Franchise Legislation in US
Franchising is the practice of leasing for a certain period, the right to use a company’s successful business model and brand. For the franchisor, the franchise is just another option for building chain stores to distribute goods that help in avoiding the investment and liability of a chain. The franchisees success is the main focus of the franchisor. The franchisee is given more incentives for their work than a direct and casual employee because he or she has a direct stake in the business.
In layman’s term, the franchisor is the supplier who allows a franchisee to use the supplier’s trademark and distribute the goods whereas the franchisee in return uses the supplier’s property and pay him a fee in return. Excluding the US, thirty-three other countries have laws that regulate franchising that may either have a direct or indirect impact on franchising. There may be mid-sized or large franchisees. Mid-sized franchises like small restaurants, gas and trucking stations involve substantial investment and all attention of the owner whereas large franchises like hotels, spas and hospitals have discussed their interest further under technological alliances.
The three major payments made by the franchise to the franchisor.
- Firstly a royalty that is a kind of rent is paid for the trademark.
- Secondly, the payment is made for the other facilities such as training and advisory services given to the franchisee.
- Lastly, a certain percentage of what the franchisee earns or the individual business unit’s sale is given to the franchisor.
These three payments may be given separately depending on the size of business or maybe combined in a single management fee.
A franchise lasts for a certain period which is usually fixed. It is merely a temporary investment, which includes leasing and renting an opportunity and not only the purchase of a business for the sole purpose of ownership.
In United States, franchising is controlled by Federal Trade Commission (FTC) rather than the U.S. Securities & Exchange Commission. Franchise rule in the US is very strict and are needed to be studied carefully to save small and startup franchisees. Not only trademark but also the proprietary service marks may be copyrighted. Franchise legislation came into effect since the enactment of California franchise investment law in 1970. Currently, both the state and federal laws govern the sale and purchase of franchises.
As per FTC, franchisee must be provided the Franchise Disclosure document by the franchisor at least fourteen days before the money is exchanged or the signing of the final agreement. FDD is a lengthy document with various elements of disclosure in details& the audited financial statements of the franchisor (in the prescribed format). In the US, rules related to FDD might vary from state –to-state, but the state disclosure document must be in compliance with the Federal rule. These laws are designed to provide the relevant information to the investor before he/she commits to becoming a franchisee.
Usually, the prospective franchisees hire an attorney to take forward the franchise selection process. Also, while signing the agreement legal assistance is required, as the franchise agreement lays down the complete terms & conditions & defines the relationship of both the parties for a specific agreed upon term period. A franchise agreement clearly defines the following:
- Accounting & record maintaining provisions
- Investment terms
- Restricted activities or activities that are beyond the scope of an agreement
- Termination clause
- Franchise renewal clause etc.
The FTC regulates franchise under Federal law. The FTC rule does not apply on any existing franchisor- franchise relationship rather it only imposes pre-sale disclosure requirement. The jurisdictional factors vary from state-to-state, so franchisors are required to be aware of the possible application of ‘multiple states’ franchise laws’.
A franchisor must comply with the FTC Rules requirements regarding, FPR disclosures & the applicable state laws, in case it is making any financial performance representation to the prospective franchisees. In the case of non- compliance of the FTC laws or regulations, a company exposes itself and its directors & employees to damages, injunctions and civil & criminal penalties.
Tax system relevant to franchisors
A franchisor in the US is taxed upon franchise fee payments & royalties as ordinary incomes & not as ‘capital gains’ as sale of a franchise is not considered as a sale or exchang e of capital assets. As per US Internal Revenue Code, payments are treated as capital gains only if the franchisor does not retain a significant right, power or continuing interest that is not the case in US. That is; most of the franchisors do retain rights in the franchisee & do not qualify for the capital gain treatment.
In the case of any violation FTC may initiate an enforcement action against the franchisor. Again, all of the state registration and disclosure statutes create their enforcement structures. These statutes vest investigating & prosecuting powers in the state administrator. These state administrators have the power & authority to issue stop orders prohibiting franchise sales activities to those whom they suspect to have been violating the franchise statute till a hearing is conducted.
As a result of challenges faced by US economy, US based franchisors have started looking outside of their country. For franchisors, international expansions offer the potential of large untapped markets. Regions like Middle East, South East Asia & North Africa etc., are considered as hot markets for such franchisors. Canada has become the most popular choice for many US Franchisors not only because it’s the largest trading partner but also because Canada has a stable government & a reliable economy. Also, the Canadian consumer base demands similar goods & services as are predominant in the US. Although, there is no federal law in Canada, it is worth considering the interaction of the various provincial laws when US franchisors grant master franchises. It is quite common for US franchisors to grant the entire Canada to a single master franchise.
But any such international exposure also has its own challenges like rise in the cost, different legal systems and the disparity in culture, economy, language, etc.