INFORMAL STAFF ADVISORY OPINION 98-6
This staff advisory opinion is issued in response to your request for advice on whether your client's proposed affiliation program is covered by the Franchise Rule and, if it is, whether the program qualifies for the fractional franchise exemption. 16 C.F.R. § 436.2(a)(3)(i). For the reasons stated below, we conclude that the business arrangement is covered by the Rule, but may fall within the fractional franchise exemption.
In your letter, you state that your client, Martin-Williams, Inc., owns and operates a technology integration services business, which adapts computer technology to specific customers' needs. These services include evaluating a customer's computer technology needs; selling, testing, and repairing computer hardware and software; and training customers in the use of hardware and software. To promote its services, Martin-Williams established an advertising and marketing affiliate, Technology's Edge. Martin-Williams has now formed a new entity, "Technology's Edge Partners," to share its advertising and marketing expertise with other companies in the same or similar business.
In your letter, you state that Martin-Williams would like to offer the Technology's Edge system through the creation of an "Alliance." To qualify for membership in the proposed Alliance, each member must have annual sales of more than $1 million, be in operation for at least two years, and possess competency certifications from certain computer software companies. Each member will pay an initial membership free of $7,500, a monthly license fee of $1,200, and a monthly marketing program fee of $1,370. In return, each member will obtain the right to use the "Technology's Edge" trademark in a specific geographic territory.
You now ask if the proposed Alliance constitutes a franchise within the meaning of the Commission's Franchise Rule. You state that Technology's Edge Partners will not impose controls over the Alliance members, except to the extent necessary to protect its trademark. In addition, Technology's Edge Partners intends to offer only promotional assistance, which you assert does not constitute "significant" assistance under the Rule. Finally, you contend that even if the Alliance if a franchise, it qualifies for the fractional franchise exemption to the Rule.
II. THE ALLIANCE PROGRAM IS COVERED BY THE FRANCHISE RULE
Participants in the Technology's Edge Partners Alliance are clearly covered by the Franchise Rule. To be covered by the Rule, a business format or product franchise must satisfy the three definitional elements of a "franchise" set forth in the Rule: (1) the distribution of goods or services associated with the franchisor's trademark or trade name; (2) significant control over, or significant assistance to, the franchisee; and (3) a required payment of at least $500 within six months of commencing operations under the agreement. 16 C.F.R. § 436.2(a)(1)(i). As described in your letter, participants in the Alliance will use the Technology's Edge trademark. Further, your client's promotional assistance coupled with the grant of an exclusive territory constitutes significant control and assistance under the Rule. See Final Interpretive Guides, 44 Fed. Reg. 49966, 49967 (August 24, 1979). Finally, you mention that Alliance members will pay over $500 within the first six months of joining the Alliance. For these reasons, the three definitional elements of a franchise are clearly satisfied.
III. THE FRACTIONAL FRANCHISE EXEMPTION
Although participation in the Alliance program is covered by the Franchise Rule, it is possible that participating members may qualify for the Rule's fractional franchise exemption. 16 C.F.R. § 436.2(a)(3). The exemption is available to a company offering a business relationship that meets each of the elements for Rule coverage if it can prove that the following two conditions are met: (1) the franchisee with whom it enters a relationship has been "in the business represented by the franchise more than 2 years;" and (2) the "sales arising from the relationship . . . represent no more than 20 percent of the sales in dollar volume of the franchisee." Id. at § 436.2(h).
The Final Interpretive Guides to the Franchise Rule provide additional guidance. First, the Guides note that a "fractional franchise" relationship results when an established distributor adds a franchised product line to its existing line of goods or services. 44 Fed. Reg. at 49968. See also Statement of Basis and Purpose, 43 Fed. Reg. 59614, 59706-07 (December 21, 1978).
Second, when interpreting the term "business represented by the franchise," the Guides state that: "[t]he required experience may be in the same business selling competitive goods, or in a business that would ordinarily be expected to sell the type of goods to be distributed under the franchise." 44 Fed. Reg. at 49968. Similarly, the Statement of Basis and Purpose states: "if the prospective franchisee is currently selling the type of goods or services which he will distribute under the new franchise . . . he will be 'in the business represented by the franchise.'" 43 Fed. Reg. at 59706, n.80. For example, a hardware store may expand its line of goods by offering lawn care equipment. Even though the hardware store owner may never have sold lawn care equipment before, he will still be "in the business" represented by the franchise because hardware stores commonly carry such goods and the hardware store can be expected to have some familiarity with comparable goods. Id.
Third, with respect to the twenty percent of sales limitation, the Guides state: "The Commission will expect the parties invoking this exemption to take into account in good faith the franchisee's anticipated sales for a period of at least 1 year after the franchisee begins selling the goods or products involved in the franchise." 44 Fed. Reg. at 49968. See also Statement of Basis and Purpose, 43 Fed. Reg. at 59707 and at n.84.
Finally, the Statement of Basis and Purpose accompanying the Franchise Rule explains the policies underlying the fractional franchise exemption. A franchisee in a fractional franchise relationship will usually be familiar with the costs, profits, and potential risks and benefits of distributing similar goods or services. Thus, the franchisee's experience reduces his dependence on the expertise of the franchisor and reduces the ability of the franchisor to mislead the franchisee through incomplete and inaccurate disclosure. In addition, because at least 80 percent of the franchisee's sales are derived from non-franchised goods or services, the franchisee is not substantially dependent on the sales of the franchised products or services for his or her own success.
IV. THE ALLIANCE PROGRAM APPEARS TO QUALIFY FOR THE FRACTIONAL FRANCHISE EXEMPTION
As noted above, the fractional franchise exemption typically applies where an existing business expands to include additional product lines or services. In such circumstances, the business owners are not dependent upon the new product line or services for their core business; their risk is minimized because they can readily continue in business if their association with the franchisor is terminated.
In a typical affiliation arrangement, however, the business grows not by adding product lines or new services, but by expanding its traditional market. In that respect, an affiliate is analogous to a conversion franchise, where an existing business converts to a franchise in order to associate with the franchisor's trademark and to tap the franchisor's business experience or, in this case, marketing expertise.
In a previous advisory opinion, Advisory 96-2, Bus. Franchise Guide (CCH), ¶ 6477 (1996), we noted that there may be circumstances in which an affiliation arrangement can qualify for the fractional franchise exemption. In analyzing whether an affiliation arrangement may qualify for the fractional franchise exemption, we will be guided by several considerations. Consistent with the policies underlying the exemption, we will consider whether the franchisee is experienced enough to understand the risks that will likely arise when switching from an independent business to an affiliated business. We will also consider the practical and contractual impediments that may prevent the franchisee from disengaging from the affiliation relationship. In that regard, we will examine such factors as whether the affiliate retains its own goodwill and its own client base, whether the affiliate has other sources of income, and the extent to which the affiliate is subject to covenants not to compete or other post-term restrictions. Id. at 9674.
Further, we will also examine whether the parties have reasonable grounds to anticipate that the affiliate's income will increase by less than twenty percent due to the affiliation. In an affiliation arrangement, income generated from the sale of goods, and especially services, may be fungible: accordingly, it may be difficult for the parties to segregate that portion of the income that would be generated in the absence of the affiliation from that incremental portion generated as a result of the affiliation. Therefore, mere allegations that the parties anticipate that income generated from the affiliation arrangement will not exceed the threshold may be insufficient to establish a fractional franchise. Rather, we will consider whether the parties have a good faith basis to support their claim. For example, we will consider whether both parties are capable of performing an analysis of each affiliate's historical and projected earnings, a market analysis, or otherwise demonstrating that each affiliate can derive eighty-percent of its income independent of the affiliation arrangement. Id.
Based upon the representations made in your request, it appears that your client can satisfy these requirements. For example, you state in your letter that Technology's Edge Partners will contact only sophisticated firms to become affiliates. Each of these affiliates will have more than two years of experience, and must have annual sales of more than $1 million. Accordingly, it is likely that the affiliates are experienced enough to weigh the risks and benefits of affiliation. Further, because the Affiliation program is limited to marketing and advertising assistance, it appears that the affiliate-members will not sacrifice their previously earned business identity and goodwill, and can readily resume marketing activities if the affiliation is terminated. Accordingly, it appears that the Alliance program may satisfy the first prong of the fractional franchise exemption.
Finally, you state that your client does not anticipate that a member's overall gross sales with increase by as much as 20% during the first year of membership and that any sales gains are not likely to be generated solely from the Affiliation's promotional activities. You further assert that the "benefits of a corporate advertising program are normally realized over a period of time well in excess of a year." It appears that your client is likely to have a good faith basis for these representations. As noted above, Martin-Williams and Technology's Edge are sophisticated with substantial knowledge of the computer industry and costs and benefits of advertising programs. For these reasons, we believe that the Alliance may also satisfy the second prong of the fractional franchise exemption.
For the reasons set forth above, we find that the affiliation arrangement, as described in your letter, constitutes a franchise. At the same time, we conclude that the Technology's Edge Affiliation arrangement may fall within the fractional franchise exemption. 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: August 12, 1998
Franchise Rule Staff