INFORMAL STAFF ADVISORY OPINION 97-4
This staff advisory opinion is issued in response to your request for advice, dated April 18, 1997, concerning the application of the Franchise Rule to your client's proposed business arrangement.
In your letter, you state that your client's primary business is cosmetic consulting and the sale of cosmetics. In 1995, your client ("Licensor") licensed the use of its trademark and service mark ("marks") to an optometrist ("Licensee") who, with a business partner, operated 10 retail optical stores. The Licensee used your client's color consulting analysis in its optical store business to match eyeglass frames to customers' facial coloring and shape.
Based on the success of its retail optical stores, the Licensee now wishes to establish a retail optical store franchise system. Its franchisees will provide eye examinations and sell eyeglasses, frames, and contact lenses. The Licensee also wishes to sub-license your client's marks so that the franchisees can use your client's name and color analysis system. In effect, the Licensor will continue to license its marks to the Licensee, who will, in turn, sub-license the marks to its franchisees.
You state that the Licensee clearly constitutes a franchisor with respect to the sub-licensees and is now preparing an offering circular. You express concern, however, that your client may inadvertently become a franchisor by entering into an agreement that allows the Licensee to use your client's marks and color analysis system in the operation of the Licensee's franchised optical stores. You also express concern that your client might be deemed a "co-franchisor" along with the Licensee because the agreement between your client and the Licensee for the use of the color analysis system is important in the franchise agreement between the Licensee and its proposed franchised units.
II. THE RELATIONSHIP BETWEEN THE LICENSOR AND THE SUB-LICENSEES DOES NOT APPEAR TO CONSTITUTE A FRANCHISE
We will begin our analysis by addressing the issue whether your client constitutes a franchisor with respect to purchasers of the Licensee's franchised optical stores. As noted above, these franchisees will effectively gain a sub-license to use your client's color analysis system when they purchase an optical store franchise from the Licensee. We conclude that the relationship created between your client, the Licensor, and the Licensee's franchisees does not constitute a franchise relationship.
We note that sub-licensing in the franchise industry is not a novel concept. Many franchisors have entered into license agreements with various manufacturers in order to distribute the Licensor's trademarked products through the franchisor's network of outlets. For example, it is common in the restaurant industry for franchisors to enter into license or distributorship arrangements with soft-drink manufacturers. When franchisees buy the franchised restaurant outlets, they purchase, in part, the right to use those specific licensed products and, in many instances, the obligation to do so. However, a franchise relationship does not always exist between a licensor and sub-licensees.
Inherent in the concept of franchising is that the parties, the seller-franchisor (or its affiliate) and the buyer-franchisee, intend to enter into a franchise agreement or relationship. See, e.g., Statement of Basis And Purpose, 43 Fed. Reg. 59614, 59700 at n.27 (December 31, 1978)("The rule applies to a relationship only if the parties reasonably anticipated at the time of entering into it that it would originally have the features of [a] franchis[e]."). Ordinarily, sub-licensees do not always intend to enter into a franchise relationship with the licensor. Further, licensors do not always exert significant control over or provide significant assistance to sub-licensees in the operation of the business, as contemplated by the Rule. Finally, sub-licensees do not always make a required payment to the licensor as a condition of obtaining or commencing the franchise operation.
In this instance, there is no suggestion that the optical store franchisees have any expectation that they are entering into a franchise agreement with your client. Rather, they are the beneficiaries of an agreement that your client has entered into with the Licensee. In addition, it does not appear that the franchisees would be paying any required fee to the Licensor in order to commence business. For these reasons, the relationship between your client and the sub-licensees does not appear to constitute a franchise relationship.
In contrast, a co-franchise, or co-branded franchise, often constitutes a "franchise" relationship under the Rule. The area of co-branding is relatively new in the franchise industry, and the Commission's staff is currently studying the issue in greater depth. See Advance Notice of Proposed Rule, 62 Fed. Reg. 9115 (February 28, 1997). Nonetheless, we understand that co-branding occurs in at least three situations: (1) an existing franchisee adds to its line of business by entering into a franchise agreement with a second franchisor to sell that franchisor's trademarked goods or services; (2) two or more franchise systems jointly execute a single agreement with a prospective franchisee, enabling the franchisee to sell the two franchisors' trademarked goods or services jointly in one unit; and (3) two or more franchise systems simultaneously, and with knowledge of the other, enter into separate agreements with a prospective franchisee, enabling the franchisee to sell their respective trademarked goods or services from one unit.(1) Regardless of form, in all of these situations the parties involved often intend to create a franchise relationship and the three definitional elements of a franchise are ordinarily present.
III. THE RELATIONSHIP BETWEEN THE LICENSOR AND THE LICENSEE APPEARS TO CONSTITUTE A FRANCHISE
We next turn to whether the relationship between your client, the Licensor, and the Licensee, constitutes a franchise relationship. In numerous advisory opinions we have stated that the name attributed to a relationship is irrelevant in determining whether a relationship is covered by the Franchise Rule. See, e.g., Advisory 96-1, Bus. Franchise Guide (CCH) ¶ 6476 (April 12, 1996); Advisory 95-1, Bus. Franchise Guide (CCH) ¶ 6466 (January 31, 1995). To be covered by the Franchise Rule, a commercial relationship must 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 or significant assistance; and (3) a required payment of at least $500 within six months of signing an agreement. 16 C.F.R. § 436.2(a)(1)(i). In a typical license arrangement, the first and third definitional elements are usually satisfied. Indeed, you concede this point in your letter. Rather, the issue is generally whether the licensor provides controls or assistance that are "significant."
A. The Licensor Will Exercise Controls And Will Provide Assistance to the Licensee
According to the proposed license agreement, the Licensor intends to exercise some controls over the Licensee's use of its color analysis system. Specifically, the Licensor will require the Licensee to provide services "consistent with the training" provided by the Licensor. The Licensee must also abide by rules and regulations which the Licensor may impose. The Licensor also has the right to approve any products or packaging bearing its mark and requires the Licensee not to use the marks in a way or in a location that will cause "it or the public perception of it to suffer." Further, the Licensee agrees to display appropriate signage in all of its retail optical outlets. In addition, the Licensee agrees not to use cosmetics or swatch packets of competitors without the Licensor's consent. You further state that the Licensor has the right to approve any provision of the Licensee's franchise agreement that deals with the mark. Finally, you add that the Licensor will also provide assistance to the Licensee. Specifically, your client will provide an initial 3-day training period and an annual 3-day training for each of the Licensee's franchised units.
B. The Relevant Business is the Provision of Color Analysis Services
In your letter you contend that these restrictions and assistance are not related to the Licensee's entire method of operation, observing that the restrictions apply only to color analysis -- a small part of the optical stores' general business. In a similar vein, you contend that the Licensee does not rely on these forms of controls and assistance, noting that the Licensee is sophisticated in the operation of an optical store business.
There is no question that to be deemed "significant," a franchisor's controls must pertain to the franchisees' entire method of operation of a business, not just to the sale of one product or service. Final Interpretive Guides, 44 Fed. Reg. 49966, 49967 (August 24, 1979). Before we can address what constitutes the method of operation, we must first determine what constitutes the relevant business. You apparently contend that the relevant business in this instance is the optical store business. We disagree. The relevant business is not what the sub-licensees will ultimately sell, but the business that is the subject of the relationship between the Licensor and the Licensee. Thus, in this instance, the relevant business between the Licensor and the Licensee is the provision of color analysis services.
In effect, the relationship created between the Licensor and its Licensee is akin to a fractional franchise relationship. A fractional franchise relationship typically develops when a store owner adds to its existing product line. Even though the store owner sells perhaps hundreds of other products, it nonetheless may become a franchisee with respect to a single additional product or service line. Fractional franchises are exempt from Rule coverage under narrow circumstances: (1) the store owner has been in the business represented by the franchise for more than two years; and (2) the parties anticipate that additional revenue generated from the addition of the franchised product or service line will not exceed 20 percent of the store owners' anticipated revenues. See 16 C.F.R. § 436.2(a)(3)(i). Where the store owner has not been in the business before, he will be deemed a franchisee even though the subject of the franchise may be a single product line. In this instance, we recognize that the Licensee's chief sales line consists of eye examinations and the sale of frames and glass. Nonetheless, the Licensee appears to constitute a franchisee with respect to the sale of the Licensor's color analysis services.(2)
C. The Licensor's Controls and Assistance Appear To Be Significant
The Commission has long recognized that the distinction between a trademark license and a package franchise is not always easy to draw. In the Statement of Basis and Purpose, the Commission described the primary differences as follows:
The primary difference between simple trademark licensing and package franchising is in the type and degree of control exercised by the franchisor and licensor. The trademark licensor is interested in the quality of the final goods produced by the licensees, not in the licensee's method of operation. The kind of control he exercises is thus likely to be limited to "passive" control such as inspection of produced goods and testing to insure that quality standards are being met. Package franchising, on the other hand, involves active control over the franchisee's "method of operation": The location of the business, the hours of operation, the management of the business, and other business matters.
43 Fed. Reg. at 59710.
In your letter, you contend that the controls exercised by the Licensor are limited to protecting its trademark rights. Indeed, you contend that the "controls simply protect the [trademark] from diminution in value by maintaining standards of quality." We disagree.
There is no question that some of the controls outlined in your letter are designed to protect the Licensor's mark. For example, restrictions on the use of the Licensor's cosmetic analysis system, signage, and packaging are clearly designed to protect quality control and are not deemed significant. However, the Licensor goes beyond "passive" quality controls to more aggressive restrictions, including restricting the Licensee from using competitors' products and imposing an affirmative duty on the part of the Licensee to obtain pre-approval from the Licensor concerning provisions of the Licensee's agreement with its franchisees dealing with the cosmetic analysis system. These restrictions are more akin to controls over the Licensee's method of operation and, under the circumstances, appear to be significant. Further, the Commission has long recognized training as a form of significant assistance. See Final Interpretive Guides, 44 Fed. Reg. at 49967.
For the reasons stated above, we conclude that the relationship between your client, the Licensor, and the Licensee's franchisees who will use the color analysis system apparently does not constitute a franchise. However, the relationship between the Licensor and the Licensee does appear to be a franchise relationship. There is no question that the Licensor will control the Licensee's use of the color analysis system, as well as assist the Licensee by providing training. The question is whether such controls and assistance are "significant." We conclude that they are. There is no suggestion that the Licensee is experienced in color analysis. Indeed, it would appear that the Licensee is pursuing the license arrangement precisely because it is relying on your client's expertise in that specialized field. Finally, the Licensor's controls and assistance pertain to the method of operating its color analysis system, which is the relevant business under consideration.
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.
Franchise Rule Staff
Date: July 30, 1997
1. This list of possible co-branding arrangements is illustrative only. We do not mean to suggest that these are the exclusive forms of co-branding arrangements.
2. In numerous advisory opinions we have discussed the fractional franchise exemption in detail. See e.g., Advisory 97-1, Bus. Franchise Guide (CCH) ¶ 6481 (1997); Advisory 96-2, Bus. Franchise Guide (CCH) ¶ 6477 (May 20, 1996). We have no basis to determine whether the your client qualifies for the exemption in this instance.