INFORMAL STAFF ADVISORY OPINION 03-4
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 to two proposed business arrangements.
Your client is in the automotive paint matching business. Specifically, your client owns equipment and software used to mix resin and pigments to produce paints used by auto body shops. According to your letter, your client does not sell directly to the body shops. Rather, your client sells to "jobbers," both directly and through "warehouse suppliers."
According to your letter, only jobbers sell directly to end-user body shops. Jobbers are essentially distributors, selling a wide variety of products to auto body shops, only one of which is your client's automotive paint line. When a body shops needs automobile paint, it contacts a jobber and requests paint that matches either the color code of an automobile or a car paint sample. The jobber either acquires the necessary materials - resins and pigments - directly from your client or from a warehouse supplier that stocks those products.
B. Warehouse Suppliers
Your client also sells product indirectly to jobbers through "warehouse suppliers." According to your letter, there are currently approximately 20 such warehouses spread evenly throughout the United States. All are well-established businesses owned by five large companies. These warehouses also buy and sell competitive products and carry numerous other automotive-related products not supplied by your client.
C. Proposed Business Relationships
Your client proposes to provide select jobbers with the necessary equipment, software, and training to perform color matching and mixing of your client's paint resins and pigments. In lieu of selling the equipment and software - which would be very expensive - your client proposes to lease the equipment and software for more than $500 per year, which would be forgiven if sales reach a specified minimum. While you do not state a specific minimum sales level, you say that the minimum "is set for a territory in an effort to recover the investment in the equipment and software." Since the equipment is delicate and subject to clogging or loss of calibration if used incorrectly, your client will require that the equipment be used only with your client's products and in accordance with your client's instructions. The lease agreement, however, would not prohibit the jobbers from buying or selling competitive paint products, as long as they were not used on your client's equipment.
You state that other than training in the use of the software and equipment, there will be no other training or management control exercised over the jobbers' business operations. Finally, you note that your client's trademark would be used to market the products, subject to quality controls, but there would be no general grant of a trademark license included in the lease agreement.
For the warehouse suppliers, your client intends to enter an agreement requiring the warehouse to stock and supply your client's paint products to jobbers in specific geographic regions. To encourage the warehouse to invest in sufficient stock of resins and pigments, your client will offer a "secure territory." Your client would also authorize the use of its trademark in connection with the sale of paint products, subject only to the same quality controls as for jobbers. There would be no training, management control, or other involvement in the warehouses' businesses. However, to initiate and retain an account with your client, the warehouse would be required to acquire more than $500 of products.
You ask whether the proposed business arrangement with the jobbers and warehouse suppliers constitutes a franchise under the Franchise Rule.
II. THE DEFINITION OF FRANCHISE
We begin our analysis by noting that the term "franchise" refers to a continuing commercial relationship. According to your license agreement, both jobbers and warehouse suppliers will buy paint resins and pigments from your client on an ongoing basis. Accordingly, it is clear that your client's relationship with the jobbers and warehouse suppliers is both continuing and commercial.
To be covered by the Franchise Rule, a business arrangement must also satisfy the three definitional elements of a "franchise" set forth in the Rule: (1) the distribution of goods or services associated with 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). We address each of these elements below.
1. Distribution of Goods or Services Associated with the Franchisor's Trademark or Trade Name
The first definitional element of a franchise is trademark. The Rule provides that the trademark element will be satisfied under one of two conditions:
1. The franchisee offers, sells, or distributes goods, commodities or services which are identified by a trademark; or
2. The franchisee indirectly or directly is required or advised to meet prescribed quality standards where the franchisee operates under a name using the trademark.
16 C.F.R. § 436.2(a)(1)(i)(A)(1) and (2).
In this instance, both jobbers and warehouse suppliers will distribute paint products identified with your client's trademark. In addition,the jobbers selected to obtain your client's equipment will perform paint matching services identified by your client's trademark. It also appears that they will meet certain standards in the operation of the paint matching system. This would appear to satisfy the Rule's trademark element.
2. Significant Control or Assistance
As noted above, you state that your client intends to impose some controls over the use of the paint matching equipment, as well as require a minimum level of sales. In addition, your client will provide jobbers with some assistance. Specifically, your client will train jobbers in the use of the paint matching equipment and software and will provide a sales territory. The question remains, however, whether the assistance and control is "significant."
In the Final Interpretative Guides, the Commission stated that "significance" is a "function of the degree of reliance which franchisees are reasonably likely to place upon the controls or assistance." See Final Interpretive Guides, 44 Fed. Reg. at 49967. This is especially true of purchasers who are inexperienced in the particular business. Id. The Commission examines "significant control and assistance" 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 purchasers. Id. See also Statement of Basis and Purpose, 43 Fed. Reg. 59614, 59701 (December 21, 1978).
In your letter, you state that both jobbers and warehouse suppliers are "well-established commercial business enterprises, who buy and sell paint products that are competitive to our client's products as well as carrying numerous other automotive business product lines not supplied by our client." Accordingly, it would appear that the jobbers and warehouse suppliers are not likely to place great reliance on your client in the operation of their businesses.
In addition, the Commission has noted that reliance is proportionate with financial risk (e.g., the risk assumed by adding a new product line). It is clear from your letter that your client's product line is only one of several lines sold by the jobbers and warehouse suppliers. If the portion of the jobbers and warehouse suppliers' overall sales attributable to the sale of your client's products is small, then reliance might be lacking.(1)
Moreover, the assistance and controls imposed by your client appear to be narrowly tailored to ensure the proper operation of the paint matching system, rather than the operation of the jobbers and warehouse suppliers' overall business. The Commission has stated that controls and assistance must be over the franchisee's "entire method of operation - not its method of selling a specific product or products which represent a small part of the franchisee's business." The Commission reasoned:
Controls or assistance directed to the sale of a specific product which have, at most, a marginal effect on a franchisee's method of operating the entire business will not be considered in determining whether control or assistance is "significant."
44 Fed. Reg. at 49,967.
For these reasons, your client's proposed controls and assistance to both the jobbers and warehouse suppliers do not appear to rise to the level of significance contemplated by the Rule.
3. Minimum Payment
Finally, it appears that the jobbers and warehouse suppliers may satisfy the minimum payment requirement. As an initial matter, you state that the warehouse suppliers will pay more than $500 for products in order to initiate and retain the account with your client. That is sufficient to satisfy the Rule's minimum payment requirement.
Further, you state that jobbers will pay at least $500 per year that is "forgiven" if sales reach a specified level. A franchise relationship will be exempt from the Rule if payments or commitments to pay do not exceed $500 in the first six months of operation. Thus, it is possible that some or all of the payments made in the first year might be made within the first six months. It is also possible that jobbers may ultimately pay at least $500 if they do not satisfy the level of sales necessary to trigger the fee waiver. We note that the franchisor always carries the burden of proving that it qualifies for a Rule exemption at the time of sale. In the absence of sufficient facts showing that jobbers will not pay at least $500 in the first six months of operations, we must conclude that the minimum payment requirement is satisfied in this instance.
Based upon the information you have provided, it appears that your client's business arrangement with both the jobbers and warehouse satisfies both the trademark and minimum payment requirements. However, for the reasons noted above, based upon the factual assertions made in your letter it appears that any imposed controls or assistance offered to jobbers and suppliers does not rise to the "significant" level. Accordingly, it appears that your client's proposed business arrangement would not be covered by the Commission's Franchise Rule.
Please be advised 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: October 14, 2003
Franchise Rule Staff
1. Indeed, if the sales of your client's products are less than 20% of overall sales within the first year, then your client's proposed business relationship might qualify for the fractional franchise exemption. See 16 C.F.R. § 436.2(a)(3)(i). There are two prerequisites to the exemption: (1) two years of experience in the type of business represented by the franchise; and (2) the sales arising from the relationship would represent no more than 20% of the total dollar volume of sales by the franchisee. Id. at § 436.2(a)(h).