Items to Ponder: Misclassification of Workers (Licensees vs. Franchisees)

I have been researching. Like, a lot. So much so that my computer may actually overheat or blow up.

My husband told me that the number of tabs open on my computer is tantamount to computer abuse, so this post is purely for the good of my computer, to close some tabs down, and try to get some closure.

As I mentioned in my last post, Items to Ponder: Misclassification of Workers (IC vs. Employees), I’m not an attorney, nor did I sleep at a Holiday Inn, but I do have questions that might be relevant to other people. If they aren’t relevant to your situation, scroll right on by and never look at this post.

You do you.

Over here, I’m going to write about what’s been on my mind, and that involves questions about misclassification of workers.

So, prior to a few months ago, I had never researched the difference between a licensee and a franchisee. However, circumstances have forced me to take a little closer look and now I am learning that there is actually a significant difference between those two classifications.

What is the difference between a licensee and franchisee?

“With a licensing agreement, you’re selling your brand. Disney, for example, is a titan of licensing. … A franchise agreement is more restrictive than a license agreement: franchisors expect franchisees to do things the company way. Usually franchisors also provide more support and training than a licensor.” (Difference Between Licensing and Franchise Agreements | Chron.com)

It turns out a surprising number of businesses are unintentional franchises.

“Although there is no uniform definition of a franchise at the federal and state levels, the United States Federal Trade Commission (FTC) definition, found in 16 C.F.R. § 436.1(h), is the baseline upon which states are free to elaborate or adopt more specific requirements, as long as the state’s additional requirements increase the level of protection afforded to the franchisee. The FTC defines a franchise as any continuing commercial relationship or arrangement that contains three separate elements:

  1. Right to use a trademark. The franchisor must give the franchisee permission to identify or associate with the franchisor’s trademark, or to offer, sell or distribute goods or services using that trademark.
  2. Payment. The agreement must require that the franchisee pay royalties or fees to the franchisor/trademark owner or an affiliate.
  3. Control. The franchisor must either impose significant controls over, or offer significant assistance in, the franchisee’s method of operating the business using the trademark.” (Avoiding an “Accidental” Franchise in U.S. Trademark Licensing | International Trademark Association)

So ask yourself some questions to help clarify the relationship your small business actually has with the distributor to help identify whether you might be participating in an accidental franchise:

Right to Use Trademark

Do you have an email account that includes the distributor’s name in it that you use to conduct your business?

Have you advertised outreach events using corporate logos or trademarks, or only with your own self-generated marketing efforts?

When you refer to your business, do you lean on the relationship you have with the distributor to add the weight and history of the company to your actions?

Payment

Do you submit annual or semi-annual payments to the distributor for the right to do business using their name?

Do those payments amount to more than $500 per year?

Control

Do you have regular, required meetings with the distributor’s representative?

Has the distributor made statements about where your business may be located?

Has the distributor made statements regarding what workers you may contract?

Has the distributor told you that your business may not operate without a clear statement of religious belief?

  • Is that statement of religious belief used to identify which groups of people you will serve in your business?
  • Have you been led to believe you are required to contract workers based on their stated religious beliefs? (If so, and if you are operating as a for-profit or sole proprietorship company, you might be violating the Civil Rights Act of 1964 which prohibits discrimination on the basis of religion.)

Have you been asked to share progress reports with a representative of your distributor without notifying the person being evaluated (or their parent or legal guardian) that this information is being shared? (If so, you may be in violation of the Family Educational Rights and Privacy Act (FERPA). FERPA is a federal law that ensures NO third-party access of student data without parental notice.)

Are you required by the distributor to possess certain items or tools like curriculum or a training DVD set in order to operate your business?

“Whenever there is a trademark, the exchange of money, and a continuing relationship between your client and its purchasers, you need to analyze whether the franchise disclosure laws apply to the relationship. If the three elements of a franchise exist, then the relationship is a franchise, even though you may refer to it as a distributorship, dealership or license arrangement.” (The Accidental Franchise | American Bar Association)

“Most franchisors exert a lot of control on franchisees to make sure they keep standards high and deliver what customers expect.” (Differences Between Licensing and Franchising Agreements | Small Business)

A few more questions regarding transition of the business and whether that indicates a licensee or franchisee relationship:

What type of support did you receive from the distribution representative regarding your business opportunity?

Who established the relationship with the location of your activities?

Did you step into a pre-existing business at a specific location or with a group of people who were previously meeting together for an identical or similar purpose?

Did another business owner pass on their business contacts to you during the transition?

“A seller who helps set up an inexperienced buyer in business with a representation on an assured market—such as a manufacturer who turns over a territory, including established accounts or locations—and charges for the privilege has probably created an FTC Rule business opportunity.” (Unintentional Franchising | St. Mary’s Law Journal)

All of these questions, depending on your answer, might give you some clues about whether you are correctly classified as a licensee or a franchisee. (The Accidental Franchise | American Bar Association)

Who cares if you’re a licensee or a franchisee?

Franchising is based on securities law while licensing falls under the purview of contract law. In layman’s terms, this means that if a business wishes to expand through franchising, it must register in the appropriate jurisdictions and also incorporate certain information into its franchise agreement. A license agreement is simply a business contract between two parties.” (Franchise Agreements vs. License Agreements | Bizfluent)

As one might assume, when the Federal Trade Commission gets involved in things the need for attorneys, the amount of paperwork, and the cost of reporting is significantly higher than just a few people signing a contract in some random zip code to provide a service that pays very little!

“Compliance with these laws can be cumbersome and will delay the rollout of your client’s “licensing” program. However, failure to comply with these laws can subject your client and its principals to liability for damages or rescission. In addition, many of these laws have provisions for criminal penalties, civil fines and the award of attorneys’ fees. Unfortunately, many companies that offer dealerships or licenses discover they have sold a franchise only after an unhappy franchisee — or regulator — has filed suit against them. At that point, it is too late for the franchisor to “cure” its failure to register the franchise or to provide appropriate disclosures to the distributor or licensee.” (The Accidental Franchise | American Bar Association)

If a company chooses to have a franchise agreement there’s A LOT more governmental interference to ensure that the contractees and consumers are being treated fairly.

So, as I interpret this information, a licensing agreement means that people can operate and have “branch” differences. But the moment that the distributor starts placing pressure for identical “branches” across the company, they start into the amount of control operated by a franchise agreement.

But… Tell Me When?

I don’t think anyone goes into any relationship with a full understanding of what was coming. I mean, seriously, think of any marriage you have known in the history of forever! There are always little quirks and tendencies that will surprise you, and business is no different.

However, there is legal protection with the laws of the United States when it comes to business opportunities so that people are not blindsided.

The law has established fairly clear expectations regarding what needs to be shared with a person prior to them signing on the dotted line of a contract.

Incoming businesses owners need to have their business opportunity clearly and fully explained, in writing, or there is an issue with a term called Failure to Disclose. This is particularly significant if you’re operating a franchise.

The FTC Rules mandate a franchisor provide written disclosures to prospective franchisees at the earlier of (1) the first face-to-face meeting between the franchisor and the prospective franchisee for the purpose of discussing the possible sale of a franchise or (2) ten business days prior to executing the franchise agreement.

So, here are a few questions to ponder for clarity’s sake:

Did you receive anything besides a license application from the distributor prior to signing the contract?

Did you receive a handbook of operations to help you understand the depth of the expected operating procedures prior to signing your contract?

Did anyone disclose questions that could be important to ask a tax or legal professional regarding this relationship prior to signing the contract?

Did you understand the scope of the business and its liabilities prior to signing the contract ?

Could you be participating in an unintentional franchise?

“When I suggest someone may be in violation of the Franchise Rule, the first words I often hear are, “My attorney drafted this, so it must be OK.” But unfortunately, attorneys–like the rest of us–are fallible, and attorneys who are unfamiliar with the complexities of franchise law will occasionally try to muddle through the issues without calling on an expert, and the result can be disastrous.” (The Accidental Franchisor | Entrepreneur)

“A client asks you to prepare an agreement to distribute goods and services through independent dealers or distributors. Or, a client has a system it wants to license to others who will use it to market a product or service to consumers. If you do not consider that the arrangement may actually be a franchise or business opportunity regulated by more than three dozen laws, you may find yourself the target of a significant malpractice claim.” (The Accidental Franchise | American Bar Association)

In some cases I can think of, the organization being defined is unlike any other company, marketing plan, or distributor that exists, which means that legal professionals may not have a frame of reference. Also consider:

“All franchises are licenses.  A ‘franchise’ is a defined legal term and applies no matter what the parties call their relationship.  Trying to redefine a relationship that is ‘franchise’ by naming it a ‘license,’ ‘distributorship,’ or otherwise does not make it a non-franchise – just like you can’t call a duck a cow and make the animal become cow.  Franchise laws cannot be waived and therefore offering and selling a relationship that is a ‘franchise’ without complying with applicable regulatory rules can be a risky and costly choice.” (The Hidden Franchise: Inadvertent Franchising Equals Inevitable Risk | Forbes)

So in some cases, it’s possible that the distributor chose the avenue of progress forward that avoided the most oversight… and prayed that the grey areas would cover their activities. However:

“Failing to comply with the FTC Rule and/or state registration and disclosure rules exposes the franchisor to claims by the state or federal governments and to claims by the ‘franchisee’ that purchased the franchise.  Illegal franchising may also expose the franchisor’s management to, among other things, damages, fines, injunctions, administrative remedies, and criminal sanctions.  Even if a franchise is not intended or compliance is consciously disregarded, the failure to comply can lead to the franchisor and its management being liable to the franchisee for significant damages or rescission – ‘bet the company’ litigation.” (The Hidden Franchise: Inadvertent Franchising Equals Inevitable Risk | Forbes)

I wasn’t able to locate exact and clear cut consequences for misclassification of licensees as franchisees, so here are a few cases that inform my understanding:

  • In Mirza v. TV Temp, the plaintiffs in the case were awarded $1.45 million based on defendant’s failure to provide disclosure documents 10 days prior to the signing of a master distributor agreement.
  • KIS Corp. paid $1.55 million in damages after agreeing its plan violated the FTC Rule.
  • In LASVN #2 v. Sperry Van Ness Real Estate, a jury awarded more than $6 million in a case in which both parties had agreed in writing that the relationship wasn’t a franchise. (The Accidental Franchisor | Entrepreneur)

There are many, many articles to be found regarding this licensee vs. franchisee issue, and I haven’t found one yet that started with grey area that didn’t eventually come down on the franchise side after it was considered by a court. In fact, one resource said that the FTC is deliberately “out to get you” as a franchiser. Is this an exhaustive search? Well, my computer thinks so based on the number of tabs I’ve had open!

Many thanks for following me along this path for an admittedly long blog post. My computer also thanks you for giving me the opportunity to close a ton of tabs!

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