Distributors Are Treated Differently Than Franchises Under New Jersey Laws
We’ll Explain How
What You Should Know About Franchise Laws vs. Distributorship Agreements
A franchise is different than a distributorship and each is treated differently under NJ laws. Several levels of regulations govern the franchise relationships. First, there are federal regulations and then New Jersey laws which address pre-sale disclosures of information material to the franchise being offered by the franchisor, as well as information about the franchisor itself. Unfortunately, New Jersey’s statutes and regulations are void of any meaningful pre and post franchise and distributorship controls, except when a franchisor proposes to terminate a franchise. That law is known as the New Jersey Franchise Practices Act. Some agreements state that the relationship is that of a distributorship and not a franchise. But there is an old cliché I want you to recall. If it looks like a duck and quacks like a duck… it’s a duck. Some “distributorship agreements” are in actuality “franchise agreements”.
Federal Regulation of Franchising: The “Amended Franchise Rule and Disclosure Requirements”
Federal laws governing franchises are expansive. These laws will supersede portions of a distributorship agreement that violate federal law. Federal regulations of franchising began in 1979. In 2007, the FTC (Federal Trade Commission) approved amendments to its Franchise Rules which became known as the “Amended Franchise Rule(s).
The Amended Franchise Rule(s) are very helpful to franchisees. The rules provide that franchisors must furnish prospective franchisees with a Franchise Disclosure Document (“FDD”) at least 14 calendar days before the prospective franchisee signs a binding agreement with, or makes any payment to, the franchisor or an affiliate in connection with the proposed franchise sale. The 14 day period begins the day after delivery of the FDD. The signing of a binding agreement or receipt of payment by the franchisor or an affiliate of the franchise can occur only after the fifteenth day after delivery of the FDD. This Rule ensures that prospective franchisees have at least 14 days in which to review the disclosures (the so-called “cooling off period”).
Absent an exemption, it is deemed to be an unfair or deceptive act or practice in violation of the Federal Trade Act for any franchisor to fail to furnish a prospective franchisee with a copy of the franchisor’s current FDD as described above.
What is a Binding Agreement that Triggers FDD Disclosure?
The FTC has ruled that a confidentiality agreement (often signed by prospective franchisees before being granted access to the franchisor’s operations manual and other proprietary information) is a necessary step in the sales process, but is not the type of agreement that triggers disclosure obligations.
Specifically, the Amended Franchise Rule provides that it is an “unfair or deceptive practice” to “fail to furnish a copy of the franchisor’s disclosure document to a prospective franchisee earlier in the sales process upon reasonable request.
The applicable regulations state that a franchisor must tender a disclosure document where the parties have already conducted specific discussions or negotiations or otherwise taken steps to begin the sales process. The FTC has ruled that this provision enables a prospective franchisee to ask to see a copy of the FDD before agreeing to travel to company headquarters or spending other money during the pre-sale process.
What Types of Relationships are Covered?
ATTENTION ALL BUSINESSMEN AND WOMEN WHO HAVE SIGNED A “DISTRIBUTORSHIP AGREEMENT”. READ THIS SECTION CLOSELY.
The Federal Franchise Rules cover the offer and sale of franchises. Under this Rule, a commercial business arrangement is a “franchise” (not a distributorship!) if it satisfies three elements. The franchisor must: (1) promise to provide a trademark or other commercial symbol; (2) promise to exercise significant control or provide significant assistance in the operation of the business; and (3) require a minimum payment of at least $500 during the first six months of operations.
The name given to the business arrangement (ie., franchise vs. distributorship) is irrelevant in determining whether it is covered by the Federal Franchise Rule. Similarly, a self-described “distributorship” or “license” will be covered by the Amended Franchise Rule if the three definitional elements mentioned above are satisfied.
I bet now after reading the above you’re convinced you’re a franchise. You’re probably correct.
The “Trademark” Requirement
A franchise entails the right to operate a business that is “identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark.” The term “trademark” is read broadly to cover not only trademarks, but any service mark, trade name, or other advertising or commercial symbol.
The “Significant Control or Assistance” Requirement
The Amended Federal Franchise Rule covers business arrangements where the franchisor “will exert or has the authority to exert a significant assistance or direction in the franchisee’s method of operation, or provide significant amount or degree of assistance in the franchisee’s method of operation.” And most franchises do just that!
When Is Control or Assistance is Deemed Significant?
The more that you reasonably rely upon the franchisor’s control or assistance, the more likely the control or assistance will be deemed “significant.” Franchisees’ reliance is likely to be great when they are relatively inexperienced in the business being offered for sale or when they undertake a large financial risk. Similarly, franchisees are likely to reasonably rely on the franchisor, as opposed to a typical practice employed by all businesses in the same industry.
Significant types of control over the franchise include:
- Site approval for unestablished businesses;
- Site design or appearance requirements;
- Hours of operation;
- Production techniques;
- Accounting practices;
- Personnel policies;
- Promotional campaigns requiring franchisee participation or financial contribution;
- Restrictions on customers; and
- Locale or area of operation.
Significant types of assistance include:
- Formal sales, repair, or business training programs;
- Establishing accounting systems;
- Furnishing management, marketing, or personnel advice;
- Selecting site locations;
- Furnishing system wide networks and website; and
- Furnishing a detailed operating manual.
The following factors will also be considered when determining whether “significant control or assistance” is present in a relationship:
- A requirement that a franchise service or repair a product (except warranty work);
- Inventory controls;
- Required displays of goods; and
- On the job assistance with sales or repairs.
What Types of Payments Constitute “Required Payments”?
“Payment” means and is intended to be read liberally, capturing all sources of revenue that a franchisee must pay to a franchisor or its affiliate for the right to associate with the franchisor, market its goods or services, and begin operation of the business. Often, required payments go beyond a simple franchisee fee, entailing other payments that the franchisee must pay to the franchisor or an affiliate by contract – including the franchise agreement or any companion contract. Required payments may include:
- Initial franchise fee;
- Advertising assistance;
- Equipment and supplies ( including such purchases from third parties if the franchisor or its affiliates
- receives payment as a result of the purchase);
- Security deposits;
- Escrow deposits;
- Non-refundable bookkeeping charges;
- Promotional literature;
- Equipment rental; and
- Continuing royalties on sales.
Payments which, by practical necessity, a franchisee must make to the franchisor or affiliate also count toward the required payment. A common example of a payment made by practical necessity is a charge for equipment that can only be obtained from the franchisor or its affiliate and no other source.
Do you have a question(s) not addressed here about your distributorship contract? If so, contact Fredrick P. Niemann, Esq. toll-free at (855) 376-5291 or email him at firstname.lastname@example.org to schedule a consultation about your particular needs. He welcomes your calls and inquiries and you’ll find him very approachable and easy to talk to.
Written by Fredrick P. Niemann, Esq. of Hanlon Niemann & Wright, a New Jersey Franchise Law Attorney