising out of the contract. These clauses are generally presumed to be valid and enforceable; however, they can be challenged on the basis that they contravene a strong public policy of a forum state. In particular, certain franchise relationship statutes at the state level purport to render void a provision in a franchise agreement requiring the franchisee to litigate certain claims in an out-of-state forum. 

Alternative dispute resolution

Is alternative dispute resolution (ADR) commonly used for franchising disputes in your jurisdiction? What considerations should be borne in mind when opting for ADR?

ADR is commonly used to resolve franchise disputes in the United States. US law strongly favours the enforcement of arbitration agreements, and many franchisors include broad arbitration clauses in their franchise agreements covering disputes arising from or relating to the franchise relationship. Accordingly, a significant percentage of franchise disputes are arbitrated rather than decided in a judicial forum.

Arbitration traditionally has been viewed as offering a number of advantages over litigation, including:

• greater efficiency and lower costs due to more limited discovery and streamlined pre-hearing procedures;
• the ability to select an arbitrator with franchise industry or commercial experience;
• the opportunity to keep the proceedings confidential; and
• the general lack of a preclusive effect of an adverse arbitration award.

However, experience over the last several decades may cast doubt on those efficiency claims. In addition, arbitration results in a binding decision, and there are limited rights to appeal or challenge arbitration awards. Moreover, some claims may not be well suited for arbitration (eg, those that require expedited relief in the form of a temporary restraining order or preliminary injunction).

Some franchisors and franchisees agree to pre-suit mediation as an alternative means of dispute resolution. Franchise agreements may even require that the parties first engage in mediation before initiating litigation or arbitration, and those provisions are generally enforceable. As with arbitration, parties to a franchise agreement can negotiate the terms of the mediation, including the allocation of mediation costs, the process for selecting the mediator and the location for the mediation. In addition, many state and federal courts have enacted mandatory mediation programmes that require parties to participate in mediation with a court-appointed mediator before the litigation will proceed.

Foreign judgments and awards

What regulations and procedures apply to the recognition of foreign judgments and arbitral awards where international franchising networks are concerned?

The United States has not enacted federal legislation to govern the recognition and enforcement of judgments issued abroad, and it is not a party to any international treaty that addresses those issues. Accordingly, state law provides the applicable legal framework for enforcing foreign judgments in both state and federal courts. Some states have adopted the Uniform Foreign Money-Judgments Recognition Act 1962; others have adopted the Uniform Foreign-Country Money Judgments Recognition Act 2005, or have adopted neither and instead follow common law principles. Both of these recognition acts apply solely to judgments granting or denying a sum of money and exclude from their coverage judgments for injunctive, declaratory or other equitable relief. 

A party seeking to enforce a foreign judgment must first bring an action in federal or state court to have the judgment recognised (ie, converted into a US judgment). Under the recognition acts, the applicant must establish that the judgment is final, conclusive and enforceable in its country of origin. The party opposing recognition may raise any grounds for non-recognition, including that the judgment was rendered under a judicial system that does not provide impartial tribunals or procedures compatible with due process of law. The court considering the recognition petition must also have personal jurisdiction over the judgment debtor or over the judgment debtor’s assets in the forum state. Once it is judicially recognised, a foreign judgment is enforceable as a domestic judgment and the judgment creditor may proceed against the property of the judgment debtor in the forum state to satisfy the judgment amount. 

With respect to arbitral awards, the Federal Arbitration Act implements two multilateral treaties: the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (the New York Convention) and the Inter-American Convention on International Commercial Arbitration (the Panama Convention). An arbitral award arising from a commercial relationship and obtained in a country that is also a party to the New York Convention is enforceable by application to one of the federal district courts, which have original jurisdiction to confirm the award. The Panama Convention governs the enforcement of arbitral awards rendered in disputes between citizens of two or more of the 19 signatory South, Central and North American countries. 

Actions to enforce a foreign arbitral award must be brought before a court that has personal jurisdiction over the defendant or its property, and proper venue must also be established. Under the New York and Panama Conventions, an application to obtain the recognition and enforcement of a foreign arbitral award may be filed in any court in which the underlying dispute could have been brought if there had been no agreement to arbitrate, or in the location designated for arbitration in the arbitration agreement if that location is within the United States. In addition, where the award was rendered in a language other than English, certified translations will also be required. If enforcement is not challenged and no grounds for modification or vacatur are found, the court will enter judgment on the award.  

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