Hidden franchises can cause big legal problems for unwary

A hidden franchise involves the characteristics of a franchise even though neither party intended to create a franchise relationship.

The Denver Business Journal
July 30, 2004

Hidden franchises can cause big legal problems for unwary
Jeffrey Brimer

Have you recently profited by sharing your marketing plan with another business or by allowing your trademarked products to be used by another company?

Are you making money by having significant control over the operations of another person's business as well as your own?

If you answered "yes" to any of these questions, you may have formed a hidden franchise — and put your business at considerable legal and financial risk. It's illegal to sell a hidden franchise, and those doing so are subject to civil and criminal fines and other penalties. (It's not illegal to buy one.)

More people are looking at franchising opportunities that allow business owners to leverage a widely known brand or product.

According to the International Franchise Association, franchises generate more than $229 billion in annual revenue and provide nearly 10 million jobs nationwide. In Colorado, there are more than 15,000 franchises employing more than 180,000 people.

Their growing popularity can be attributed to potential rapid growth, access to capital and other factors. But these factors also have been known to entice the formation of relationships that unintentionally take the form of a (hidden) franchise.

By definition, a franchise is a formal business relationship, typically between independent persons, that involves the sale or distribution of goods or services. The foundation of a formal franchise relationship is established in a franchise offering circular (FOC). This customized document contains details, including general franchisor information, franchise fees, restrictions on sources of products and/or services, financing, obligations, patents and copyrights, a list of franchise outlets and a sample copy of the franchise agreement.

This example illustrates the ease with which a hidden franchise can occur:

The owner of Company A, a boutique clothing company specializing in ward-robes and attire for female executives, has an established brand and rising profits.

The owner of Company B approaches him with an enticing offer. Company B plans to open a similar retail clothing outlet in another location, and offers a cut of its profits in exchange for access to A's marketing plan and use of the established brand.

Sounds like a good deal, right? It will allow Company A's brand and exposure to expand, while generating additional revenue.

Not so fast.
A hidden franchise is considered to have formed if a company shares a marketing plan, a trademark, has significant control over or assistance in the operation of the other person's business and charges a fee for the services provided.

A hidden franchise involves the characteristics of a franchise even though neither party intended to create a franchise relationship. The consequences of unintentional or hidden franchises can include fines, penalties and/or restrictions on creating further unintentional franchises imposed by federal or state governments. In some cases, these penalties can even include termination of the business relationship.

Problems usually arise when one party decides to end or not renew the relationship and the other party wants the relationship to continue.

The issue may also develop when one party is not delivering an expected level of performance, or if a party simply wants to withdraw its goods or services from the marketplace.

The franchise laws of many states include certain notice and inventory repurchase requirements that may not be consistent with the parties' agreement. The parties would've been protected from unintended consequences if they'd treated the relationship like a franchise. Without a FOC, these parties put themselves at great risk.

The most common victims of the perils of hidden franchises include businesses that manufacture, sell or distribute products that are identified by a trademark or brand name.

In one case, a person was selling hidden franchises for auto parts distributorships, providing brake and other parts to garages and auto repair shops. Then he sold "franchises" to people who would go to these shops, re-stock the cabinets and collect the money for the parts that were used.

There were several problems with this scheme.

The franchisor didn't provide any of the required franchise disclosures and also provided false, outdated and misleading information about sales of these products.

The franchisees were required to purchase the inventory of parts in the shops in their areas up front and had to collect payment as the parts were used.

The parts were of poor quality and often didn't work, so few of the shops used them.

The promoter wound up being sentenced to 51 months in jail and ordered to pay more than $700,000 in restitution.

Consider these questions, which will help to determine what steps to take to protect your business interests, and avoid costly and unintended legal complications.

  • Are the goods or services sold by the other party closely identified with your trademark? Is the success or failure of the person's business tied significantly to the products or services you provide?
  • Are you allowing another person to use or share your marketing plan, or do you have significant control over or provide substantial assistance to, the operations of a business owned by another person?
  • Do you charge a fee for the services you provide or sell products to another business owner at amounts in excess of a bona-fide wholesale price?

If you answer "yes," your business could be vulnerable to the penalties associated with hidden franchise relationships. You should consult with an attorney who specializes in franchise and distribution law. Typically, a remedy can be identified and implemented that will help to protect your business from losses.

Jeffrey Brimer is a franchise attorney with the Denver office of Snell & Wilmer. He can be reached at moc.walws|remirbj#moc.walws|remirbj or 303-634-2066.

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