BLAW ch.36

Pricing Arrangements

Franchises provide the franchisor with an outlet for the firm's goods and services. Depending on the nature of the business, the franchisor may require the franchisee to purchase certain supplies from the franchisor at an established price. A franchisor cannot set the prices at which the franchisee will resell the goods. Such price setting may be a violation of state or federal antitrust laws, or both. A franchisor can suggest retail prices but cannot mandate them.

The Importance of Good Faith and Fair Dealing

Generally, both statutory law and case law emphasize the importance of good faith and fair dealing in terminating a franchise relationship. In determining whether a franchisor has acted in good faith when terminating a franchise agreement, the courts usually try to balance the rights of both parties. If a court perceives that a franchisor has arbitrarily or unfairly terminated a franchise, the franchisee will be provided with a remedy for wrongful termination. A court will be less likely to consider a termination wrongful if the franchisor's decision was made in the normal course of business and reasonable notice was given.

Types of Franchises

Many kinds of businesses sell franchises, and numerous types of franchises are available. Generally, franchises fall into one of three classifications: distributorships, chain-style business operations, and manufacturing arrangements.

Grounds for Termination Set by Franchise Contract

Usually, the franchise agreement specifies that termination must be "for cause" and then defines the grounds for termination. Cause might include the death or disability of the franchisee, insolvency of the franchisee, breach of the franchise agreement, or failure to meet specified sales quotas.

Opportunity to Cure a Breach

A franchise agreement may allow the franchisee to attempt to cure an ordinary, curable breach within a certain time after notice to postpone—or even avoid—termination. Even when a contract contains a notice-and-cure provision, a franchisee's breach of the duty of honesty and fidelity may be enough to allow the franchisor to terminate the franchise.

Advantages of the Sole Proprietorship

A major advantage of the sole proprietorship is that the proprietor owns the entire business and receives all the profits (because she or he assumes all the risk). -Starting a sole proprietorship is also easier and less costly than starting any other kind of business because few legal formalities are required. Generally, no documents need to be filed with the government to start a sole proprietorship.

State Disclosures

A number of states have laws like the federal rules that require franchisors to provide presale disclosures to prospective franchisees. Many state laws also require that a disclosure document (known as the Franchise Disclosure Document, or FDD) be registered or filed with a state official. State laws may also require that a franchisor submit advertising aimed at prospective franchisees to the state for approval. To protect franchisees, a state law might require the disclosure of information such as the actual costs of operation, recurring expenses, and profits earned, along with facts substantiating these figures. State deceptive trade practices acts may also apply and prohibit certain types of actions by franchisors.

Degree of Control

As a general rule, the validity of a provision permitting the franchisor to establish and enforce certain quality standards is unquestioned. The franchisor has a legitimate interest in maintaining the quality of the product or service to protect its name and reputation. If a franchisor exercises too much control over the operations of its franchisees, the franchisor risks potential liability. A franchisor may occasionally be held liable—under the doctrine of respondeat superior—for the tortious acts of the franchisees' employees.

Laws Governing Franchising

Because a franchise relationship is primarily a contractual relationship, it is governed by contract law. If the franchise exists primarily for the sale of products manu-factured by the franchisor, the law governing sales contracts as expressed in Article 2 of the Uniform Commercial Code applies. The federal government and most states have also enacted laws governing certain aspects of franchising. Generally, these laws are designed to protect prospective franchisees from dishonest franchisors and to prevent franchisors from terminating franchises without good cause.

Chain-Style Business Operation

In a chain-style business operation, a franchise operates under a franchisor's trade name and is identified as a member of a select group of dealers that engage in the franchisor's business. The franchisee is generally required to follow standardized or prescribed methods of operation. Often, the franchisor insists that the franchisee maintain certain standards of performance. The franchisee may also be required to obtain materials and supplies exclusively from the franchisor. Chipotle Mexican Grill and most other fast-food chains are examples of this type of franchise. Chain-style fran-chises are also common in service-related businesses, including real estate brokerage firms and tax-preparing services.

The Franchise Rule

The FTC's Franchise Rule requires franchisors to disclose certain material facts that a prospective franchisee needs to make an informed decision concerning the purchase of a franchise. Those who violate the Franchise Rule are subject to substantial civil penalties, and the FTC can sue on behalf of injured parties to recover damages. The rule requires the franchisor to make numerous written disclosures to prospective franchisees. All representations made to a prospective franchisee must have a reasonable basis. For instance, if a franchisor provides projected earnings figures, the franchisor must indicate whether the figures are based on actual data or hypothetical examples. If a franchisor makes sales or earnings projections based on actual data for a specific franchise location, the franchisor must disclose the number and percentage of its existing franchises that have achieved this result.

Quality Control by the Franchisor

The day-to-day operation of the franchise business normally is left up to the franchisee. Nonetheless, the franchise agreement may specify that the franchisor will provide some degree of supervision and control so that it can protect the franchise's name and reputations

Federal Regulation of Franchises

The federal government regulates franchising through laws that apply to specific industries and through the Franchise Rule, created by the Federal Trade Commission (FTC).

Business Premises

The franchise agreement may specify whether the premises for the business must be leased or pur-chased outright. Sometimes, a building must be constructed to meet the terms of the agreement. The agreement will specify whether the franchisor or the franchisee is responsible for supplying equipment and furnishings for the premises.

Business Organization

The franchisor may require that the business use a certain organizational form and capital structure. The franchise agreement may also set out standards such as sales quotas and record-keeping requirements. A franchisor may also retain stringent control over the training of personnel involved in the operation and over admin-istrative aspects of the business.

Lack of Continuity and Limited Ability to Raise Capital

The sole proprietorship also lacks continuity after the death of the proprietor. When the owner dies, so does the business—it is automatically dissolved. In raising capital, the proprietor is limited to his or her personal funds and any loans that he or she can obtain for the business. Lenders may be unwilling to make loans to sole proprietorships—particularly start-ups—because the sole proprietor risks unlimited personal liability and may not be able to pay.

May Require Good Cause to Terminate the Fran-chise

To prevent arbitrary or bad faith terminations, a state law may prohibit termination without "good cause" or require that certain procedures be followed in terminating a franchise.

Location of the Franchise

Typically, the franchisor deter-mines the territory to be served. Some franchise contracts give the franchisee exclusive rights, or "territorial rights," to a certain geographic area. Other franchise contracts, while defining the territory allotted to a certain franchise, either specifically state that the franchise is nonexclusive or are silent on the issue of territorial rights. Many franchise disputes arise over territorial rights, and the implied covenant of good faith and fair dealing often comes into play in this area of franchising. If the contract does not grant exclusive territorial rights to the franchisee and the franchisor allows a competing franchise to be established nearby, the franchisee may suffer significant lost profits. In this situation, a court may hold that the franchisor breached an implied covenant of good faith and fair dealing.

FRANCHISES

is an arrangement in which the owner of intellectual property—such as a trademark, a trade name, or a copyright—licenses others to use it in the selling of goods or services. -A franchisee (a purchaser of a franchise) is generally legally independent of the franchisor (the seller of the franchise). At the same time, the franchisee is economically dependent on the franchisor's integrated business system and obtains the advantages of a regional or national organization. -Franchising companies and their franchisees account for a significant portion of all retail sales in the United States. Franchising has also become a popular way for businesses to expand their operations internationally without violating the legal restrictions that many nations impose on foreign ownership of businesses.

FRANCHISE TERMINATION

The duration of the franchise is determined between the parties. Sometimes, a franchise relationship starts with a short trial period so that the franchisee and the franchisor can determine whether they want to stay in business with one another. At other times, the duration of the franchise contract correlates with the term of the lease for the business premises, and both are renewable at the end of that period.

Taxes

A sole proprietor pays only personal income taxes (including Social Security and Medicare taxes) on the business's profits. The profits are reported as personal income on the proprietor's personal income tax return. Sole proprietors can establish retirement accounts that are tax-exempt until the funds are withdrawn. Like any form of business enterprise, a sole proprietorship can be liable for other taxes (such as those collected and applied to the disbursement of unemployment compensation).

Flexibility

A sole proprietorship offers more flexibility than does a partnership or a corporation. The sole proprietor is free to make any decision she or he wishes concerning the business—including what kind of business to pursue, whom to hire, and when to take a vacation. The sole proprietor can sell or transfer all or part of the business to another party at any time without seeking approval from anyone else. In contrast, approval is typically required from partners in a partnership and from shareholders in a corporation.

Wrongful Termination

Because a franchisor's termination of a franchise often has adverse consequences for the franchisee, much franchise litigation involves claims of wrongful termination. Generally, the termination provisions of contracts are more favorable to the franchisor than to the franchisee. This means that the franchisee—who normally invests substantial time and financial resources in making the franchise operation successful—may receive little or nothing for the business on termination. The franchisor owns the trademark and hence the business. It is in this area that statutory and case law become important. Federal and state laws attempt to protect franchisees from the arbitrary or unfair termination of their franchises by the franchisors.

Trademarks

Choosing a trademark or service mark and making sure that it is protected under trademark law can be crucial to the success of a new business venture. The general rule is that a trademark cannot be the same as another's mark or so similar that confusion might result. -For the most protection, trademarks should be registered with the U.S. Patent and Trademark Office (PTO). If the mark is federally registered, the owner may use the symbol ® with the mark. This symbol puts others on notice of the registration and helps to prevent trademark infringement. -An owner who has not registered can use the symbol TM. Registration with the PTO should be renewed five years after the initial registration and at ten-year intervals thereafter.

Industry-Specific Standards

Congress has enacted laws that protect franchisees in certain industries such as automobile dealerships and service stations. These laws protect the franchisee from unreasonable demands and bad faith terminations of the franchise by the franchisor. An automobile manufacturer-franchisor cannot make unreasonable demands of dealer-franchisees or set unrealistically high sales quotas. If an automobile manufacturer-franchisor terminates a franchise because of a dealer-franchisee's failure to comply with unreasonable demands, the manu-facturer may be liable for damages. Federal law prescribes the conditions under which a franchisor of service stations can terminate the franchise. Sometimes, federal antitrust laws apply in specified circumstances to prohibit certain types of anticompetitive agreements.

Personal Assets at Risk

Creditors can pursue the owner's personal assets to satisfy any business debts. Although sole proprietors may obtain insurance to protect the business, liability can easily exceed policy limits. This unlimited lia-bility is a major factor to be considered in choosing a business form.

Distributorship

In a distributorship, a manufacturer (the franchisor) licenses a dealer (the franchisee) to sell its product. Often, a distributorship covers an exclusive territory. Automobile dealerships and beer distributorships are common examples.

Manufacturing Arrangement

In a manufacturing, or processing-plant, arrangement, the franchisor transmits to the franchisee the essential ingredients or formula to make a certain product. The franchisee then markets the product either at wholesale or at retail in accordance with the fran-chisor's standards. Examples of this type of franchise include Pepsi-Cola and other soft-drink bottling companies.

SOLE PROPRIETORSHIPS

In its earliest stages, a small business may operate as a sole proprietorship, which is the simplest form of business. In this form, the owner is the business and anyone who does business without creating a separate business organization has a sole proprietorship. The law considers all new, single-owner businesses to be sole proprietorships unless the owner affirmatively adopts some other form. -More than two-thirds of all U.S. businesses are sole propri-etorships. Sole proprietors can own and manage any type of business. About 99 percent of the sole proprietorships in the United States have revenues of less than $1 million per year.

Obtaining Loans

In the early days of a business, the sole proprietor may be able to contribute sufficient capital, but as the business becomes successful, more funds may be needed. The owner may want to raise capital from external sources to expand the business. -Obtaining a bank loan is beneficial for small businesses because it allows the owner to retain full ownership and control of the business. However, the bank may place some restrictions on future business decisions as a condition of granting the loan. -The loans may not be available for some businesses. Banks are usually reluctant to lend significant sums to businesses that are not yet established. Even if a bank is willing to make such a loan, it may require personal guaranty contracts from the owner, putting the owner's personal assets at risk. -Loans with desirable terms may be available from the U.S. Small Business Administration (SBA). One SBA program provides loans of up to $25,000 to businesspersons who are women, low-income individuals, or members of minority groups. Be aware that the SBA requires business owners to put some of their own funds at risk in the business. In addition, many states offer small-business grants to indivi-duals starting a business.

Notice Requirements

Most franchise contracts provide that notice of termination must be given. If no set time for termination is specified, then a reasonable time, with notice, is implied. A franchisee must be given reasonable time to wind up the business—that is, to do the accounting and return the copyright or trademark or any other property of the franchisor.

Trade Secrets

Much of the value of a small business may lie in its trade secrets such as information about product development and customer lists. Preserving the secrecy of the information is necessary for legal protection. -Trade secrets must be divulged to key employees. Thus, any business runs the risk that those employees might disclose the secrets to competitors—or even set up competing businesses themselves. -Companies may require employees who have access to trade secrets to agree in their employment contracts never to divulge those secrets. -A small business may also include a covenant not to compete in an employment contract. A noncompete clause will help to protect against the possibility that a key employee will go to work for a competitor or set up a competing business.

Requirements for All Business Forms

No matter its form, any business must meet a variety of legal requirements, which typically relate to the following: (1) Business name registration. (2) Occupational licensing. (3) State tax registration (e.g., to obtain permits for collecting and remitting sales taxes). (4) Health and environmental permits. (5) Zoning and building codes. (6) Import/export regulations. If the business has employees, the owner must also comply with a host of laws governing the workplace.

GENERAL CONSIDERATIONS FOR SMALL BUSINESSES

Once a business is under way, the sole proprietorship form may become too limited. The owner and any additional investors may then want to establish a more formal organization, such as a partnership, a limited liability company (LLC), or a corporation. These forms of business limit the owner's personal liability (legal responsibility) for business debts and obligations. Each business form has its own advantages and disadvantages, but legal limited liability generally is necessary for those who wish to raise outside capital.

Protecting Intellectual Property

Protecting rights in intellectual property is a central concern for many small businesses. Without copyright or patent protection, a competitor or a customer could simply copy the software or app.

State Regulation of Franchising

State legislation varies but often is aimed at protecting franchisees from unfair practices and bad faith terminations by franchisors.

The Franchise Contract

The franchise relationship is defined by the contract between the franchisor and the franchisee. The franchise contract specifies the terms and conditions of the franchise and spells out the rights and duties of the franchisor and the franchisee. If either party fails to perform its contractual duties, that party may be subject to a lawsuit for breach of contract. If a fran-chisee is induced to enter into a franchise contract by the franchisor's fraudulent misrepresentation, the franchisor may be liable for damages. Generally, statutes and the case law governing franchising tend to emphasize the importance of good faith and fair dealing in franchise relationships.

Payment for the Franchise

The franchisee ordinarily pays an initial fee or lump-sum price for the franchise license (the privilege of being granted a franchise). This fee is separate from the various products that the franchisee purchases from or through the franchisor. The franchise agreement may also require the franchisee to pay a percentage of the franchisor's advertising costs and certain administrative expenses. In some industries, the franchisor relies heavily on the initial sale of the franchise for realizing a profit. In other industries, the continued dealing between the parties brings profit to both. Generally, the franchisor receives a stated percentage of the annual (or monthly) sales or volume of business done by the franchisee.

Disadvantages of the Sole Proprietorship

The major disad-vantage of the sole proprietorship is that the proprietor alone bears the burden of any losses or liabilities incurred by the business enterprise. Any lawsuit against the business or its employees can lead to unlimited personal liability for the owner of a sole proprietorship.

Means of Control

When the franchise prepares a product or provides a service, the contract often states that the franchisor will establish certain standards for the facility. Typically, the contract will state that the franchisor is permitted to make periodic inspections to ensure that the standards are being maintained. As a means of controlling quality, franchise agreements also typically limit the franchisee's ability to sell the franchise to another party.