January 28, 2000 Secretary Federal Trade Commission Room 159 600 Pennsylvania Avenue, N.W. Washington, DC 20580

Ladies and Gentlemen:

This letter is submitted as a rebuttal comment in connection with the Federal Trade Commission's October 1999 Notice of Proposed Rule Making ("NPR") regarding the Commission's Franchise Rule (16 C.F.R. Part 436).

In a letter dated December 20, 1999, I provided comments on the NPR's proposed definitions of "franchise" and "required payment."  In that letter I suggested certain changes to those definitions to eliminate ambiguities and inconsistencies, and to conform the definition of "franchise" to long-standing Commission policy. 

This letter rebuts certain proposals regarding those definitions that were made by Mr. Howard E. Bundy in a comment dated December 21, 1999.  Specifically, this letter rebuts Mr. Bundy's proposals that: (1) payments made to a third party, who is not an affiliate of the putative franchisor, be deemed "required payments" which could trigger application of the Franchise Rule and (2) the "minimal investment" exclusion be revised so that payments made after the first six months of operations would be counted against that exclusion's dollar amount limit.

In accordance with the Commission's request, this letter is accompanied by a 3½" computer disk containing this letter in Microsoft Word format and labeled with my name and the word processing program.

Payments Made to Unaffiliated Third Parties Should Not Trigger Application of the Franchise Rule

Mr. Bundy proposes that payments made to a third party, who is not affiliated with the putative franchisor, should be deemed "required payments" if the putative franchisee "is required to deal with" the third party "by contract or by practical necessity." 1  If adopted, that proposal would constitute a radical departure from the Commission's long-standing policy regarding the definition of a franchise, would create a major inconsistency between the Franchise Rule and the state franchise laws, and would extend the Franchise Rule's coverage to business arrangements which the Rule was never intended to regulate.

As discussed in my December 20, 1999 comment letter, the Commission has always recognized that a "franchise" includes the following elements:  (1) association of the franchisee's business with the franchisor's trademark, (2) significant control of, or significant assistance to, the franchisee's method of operation, and (3) "required payments" to the franchisor or an affiliate of the franchisor.  The intent of the "required payments" element is to capture all payments which the franchisee must pay to the franchisor (or an affiliate of the franchisor) "for the right to associate with the franchisor and market its goods or services." 2  Thus, the "required payments" element corresponds to the "franchise fee" element under state franchise laws.3

The Commission's policy has always been that payments to unaffiliated third parties are not "required payments" under the Franchise Rule.4  This policy reflects the fact that such payments are not made " for the right to associate with the franchisor and market its good or services."

The Commission's historical policy regarding the "required payments" element is also strongly supported by court decisions and by polices of state franchise law enforcement agencies.  Courts and agencies have consistently held that payments made to unaffiliated third parties are not franchise fees and do not trigger the application of franchise laws. 5  Thus, Mr. Bundy's proposal would place the Franchise Rule in conflict with its state law counterparts.

Mr. Bundy's proposal would also broaden the "required payments" element to the point of rendering that element meaningless.  Every business makes payments to vendors and service providers.  Almost any business could argue that "practical necessity" dictates that it make payments to a particular third party.  For example, "practical necessity" may dictate that a business use a Microsoft software product or that an employee of the business fly to an airport that is served by only one airline.  Under Mr. Bundy's proposal, payments for the software or the air travel could be deemed "required payments" that could trigger the Franchise Rule.  This undesirable result underscores the soundness of the Commission's historical policy.

Mr. Bundy's proposal would in effect eliminate the "required payments" element from the definition.  His proposal would therefore extend the Franchise Rule's coverage to business arrangements that do not involve any type of franchise fee, and consequently have never been regulated under the Franchise Rule or under state franchise laws.  The Commission made clear in the NPR that it does not intend to regulate such "traditionally non-franchised" businesses under the Franchise Rule. 6  Certainly there is no basis for subjecting such a business to such regulation.

Mr. Bundy asserts that franchisors can circumvent the Franchise Rule by " . . . establishing companies that do not meet the strict definition of "affiliate" (for example, owned by a spouse or other family member) and requiring, in practice if not by contract, that the franchisee deal with that company . . ." 7  Mr. Bundy states that under those circumstances "[i]t becomes irrelevant that the money ultimately benefits the same family or organization."8

The flaw in this argument is that such a company would be deemed an "affiliate."  The NPR proposes to define "affiliate" as "an entity controlled by, controlling, or under common control with the franchisor." 9  The current Franchise Rule includes a similar definition. 10  If a franchisor "establishes" a company and monetarily benefits from payments made by franchisees to that company, it seems clear to me that the franchisor "controls" that company and that the company would be deemed an affiliate of the franchisor.  This result would be even more obvious if the company is "owned by a spouse or other family member."  Indeed, this is exactly the type of situation that the "affiliate" concept is intended to address, and the Commission would have little difficulty applying that concept to such a situation. 11

Mr. Bundy is concerned that a franchisor can monetarily benefit from payments made to a company which the franchisor sets up but which "technically" does not meet the "strict definition" of affiliate. 12  In fact, however, the Commission's definition of that term is quite broad and flexible, and Mr. Bundy's concerns are unfounded. 

Mr. Bundy also suggests that franchisors "entice" prospective franchisees to incur travel expenses or to make other payments to unaffiliated third parties, in an effort to somehow gain an unfair advantage in negotiations regarding sale of a franchise. 13  No data is provided to support that claim, and frankly I question whether companies really have an interest in enticing prospects to buy, for example, airline tickets.  In any event, there is no justification for deeming those types of transactions "required payments" which could subject a business to regulation under the Franchise Rule.

Payments Made After the First Six Months of Operations Should Not Affect the Availability of the "Minimal Investment" Exclusion 

Mr. Bundy proposes that the "minimal investment" exclusion should be "modified to provide that the $500 threshold includes both amounts the franchisee actually pays, but also any amounts that the franchisee, during that first six months, agrees to pay in the future—either by contract or by practical necessity." 14  That proposal would frustrate the purpose of the minimal investment exclusion, and would substantially impair its usefulness.

As noted above, the "required payments" element focuses on payments made "for the right to associate with the franchisor and market its goods or services." 15  Consistent with that focus, the Franchise Rule's "minimal investment" exclusion is concerned with payments made during the first six months of operations. 16  If the total amount of required payments made during that period is less than $500, the Franchise Rule does not apply. 17

The six-month cut off is a "bright line" demarcation, which allows parties to readily determine whether the exclusion is available.  Mr. Bundy's proposal would needlessly introduce uncertainty and confusion into that determination.  Assume, for example, that during the first six months of operations a distributor agrees to pay a small annual fee (say $300) to its supplier.  Under Mr. Bundy's proposal, apparently the relationship could be converted into a franchise if the relationship continues for more than a year and the second $300 payment is made.

To the extent that there is concern about schemes designed to circumvent the Commission's intent with respect to the six-month cut off, the Commission has demonstrated a willingness and ability to look through such transactions and to disallow the exclusion in appropriate circumstances. 18

Further, as explained in my December 20, 1999 comment letter, the $500 limit is outdated and unreasonably low, and no longer serves its purpose of excluding business arrangements that do not involve the type of risk with which the Franchise Rule is concerned.  Mr. Bundy's proposal would exacerbate that problem by subjecting even more such arrangements to the Rule.

Thank you for your consideration of this rebuttal comment.  Please note that the views expressed in this letter are those of the author and do not purport to represent the opinion or views of Arter & Hadden LLP.

Yours truly,

 

 

 

David Gurnick
of ARTER & HADDEN LLP

DG/lkr