Informal Staff Advisory Opinion 99-5

This staff advisory opinion is issued in response to your request for our views on whether your client's license arrangement qualifies for the Franchise Rule's fractional franchise exemption. 16 C.F.R. § 436.2(a)(3)(i). In this advisory, we address three novel issues: (1) whether the location of the fractional franchise may be disqualifying; (2) whether the exemption is available to a partnership; and (3) whether the exemption is available where the fractional franchisee operates the new line of business as a newly formed corporate subsidiary.

I. INTRODUCTION

In your letter, you state that your client, Outsourcing and Modified Employment, Inc. ("OME"), has developed the "WorkLight" system, which serves the needs of workers who are temporarily disabled from performing their normal job duties as a result of on-the-job injuries and who are collecting workers' compensation benefits or disability insurance. The WorkLight system operates a warehouse or an industrial facility ("Productivity Center") to which the injured workers are assigned to perform light fulfillment work during their rehabilitation period, such as packing products for distribution and envelope stuffing.

OME intends to license the operation of its Productivity Centers. Center managers would then obtain work projects from independent businesses on a subcontract basis. You state that OME would set workplace safety and similar operational standards for each Productivity Center, but otherwise would exert no influence over the manner in which the licensee operates its business.(1)

OME intends to grant licenses for the operation of Productivity Centers exclusively to two classes of licensees: (1) staffing companies that recruit their own forces of professional, technical, and other skilled employees and place these employees with other companies for a specific project, or on a temporary or other basis; and (2) professional employee organizations that become co-employers of other companies' employees, assuming responsibility for payroll services, employee benefit plans, workers' compensation compliance, and other related human resources matters. You state that OME will require a licensee to verify that it or at least one of its executives has two or more years of experience managing a staffing company or a professional employee organization and that revenues generated from operating a Productivity Center will not account for more than 20% of the licensee's total revenues during the first year of the Productivity Center's operation.

Finally, you add that OME anticipates that some, but not all, prospective licensees will establish wholly-owned subsidiaries (Subsidiary Licensees), which will execute the OME license agreement and operate the Productivity Centers. You state that, in such circumstances, the Subsidiary Licensees will also verify that revenues from the Productivity Center will account for not more than 20% of the total combined revenues of the Subsidiary Licensee and its parent during the first year of the Productivity Center's operation.

You now ask whether the licensing of the WorkLight system under the conditions described above falls within the Franchise Rule's fractional franchise exemption, 16 C.F.R. § 436.2(h).

II. THE FRACTIONAL FRANCHISE EXEMPTION

The fractional franchise exemption is one of four exemptions provided by the Franchise Rule. See 16 C.F.R. § 436.2(d). The exemption is available to a company offering a business relationship that meets each of the three elements for Rule coverage if it can prove that the following two conditions are met: (1) the franchisee with which it enters into 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 Statement of Basis and Purpose accompanying the Franchise Rule, 43 Fed. Reg. 59614 (December 21, 1978), provides additional clarification. When interpreting the term "business represented by the franchise," the Commission stated that: "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." Id. at 59706 at n.80. With respect to the 20% of sales limitation, the Commission also stated:

To qualify for the exclusion, the franchise relationship must be one which is, or should have been anticipated by the parties at the time they entered into the relationship to represent no more than 20 percent of the prospective franchisee's business in terms of dollar volume of goods or services to be sold or distributed by the franchisee.

Id. at 59707 at n. 84.

III. WORKLIGHT LICENSES MAY QUALIFY FOR THE FRACTIONAL FRANCHISE EXEMPTION

Based upon the information contained in your letter, the license of OME's WorkLight system may qualify for the fractional franchise exemption. We begin our analysis by determining whether the licensees have experience both in providing subcontracted work assignments for disabled employees and in handling related insurance and benefits issues. It appears that OME is targeting its system at those companies that are already familiar with employee-staffing services. You state that the licensees - staffing companies and professional employee organizations - engage primarily in human resource work, including the arrangement of modified duty assignments for employees who sustain job-related injuries. In addition, the staffing companies and professional employee organizations conduct business through subcontracts with other businesses and have extensive experience in marketing of subcontract employment services. Both types of companies also are familiar with obtaining disability and workers' compensation insurance coverage and handling the administration of disability and injury claims. Thus, not only do the prospective licensees have experience with providing work for disabled employees, they are familiar with the typical related insurance issues that are expected to arise. Finally, to ensure that the licensees have the requisite experience, OME will require the licensees to represent in the license agreement that they have been in the business for more than two years. Thus, reasonable grounds may exist to conclude that the prospective licensees are already "in the business represented by the franchise."

The next issue we need to address is whether the parties anticipate that revenue generated from the operation of the Productivity Centers will exceed 20% of all revenues in the first year of operation. You state that the licensees already operate their own core business of providing an array of job placement and related human resource services. Accordingly, you believe they will not be dependent upon the operation of a Productivity Center for a significant portion of their income. Indeed, you state that each licensee must establish to OME's satisfaction that the revenues from the operation of a Productivity Center will not account for more than 20% of the licensee's total revenues during the first year of the Productivity Center's operation. In addition, you state that OME will require that prospective licensees actually prepare projections of the amounts and sources of their revenues for one year. OME will examine and evaluate the reasonableness of these projections before accepting them.(2) W can conclude, therefore, that the parties have a reasonable and good faith basis to anticipate from the start of their relationship that the additional sales gained will be no more than 20% of total sales.

IV. A PARTNERSHIP MAY QUALIFY FOR THE FRACTIONAL FRANCHISE EXEMPTION

In your letter, you state that if the prospective licensee-company has been in business for less than two years, OME will then require that the prospective licensee's senior management have been in the same business for the requisite period. At the same time, you note that the fractional franchise exemption speaks only of a franchisee's directors and executive officers, which are positions unique to corporations. You state that it is possible that the licensee may be a partnership or a limited-liability company. You contend that there is no conceptual or policy reason for limiting the fractional franchise exemption only to corporations. You suggest that the exemption's experience requirement should be satisfied by general partners of a partnership and the managers of a limited liability company as well. We agree, as long as the partners or managers exercise control and formulate policy to the same degree as would the directors and executive officers of a corporation.

V. THE LOCATION OF THE PRODUCTIVITY CENTER IS NOT DISQUALIFYING

In your letter, you also state that the Productivity Center may not be located in the same facility as the licensee's primary business operations. Rather, the Productivity Center may be located near public transportation in order to make the facility more accessible to injured employees. You ask whether this may be a disqualifying factor under the fractional franchise exemption. That a fractional franchise may be operated out of a different facility than the franchisee's core business alone is not disqualifying. It is the nature of the franchisees' business experience, not the location of its business per se, which may bring the business relationship within the fractional franchise exemption. Nonetheless, location is one factor we will consider in determining the similarities and differences between the established business and the new franchised business. In this instance, the location of the Productivity Centers, albeit different from the licensees core business location, appears to be a reasonable accommodation to serve the expected clients' needs. Accordingly, in this instance, the location does not appear to be disqualifying.

VI. WORKLIGHT SUBSIDIARY LICENSEES MAY ALSO QUALIFY FOR THE FRACTIONAL FRANCHISE EXEMPTION

Finally, we address whether the fractional franchise exemption can apply to a subsidiary licensee. Presumably, the wholly-owned subsidiary will be a new entity without any prior business experience. Nonetheless, the experience of the subsidiary's current directors or executive officers may qualify the business entity as a fractional franchise. The more difficult issue is whether a subsidiary may satisfy the exemption's second prong: the revenue threshold. You correctly note that neither the Interpretive Guides nor any FTC advisory opinion addresses whether the combined gross sales of a subsidiary and its parent may be used in calculating the 20% figure.

In considering the applicability of the fractional franchise exemption to any particular set of facts, we do not wish to elevate form over substance. There is nothing inherently deceptive or abusive about establishing a franchised business as a wholly-owned subsidiary, especially if the determination to establish the subsidiary is initiated voluntarily by the franchisee. We note that there may be tax advantages and reduced liability benefits to be derived from establishing a subsidiary. Accordingly, where a subsidiary licensee is wholly-owned, we will consider the income derived by the subsidiary licensee, together with the income of its parent, for purposes of applying the fractional franchise exemption. If the revenue of the wholly-owned subsidiary-licensee is less than 20% of the combined income of the parent and the subsidiary licensee in the first year of operation, then the subsidiary-licensee may qualify for 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: July 2, 1999 Franchise Rule Staff

1. This statement suggests that you may believe that your client's licensing arrangement is not a franchise, for lack of "significant control." However, for purposes of this advisory, we will assume that OME's licensing arranging constitutes a franchise under the Franchise Rule.

2. You state that OPE will not require that the projections be prepared or reviewed by independent accountants, and you ask whether this would bar application of the exemption to your client. Nothing in the fractional franchise exemption requires that projections be prepared by an accountant. Rather, the burden falls on the franchisor to establish that it qualifies for the exemption. That includes a good faith basis to believe that the franchisee's income from the new line of business will not exceed 20% in the first year. In prior advisory opinions, we stated that the franchisor cannot rely simply on the franchisee's bald assertions about its likely income, but must have some basis to verify the franchisee's claims. Reasonable revenue projections prepared by the prospective licensee in good faith and reviewed by the franchisor are sufficient for this purpose.