Informal Staff Advisory Opinion 97-9

This staff advisory opinion is issued in response to your recent request for our views concerning the applicability of the Federal Trade Commission's Franchise Rule, 16 C.F.R. Part 436, to your client's proposed dealership arrangement. In particular, you ask whether an option agreement enabling your client to purchase a dealer's assets or equity interests would constitute a required minimum payment under the Rule.

I. INTRODUCTION

In your letter, you state that your unnamed client, a manufacturer ("Company"), maintains a network of dealers in approximately 100 markets throughout the United States. The company contemplates offering some of its dealers a new program ("Program"), which would establish exclusive territories. Among other things, the Company would grant participating dealers ("Dealers") the right to use the company's trademark, and would provide Dealers with financial support to expand their businesses. The Company would also impose certain controls, including requiring each Dealer to sign an Option Agreement. Under the Option Agreement, if a third party sought to purchase all or any substantial portion of the Dealer's assets or equity interests in the business, the Dealer must first offer the assets or equity interests to the Company at a discounted price. If the Company declines to exercise its option, it nonetheless would receive a portion of the net proceeds from the sale to the third party.

You now ask whether the business arrangement described above constitutes a franchise under the Franchise Rule. In particular, you ask whether the Option Agreement would constitute a minimum required payment.

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. DEFINITION OF THE TERM "FRANCHISE"

The term "franchise" refers to 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 identified by 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 signing of an agreement. 16 C.F.R. §§ 436.2(a)(1)(i) and 436.2(a)(3)(iii). We will address each of these elements below.

1. Distribution of Goods or Services Identified by the Franchisor's Trademark or Trade Name

You indicate that Dealers entering into the Program would obtain the right to use the Company's registered trademarks in the operation of their businesses. Thus, the first definitional element appears to be satisfied.

2. Significant Control or Assistance

The second required element -- significant control or assistance -- appears to be satisfied as well. In addition to providing Dealers with exclusive territories, your client will impose various controls. For example, you state that each Dealer must comply fully with the manufacturer's standards and guidelines, including, what you describe as "the Program's Business Standards and Ethic's Statement, the Program's Customer Service Standards, the Company's Trade Name Guidelines, and all other written policies and procedures." Further, Dealers would agree to sell only the manufacturer's authorized products, and the Company has the right to establish minimum purchase quotas.(2) In addition, a Dealer would not have the right to transfer any of its rights under the Program Agreement to any third party without prior written consent of the company. Dealers must also sign an Option Agreement, described more fully below, that essentially requires any Dealer wishing to sell its assets or equitable interests to allow the Company the option to purchase the assets or equitable interests first at a discounted price.(3) In addition to these controls, the Company will assist participating Dealers to expand their businesses by offering increased lines of credit, extended repayment terms, reduced prices, rebates, and incentives, and capital loans on favorable terms.

Thus, it appears that the Company intends to exert control and offer assistance to the participating Dealers. The question remains, however, whether such controls and assistance are "significant." In the Final Interpretive Guides to the Franchise Rule, the Commission said that "significance" is a function of the degree of reliance which franchisees are reasonably likely to place upon the controls or assistance. 44 FR 49966, 49967 (August 24, 1979). 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. See, e.g., Advisory 94-6, Bus. Franchise Guide (CCH), ¶ 6462 at 9645 (July 1994); Advisory 93-10, Bus. Franchise Guide (CCH), ¶ 6454 at 9633 (January 1994).

Your request for advice provides little information about the likely participants in the new Program. You state only that the participants will be drawn from existing dealers. Arguably, these dealers have some experience in the business. Nonetheless, the would-be Dealers are not currently subject to the controls and do not receive the assistance described above. Thus, their current experience may be too limited to provide them with a sufficient basis to assess the risks involved in joining the Program. In the absence of any other information describing the Dealers, it is reasonable to assume that the Company's controls and assistance, which permeate the entire business operation, would be significant to the typical Dealer.

3. Minimum Required Payment

a. The Company's Option Agreement

The Company apparently does not intend to charge Dealers an up-front fee to participate in the Program. Rather, the Company may require Dealers to purchase inventory in sufficient amounts to satisfy customers' needs. You correctly note that the Commission does not consider the purchase of "reasonable amounts of inventory at a bona fide wholesale price for resale" alone as satisfying the minimum payment requirement. 44 FR at 49967. Nonetheless, the question remains whether the Company's required Option Agreement might be construed as a minimum required payment. Before we address that issue, some additional background on the Option Agreement is warranted.

The salient features of the Option Agreement are as follows. If a third party makes a bona fide offer to purchase all or any substantial portion of a Dealer's assets or shares of capital stock, the Company would have the irrevocable option to purchase the assets or equity interests. Under the Option Agreement, the Company's purchase price would be discounted to an amount below the cash purchase price of any third party offer. If the Company declines to exercise its option, it would nonetheless be entitled to receive a specified portion of the net proceeds from the sale to the third party.

To secure performance of its obligations, the Dealer would grant the Company a perfected, first priority security interest in all of the Dealer's assets and equity interests. The Dealer would also agree not to issue any new equity interests, without the Company's consent. Each Dealer would also make certain covenants, including a covenant regarding the maximum compensation the Dealer could pay to any of its officers, directors, managers, employees, agents, or other representatives during the terms of the program, tied in part to the Dealer's annual level of sales growth.

In your letter, you contend that the Company's right to purchase the Dealer's assets or equity interests at a discount (or to receive a portion of the net proceeds of a sale to a third party) is purely speculative and cannot be reasonably quantified. If there is no bona fide third party offer, there can be no payment of any kind required to be made by the Dealer to the Company. You also contend that the value of the option would be contingent upon events over which neither the Company nor the Dealer has any control -- the occurrence of a bona fide third party offer. Accordingly, it is not certain that even if the Dealer must make a payment to the Company, that the payment will satisfy the $500 minimum payment requirement.

b. Definition of Minimum Required Payment

We start our analysis by noting that the definition of the term "franchise" contains no minimum payment requirement: "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 . . . ." 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 constitutes a franchise.

We must then determine whether the franchise falls within the minimum payment exemption of the Franchise Rule. That exemption states: "The provisions of this part shall not apply to a franchise . . . [w]here the total of payments . . . made during a period from any time before to within six months after commencing operation of the franchisee's business, is less than $500." Id. at § 436.2(a)(3)(iii). Nothing in the exemption requires the amount of payments to be fixed at the time of execution of the franchise agreement. As long as payments total at least $500 within the initial six-month period, the definitional element of a minimum required payment is satisfied.

c. Speculative Future Payments

In a previous Advisory Opinion, Advisory 93-12, Bus. Franchise Guide (CCH), ¶ 6456 at 9636-37 (January 1994), we addressed the issue of speculative payments, specifically future royalties. We observed that royalty fees, by their very nature, are dependent upon the level of revenues generated by the franchisee, which, in turn, are often dependent upon each individual franchisee's own diligence and business acumen. At the same time, we held that businesses should be able to determine with some degree of certainty whether they qualify for the minimum payment exemption at the time for making disclosures under the Franchise Rule.(4)

When determining whether a future payment constitutes a minimum payment for Rule purposes, we analyze the facts on a case-by-case basis using an objective approach: namely, whether the typical franchisee in such a business is likely to make required payments of $500 within the first six months. In applying this approach we consider the following factors, among others. First, we consider the type of industry involved and the prior financial history of the specific franchisor and any existing franchisees. Where such evidence indicates that a typical franchisee in that industry generates sufficient income to require payment of at least $500 in fees during the initial six-month period, the minimum payment requirement may be met.

Second, we consider the sales price of the franchisor's goods or services, the likely demand for such goods or services, and the specific level of the royalty. In some industries, especially those which offer high-priced goods, the franchisees' ability to generate revenues, and thus pay a royalty fee of at least $500 within the first six months, may be reasonably assured. Similarly, in other industries a low sales price -- that might suggest low revenues and thus minimal royalties paid to the franchisor -- might be offset by high demand for the products sold or services performed. We also consider the percentage rate used to calculate such fees. For example, low demand might be offset by a high royalty percentage rate.

Third, we consider any representations made by a franchisor to the prospective franchisee about potential income. Where a franchisor makes direct or indirect earnings representations, from which the franchisee can reasonably conclude that he or she can expect to earn sufficient income to pay royalty fees of at least $500 during the six-month period, we will hold the franchisor to those representations and conclude that the minimum payment requirement is satisfied.

Finally, it is the Commission's policy to interpret all of the exemptions and exclusions to the Franchise Rule very narrowly in order to protect investors. Thus, the franchisor has the burden to prove that it falls within the minimum payment exemption. Accordingly, we advised franchisors to err on the side of caution and provide prospective franchisees with disclosure documents, unless they can establish beforehand that they will qualify for the minimum required payment exemption.

d. The Option Agreement does not Appear to Constitute a Required Minimum Payment

It is clear that all Dealers wishing to participate in the Program must sign the Option Agreement "as a condition of obtaining or commencing" business. It is also clear that under the Option Agreement the Company may purchase the Dealer's assets or equitable interests at a reduced rate, or, if the Company declines the option, receive a specified portion from the Dealer's net proceeds after the sale. However, you present no facts from which we can determine the value of the option to the Company. If a third party bona fide offer triggers the Option Agreement, then it is possible that a Dealer will either forgo income or pay the Company more than $500.

Nonetheless, the question remains whether any potential future payment made by the Dealer to the Company under the Option Agreement can reasonably be construed as a "required" payment. We find that any such payments are speculative at best. While the Dealer must sign the Option Agreement at the time he or she enters the Program, the obligations under that Agreement would arise only if a third party presents an offer. In addition, the third party's offer must be bona fide. Further, inherent in the concept of a "required payment" is the expectation on the part of the franchisor to receive a payment as a matter of contract or by practical necessity. While the Company has the right to receive payment if certain conditions are met under the Option Agreement, the Company ostensibly can have no expectation of receiving payment because it has no control over whether a bona fide offer will be made or whether the Dealer will accept the offer. Indeed, because the decision to accept a third party's offer rests solely with the Dealer, any payment made to the Company under the Option Agreement would appear to be voluntary. Under these facts, it cannot reasonably be said that a typical Dealer commits to make a "required" payment to the Company of at least $500 by signing the Option Agreement.

Finally, we note that the speculative nature of the Option Agreement can be demonstrated by comparing it with an acceleration clause in a financing agreement. In a previous advisory opinion, Advisory 95-10, Bus. Franchise Guide (CCH), ¶ 6475 at 9666 (December 1995), we concluded that an acceleration clause in a financing agreement constituted a required minimum payment under the Rule. According to the acceleration clause, if the franchisee failed to make a payment or failed to observe other financing agreement requirements, the seller could accelerate the unpaid balance. Thus, by signing the financing agreement, the franchisee effectively obligated himself to pay the entire amount due, which exceeded $500. In contrast, while the Dealer must sign the Option Agreement to enter the Program, any payment obligation under that Agreement does not arise unless the Dealer accepts a third party offer, events over which the Company has no control.

A word of caution, however, is warranted. We are not making a broad policy determination that option agreements in all instances would fall outside the minimum payment requirement. As noted previously, where a franchisor can anticipate that a prospective franchisee will make a required payment of $500 within the first six months, then the Rule's minimum payment requirement will be satisfied. Your letter is devoid of any facts about the specific nature of the Company's business. If the Company engages in the type of business where bona fide third party offers are common, or if the Company can anticipate from its experience in operating the Program or otherwise that the typical Dealer will likely pay at least $500 to the Company within the first six months of operation under the Option Agreement, then the minimum payment requirement will be met.

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.

Franchise Rule Staff

Date: December 18, 1997

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.

2. You also state that the Dealer agreement requires Dealers to maintain and preserve complete and accurate books, records, and accounts, and to provide annual financial statements to the manufacturer.

3. The Option Agreement also imposes several additional controls. Among other things, the Company would obtain a perfected, first priority security interest in all of the Dealer's assets and equity interests. Each Dealer would also "make certain covenants regarding the maximum compensation the Dealer could pay to any of its officers, directors, managers, employees, agents, or other representatives during the term of the Program."

4. Under the Franchise Rule, franchisors must provide prospective franchisee with a basic disclosure document at the earlier of the first face-to-face meeting or 10 days before the execution of a franchise agreement or tendering of a payment. 16 C.F.R. § § 436.1(a), 436.2(g), 436.2(o).