Informal Staff Advisory Opinion 96-2

This staff advisory opinion is issued in response to your request dated April 17, 1996, on whether your client's commercial real estate affiliation program is covered by the Franchise Rule and, if it is, whether that 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 appears to fall within the fractional franchise exemption.

I. INTRODUCTION

In your letter, you state that your client, CB Commercial Real Estate Group, Inc. ("CB Commercial"), is the largest commercial real estate company in the United States. CB Commercial has created an affiliation program ("Program") to expand its presence in a number of domestic commercial real estate markets where it currently does not have company offices. You state that CB Commercial plans to use a wholly owned subsidiary, CBC Partners, Inc. ("CBCP") to implement the Program.

The salient features of the affiliation Program are as follows. CBCP intends to contact only one or two of the most successful commercial real estate brokerage firms "of the highest reputation in their respective regions." You state that these brokerages generally have annual revenues in excess of $1 million. CBCP will make a substantial equity investment in each of these affiliated brokerages, thereby becoming a minority owner of each. The affiliates will make an initial payment to CBCP in excess of $500 and, subsequently, will make "quarterly payments of a fixed base fee and a percentage of the amount by which the [affiliate's] annual revenues subsequent to joining the Program exceed its average annual revenues prior to joining the Program."

Further, you state that the affiliated brokerages will add CB Commercial's corporate name to their own. Affiliated brokerages will have access to CB Commercial's technology and information, including software, databases, and professional sales personnel. Affiliates will also be required to attend one training session each year and will be given the opportunity to receive additional training from CBCP. Affiliates will also participate in an advertising and promotional program. Further, each affiliate will be required to involve fellow CB Commercial affiliates or CB Commercial when providing services outside of their territory and will share any subsequently generated fees based upon the relative value of the services each affiliate provides.

You now ask whether this affiliate arrangement is covered by the Franchise Rule and, if it is, whether the fractional franchise exemption would apply.

II. CB COMMERCIAL'S AFFILIATION PROGRAM IS COVERED BY THE FRANCHISE RULE

Participants in CB Commercial's Program 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 6 months of signing of an agreement. 16 C.F.R. § 436.2(a)(1)(i). As outlined above, each of these elements is satisfied here.

You contend, however, that CB Commercial's Program falls outside the scope of business arrangements the Franchise Rule was intended to cover. Specifically, you argue that, given the size, business sophistication, and success of potential affiliates, it is not reasonably plausible to expect that CB Commercial could coerce any of them into joining the Program or agreeing to terms which they did not fully understand or accept.

We take no position on whether CB Commercial's affiliation arrangement may qualify for a broad statutory exemption from the Rule. However, we note that such an exemption cannot be granted by staff through an informal staff advisory opinion. If CB Commercial believes that it qualifies for an exemption, the proper course of action is to file a petition with the Commission for a statutory exemption under Section 18(g) of the FTC Act. 15 U.S.C. 18(g).

III. THE FRACTIONAL FRANCHISE EXEMPTION

Although CB Commercial's affiliation arrangement is covered by the Franchise Rule, it is possible it may fall within 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. 49965, 49968 (August 24, 1979). 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 such 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 own success.

IV. THE CB COMMERCIAL 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 an 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.

Despite these differences, there may be circumstances in which an affiliation arrangement can qualify for the fractional franchise exemption. As with all exemptions to the Franchise Rule, the franchisor will have the burden to demonstrate that it qualifies for the exemption. Further, the Commission will determine the application of the exemption on a case-by-case basis.

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.

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. 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.

Based upon the representations made in your request, it appears likely that CB Commercial can satisfy these requirements. For example, you state in your letter that CBCP will contact only the most successful brokerage firms: each of these affiliates will have more than two years of experience in the commercial real estate business. Accordingly, it is likely that the affiliates are experienced enough to weigh the risks and benefits of affiliation. Further, you state that the brokerages will not sacrifice their previously earned business identity and goodwill, and they can "readily resume business should that participant's involvement in the Program be terminated." Assuming that there are no practical or contractual impediments to affiliates resuming an independent commercial real estate business upon termination, your client's relationship with affiliates appears to qualify as a fractional franchise.

Finally, you contend that both CBCP and the affiliated brokerages anticipate that "sales due to participation in the Program will not constitute more than twenty percent of Participants' total sales for at least the one-year period following entrance into the Program." It appears that CB Commercial is likely to be able to document a good faith basis for this representation. As noted above, both CB Commercial and the prospective affiliated brokerages are sophisticated businesses with substantial knowledge of their industry and the local commercial real estate market. Accordingly, each can readily perform the type of income analysis that would support application of the fractional franchise exemption. For example, you indicate that the affiliates will make royalty payments based upon the difference between their sales before and after entering the affiliation arrangement. We can assume, therefore, that each affiliate has already calculated a base-line of sales against which future sales generated from the affiliation arrangement can be measured.

V. CONCLUSION

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 CB Commercial's affiliation arrangement is likely to 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: May 20, 1996
Franchise Rule Staff