Pitfall: The Unwanted Franchise Agreement?

Dear Clients,

Many German-speaking companies use authorized dealers (known as distributors) to sell their goods locally in the USA. In addition to the typical, well-known franchises such as McDonalds, however, manufacturers in the USA can also very easily find themselves in an unintended and unwanted franchise relationship with authorized dealers. However, neither the intention of the contracting parties nor the specific name of the contract is of any relevance for the establishment of a franchise in the USA.

The legal consequences of an unwanted franchise can, at worst, be fatal to the contractual relationship.

A frequent legal consequence of an unwanted franchise is that the supposed dealer agreement can suddenly only be terminated “for material cause”. In addition, the termination of a franchise may be subject to mandatory notice periods and the possibility of curing the breach of contract. The terms of the franchise may also require the manufacturer to buy back the inventory in the event of termination. Furthermore, the manufacturer may be threatened with administrative investigations, fees and/or high penalties by state franchise supervisory authorities.

Franchise law in the USA is governed by federal law as well as the applicable state law. The nexus to the respective U.S. state is one of the factors to consider here. This nexus may depend on whether the franchise business is carried on in a particular state, or whether the franchisee has been registered with their company in the respective state. The sale of goods by the franchisee in other states may also establish a franchise nexus. Some states impose chargeable reporting and/or registration requirements on a franchise. Under federal law, a franchisor must also provide a franchisee with what is known as a Franchise Disclosure Document (FDD) in good time before the contract is agreed. The comprehensive FDD consists of 23 categories, which are intended to provide the franchisee with a detailed insight into the (financial) risks of the franchise.

Depending on the respective state law, a franchise in the USA requires three elements:

1. Substantial association with the franchisor’s brand/brands;

2. The franchisee’s right to sell the goods in accordance with an established marketing plan/system which is largely determined by the franchisor and thus determines the franchisee’s business operations; and

3. Direct or indirect payment of a franchise fee.

However, every dealer agreement typically presupposes that the dealer also has the limited right to use the manufacturer’s trademarks when selling the goods. The term “franchise fee” is interpreted very broadly in case law. In case of doubt, therefore, the requirement of a franchise fee is quickly fulfilled by any type of contractual payment. The term “marketing plan” is also interpreted broadly in case law, and depends on the merits of the individual case. Any type of significant control by a manufacturer over an authorized distributor’s operations in the USA (e.g., packaging appearance requirements, specifications regarding marketing in the USA, store hours, etc.) can potentially lead to the unintended establishment of a marketing plan. If a contract also provides for operational assistance by the manufacturer (e.g. training and instruction for the dealer’s employees or specifications regarding the goods themselves), the contractually regulated operational assistance can also quickly lead to the unintended establishment of a marketing plan.

Consequently, even after years of contractual relationship, pure dealer agreements in the USA can often be interpreted as a “franchise agreement”, to the unpleasant surprise of the manufacturer. Particularly in the case of “unjustified” termination, a dealer can suddenly argue that the manufacturer failed to comply with the franchise regulations, making it extremely difficult to terminate the contract.

If you have any questions on this topic or would like us to review your dealer agreement, please contact us: