INFORMAL STAFF ADVISORY OPINION 00-2
This staff advisory opinion is issued in response to your request for our views on whether your client's operator agreement constitutes a franchise. In your letter, you acknowledge that the agreement satisfies two of the three definitional elements of a franchise - trademark and significant control or assistance. However, you question whether the unique structure of the agreement, in particular the payment provisions, may take the agreement out of the Rule's purview. For the reasons stated below, we conclude that the Rule's required payment prerequisite is satisfied in this instance.
In your letter, you state that your client is in the business of developing a chain of quick-service food restaurants. The company apparently has considerable site selection and opening experience and, therefore, provides the restaurant operators ("operators") with a "turn-key" business. In so doing, the company makes a substantial capital investment: The Company typically identifies a location for a restaurant; either purchases or leases the premises; modifies the premises, if warranted, including purchasing and installing necessary equipment; and provides opening inventory.
Operators apparently pay no standard up-front franchise or license fee for the right to operate the restaurant and to use the company's trademarks. However, pursuant to the company's standard Operator's Agreement ("Agreement"), an operator must pay to the company a working capital deposit of $5,000 before opening a restaurant. The operator is required by contract to maintain this working capital deposit throughout the term of the Agreement. This deposit (minus any expenses incurred by the company for the operation of the restaurant that the operator failed to pay) is returned to the operator upon the termination, expiration, or non-renewal of the Agreement. Under the Agreement, the operator also leases from the company the premises and the equipment to be used in the operation of the restaurant. You state that the lease payments to the company typically will be $1,200 for the premises and $750 for equipment each month.
You further add that the company performs certain accounting functions for the operator. Among other things, the company places daily receipts from each operator's account into an individual sub-account. The company maintains the sub-account and generates monthly profit and loss statements for each restaurant. Funds held in a sub-account are shared between the company and the operator according to a complex formula. In short, a share of the funds goes to the operator as a base profit draw. Fifteen percent of the funds (excluding those for equipment rental payments) are retained by the company as a "base operating service charge." After expenses are paid, the remaining funds are divided between the operator and the company, with the operator taking a 50% extra profit draw and the company taking an extra 50% as additional operating service charges. In the event of a profit shortfall, additional provisions are made for a payment advance to the operator, with repayment made by offsets against future additional profit draws.
You now ask whether this arrangement properly falls within the type of commercial relationship covered by the Franchise Rule. You acknowledge that operators who enter an agreement with the company face a financial risk. Nonetheless, you assert that the operating agreement is atypical for a franchise system because of the lack of a traditional "initial franchise fee," the company's substantial capital investment in providing a turn-key operation, and the distinctive accounting and payment arrangements to disburse monies. In particular, you contend that the working capital security for costs and expenses incurred by the operator does not resemble the typical franchise fee.
As an initial matter, you should know that, as a matter of policy, the Commission's Franchise Rule enforcement staff will not issue any staff opinion on the ultimate issue of whether, under a specific set of facts, a business relationship is covered by the Franchise Rule. We will, however, provide general guidance on the Franchise Rule that you may wish to consider in determining whether the proposed business arrangement constitutes a franchise.
II. THE MINIMUM REQUIRED PAYMENT ELEMENT
For Rule coverage, the "franchisee is required as a condition of obtaining or commencing the franchise operation to make a payment or a commitment to pay to the franchisor, or to a person affiliated with the franchisor." 16 C.F.R. § 436.2(a)(2). Thus, as long as the franchisee makes, or commits to make, any payment whatsoever, the business relationship will satisfy the Rule's payment requirement. We then must determine whether the franchise falls within the Rule's minimum payment exemption. That exemption states: "The provisions of this part shall not apply to a franchise . . . [w]here the total payments . . . made during a period from any time before to within 6 months after commencing operation of the franchisee's business, is less than $500." Id. at § 436.2(a)(3)(iii).
For the following reasons, we conclude that the minimum required payment element is satisfied in this instance. First, operators pay the franchisor a $5,000 "working capital deposit." That some or all of this deposit may be returned to the investor is irrelevant, as long as such payment is required as a condition to commencing or operating the business. Second, your letter states that operators will be required by contract to make monthly lease payments to your client for the premises and equipment. You acknowledge that these payments alone will total $1,950 each month. In the Interpretive Guides to the Rule, the Commission made clear that the term "required payment" is intended to:
capture all sources of revenue which the franchisee must pay to the franchisor . . . for the right to associate with the franchisor and market its goods or services. Often, required payments are not limited to a simple franchise fee, but entail other payments which the franchisee is required to pay to the franchisor . . . . Among the forms of required payments are initial franchise fees as well as those for rent, . . . [and] equipment rental . . . .
44 Fed. Reg. 49966, 49967 (August 24, 1979). Indeed, we have long regarded payments for purchase or lease of equipment and real property as "required payments" under the Rule. See, e.g., Ford Motor Corp., Bus. Franchise Guide (CCH), ¶ 9557 (1979); Volkswagen of America, Inc., id. at ¶ 6357 (1979); Marathon Oil Co., id. at ¶ 6393 (1979).
Third, franchisors also take certain fees out of each operator's "sub-account" for "operating service charges." There is no question that a commitment to pay continuing fees to the franchisor for the right to conduct business (such as royalties), as well as future shares of profit, may constitute a required payment for Rule purposes. See Interpretive Guides, 44 Fed. Reg. at 49967 (listing continuing royalties among types of required payments). See also Advisory 99-1, ¶ 6468, at 9710-11 (1999)(current obligation to share future profits considered a required payment). In previous advisory opinions, we noted that nothing in the Rule requires the amount of such recurring fees to be fixed at the time of execution of a franchise agreement. Whether a prospective payment will constitute a "required payment" for Rule purposes will be determined based upon the reasonable expectations of the prospective investor at the time she or he enters into the franchise relationship. Accordingly, depending upon the nature of the your clients' business, historical earnings in the industry, and expected demand, among other factors, a prospective investor might reasonably anticipate paying your client at least $500 in "operating service charges" during the first six months of operation. See Advisory 98-5, Bus. Franchise Guide (CCH), ¶ 6494, at 9703 (1998); Advisory 93-12, Bus. Franchise Guide (CCH), ¶ 6456, at 9636-37 (1993).
For these reasons, we fail to see any factual or policy reason why the business arrangement described in your letter is substantially different from more traditional franchise arrangements. The absence of an up-front franchise fee alone is not determinative: A business arrangement will constitute a franchise where other forms of payment exist, such as property leases, equipment retails, shares of future profits, and deposits, as long as such payments are required as a condition of commencing or operating the business.
Please be advised that our opinion is based on all the information furnished in your request. This opinion applies only to your client and to the extent that actual company practices conform to the material submitted for review. Please be advised further that the views expressed in this letter are those of the FTC staff. They have not been reviewed, approved, or adopted by the Commission, and they are not binding upon the Commission. However, they do reflect the opinions of the staff members charged with enforcement of the Franchise Rule.
Date: January 24, 2000
Franchise Rule Staff