INFORMAL STAFF ADVISORY OPINION 98-4
This staff advisory opinion is issued in response to your request for our views concerning the applicability of the Federal Trade Commission's Franchise Rule to a license agreement. Specifically, you ask us whether your client's business arrangement satisfies the Rule's significant control or assistance requirement. 16 C.F.R. § 436.2(a)(1)(i)(B).
According to your letter, your client, referred to only as "Licensor," offers the opportunity to operate mobile environmental laboratories. You ask whether its license arrangements constitute a franchise. 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 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 your client's license agreement constitutes a franchise.
II. A LICENSE ARRANGEMENT MAY BE A FRANCHISE
Whether a business relationship constitutes a "franchise," is not dependent upon what the parties call the relationship. Rather, a relationship is covered by the Franchise Rule if it satisfies the definitional elements of a "franchise" set forth in the Franchise Rule, 16 C.F.R. § 436.2(a). As noted in the Commission's Final Interpretive Guides to the Franchise Rule in the context of distributorship arrangements:
The name which the parties give to their relationship is not relevant in determining whether the relationship is within the scope of the rule. Thus, a relationship described by the parties as a "franchise" will not be covered by the rule unless it meets the definitional criteria of the rule; conversely, a self-described "distributorship" will be covered by the rule if the definitional elements are satisfied.
44 Fed. Reg. 49966 (August 24, 1979).
We begin our analysis by noting that the term "franchise" refers to a continuing commercial relationship. According to your letter, licensees obtain the right to use your client's trademarks and proprietary information. In return, they are required to pay a portion of their gross sales to the Licensor as a license fee and are subject to audits to ensure accurate reporting of their gross sales. Licensees also sign interim and post-term covenants not to compete. Under these facts, it appears that the Licensor and its licensees have a continuing commercial relationship.
To be covered by the Franchise Rule, a business arrangement must also satisfy the three definitional elements of a "franchise"(1) set forth in the Rule: (1) the distribution of goods or services associated with the franchisor's trademark or trade name; (2) significant control of, or significant assistance to, the franchisee; and (3) a required payment of at least $500 within 6 months of signing an agreement. 16 C.F.R. § 436.2(a)(1)(i). Based upon your letter, it appears that the first and third elements are present. Accordingly, we need only address whether your client provides significant control or assistance.
III. SIGNIFICANT CONTROL OR ASSISTANCE
From your letter, it is clear that the Licensor imposes some controls over its licensees. For example, licensees will be subject to audits to ensure proper license payments, are restrained from using the Licensed Property outside their exclusive territory, and may not enter into competing lines of business. You also state that the Licensor will assist licensees by furnishing technical operating manuals with formulas and other scientific information, as well as limited training in how to use the Licensor's system. The question is whether such controls and assistance are "significant."
In the Final Interpretive Guides, the Commission made clear that to be "significant," the controls and assistance must relate to the franchisee's entire method of operation:
[I]t should be emphasized that in order to be deemed "significant" the controls or assistance must be related to the franchisee's entire method of operation -- not its method of selling a specific product or products which represent a small part of the franchisee's business. Controls or assistance directed to the sale of a specific product which have, at most, a marginal effect on a franchisee's method of operating the entire business will not be considered in determining whether control or assistance is "significant."
44 Fed. Reg. at 49967.
Further, "significance" is a "function of the degree of reliance which franchisees are reasonably likely to place upon the controls or assistance." Id. This is especially true of investors who are inexperienced in the particular business. The Commission addresses "significant control and assistance" issues on a case-by-case basis. Among other things, the Commission considers the nature of the particular industry, the level of sophistication of the investors, as well as the meaning of the assistance and control to the investors. Id. See also Statement of Basis and Purpose, 43 Fed. Reg. 59614, 59701 (December 21, 1978).
In your letter, you contend that the Licensor does not require any operational standards, nor does it impose controls over the licensees' entire method of operation. For example, the Licensor will not approve sites, control hours of operation or production techniques, or dictate accounting practices. Rather, you contend that the limited controls are designed to protect the franchisor's rights and value in its proprietary information and to verify that license fees are properly calculated. We disagree.
You correctly state that the Commission will not consider as significant those controls designed solely to protect the franchisor's trademark rights under federal and state trademark law, such as display of the mark requirements or right of inspection. 44 Fed. Reg. at 49968. We also note that reasonable covenants not to compete, which are common in franchise systems, are frequently used to protect proprietary information. However, the exclusive sales territories imposed by the Licensor appear to go beyond mere trademark protection and pertain to the licensee's entire method of conducting its business. Such restrictions have the potential to cause serious economic harm by limiting the licensees' market and ultimately limiting the licensee's profitability. See 44 Fed. Reg. at 59660-62. Indeed, the Final Interpretive Guides specifically list "restrictions on customers" and "location or sales area restrictions" among the types of controls over a franchisee's method of operation that will be deemed significant." Id. at 49967.
Further, it is possible that the Licensor's offer of assistance is also significant. The draft license agreement attached to your advisory request suggests that the Licensor will offer its system to "professionally trained environmental consultants with considerable experience in the operation of an environmental consulting and testing business." You also state in your letter that the Licensor will provide technical assistance through its manual, as well as limited training. Without more detailed information about the nature of the Licensor's system, however, we cannot determine whether the Licensor's offer of assistance is significant to these potential licensees. That the prospective investors are sophisticated in the environmental testing field does not necessarily render the Licensor's assistance insignificant. For example, the Licensor's system may use technology that is unique or technology that is sufficiently complex that it requires some training even by individuals experienced in the field in order to be used correctly or efficiently. Where training or other assistance is necessary to ensure proper use, such assistance will be deemed significant.
Based upon the information you have provided, it appears that your client may satisfy the second definitional element of a "franchise" set out above. 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: June 8, 1998
Franchise Rule Staff
1. Another type of continuing commercial relationship covered by the Franchise Rule is the business opportunity venture. See 16 C.F.R. § 436.2(a)(1)(ii). Unlike a franchise, a business opportunity venture does not necessarily involve the use of the promoter's trademark or trade name. The most common types of business opportunity ventures are rack displays and vending machines routes.