Imagine that a client presents you with a business plan to sell equipment for use in operating a vehicle deodorizing and sanitation business under a trade name. The purchaser of the equipment will have the right to use the trade name in their business and on their work vehicle; be obligated to report weekly sales numbers to your client; and charge prices recommended by your client. Without a clear understanding of franchise law, you may advise your client into an accidental franchise.¹

An accidental franchise occurs when a business relationship unknowingly and unintentionally meets the elements expressed in the Federal Trade Commission Franchise Rule² or the Michigan Franchise Investment Law (MFIL).³ The MFIL — like the laws in 14 other states that specifically regulate franchise sales — are liberally interpreted in favor of the franchisee.⁴ While important to remain cognizant of the FTC rule, this article focuses on the MFIL, which requires registration of franchises offered for sale in Michigan and regulates the relationship between franchisors and franchisees.⁵ This article will specifically address the elements of a franchise, exceptions to the MFIL requirements, and the consequences of non-compliance under the MFIL while noting where the FTC rule differs.

MICHIGAN FRANCHISE INVESTMENT LAW

The MFIL applies only to the offer, sale, and subsequent relationship arising in connection with a franchise.⁶ The MFIL defines a franchise as a contract or agreement — whether express or implied, and whether oral or written — between two or more persons to which each of three elements apply:

1. A franchisee is granted the right to engage in the business of offering, selling, or distributing goods or services under a marketing plan or system prescribed in substantial part by a franchisor;
2. A franchisee is granted the right to engage in the business of offering, selling, or distributing goods or services substantially associated with the franchisor’s trademark, services mark, trade name, logotype, advertising, or other commercial symbol designating the franchisor or its affiliate; and
3. The franchisee is required to pay, directly or indirectly, a franchise fee.⁷

An agreement failing to meet all three elements is not a franchise under Michigan law and, thus, the MFIL does not apply.⁸ Market developments subsequent to the offer or sale cannot transform a relationship into a franchise.⁹

ELEMENTS OF A FRANCHISE

Marketing plan prescribed in substantial part by franchisor

First, the MFIL requires that the relevant contract or agreement grant the alleged franchisee the “right to engage in the business of offering, selling, or distributing goods or services under a marketing plan or system prescribed in substantial part by a franchisor.”¹⁰ A marketing plan is prescribed if the agreement, nature of the business, or other circumstances “permit or require the franchisee to follow an operating plan or standard operating procedure, or their substantial equivalent, promulgated by or for the franchisor.”¹¹

To make that determination, courts examine the policy and practices surrounding the marketing plan. Courts use the following to weigh in favor of finding a prescribed marketing plan:

• advertising material and maintaining control over the material;¹²
• provisions that require the franchisee to follow an operating plan or standard operating procedure, whether the procedure requires or prohibits certain practices;¹³
• or setting prices the franchisee will charge customers for relevant services;¹⁴ and
• a franchisee or assisting in training employees, which is expressly enumerated in the Michigan Administrative Code.¹⁵

In the cases of Vaughn v. Digital Message Systems Inc. and Buist v. Digital Message Systems Inc., the supplier reserved the right to approve all promotional material and methods; provided franchisees a training/operating manual, order/price forms, and prices for products; and required franchisees to abide by rules, regulations, and policies proffered by the supplier.¹⁶ Both the U.S. District Court for the Eastern District of Michigan and the Michigan Court of Appeals found that the respective suppliers prescribed a marketing plan.¹⁷ And similar to the hypothetical scenario at the beginning of this article, the Eastern District of Michigan found a prescribed marketing plan when the franchisor required the franchisee to purchase a van wrapped with the franchisor’s trademarks, asked for the franchisee’s client list with the purpose of sending out promotional material, suggested to the franchisee what to charge customers, and required the franchisee to report weekly sales to the franchisor.¹⁸

In short, the unwary attorney who does not focus on the client’s actual business plan may not recognize that the marketing-plan element of the definition of a franchise is satisfied. The best practice is thoroughly understanding your client’s business plan before making recommendations on a transaction or organizational structure.

Trademark association

The MFIL also requires that the relevant contract or agreement grant to the alleged franchisee the “right to engage in the business of offering, selling, or distributing goods or services substantially associated with franchisor’s trademark.”¹⁹ A substantial association exists when “circumstances permit or require the franchisee to identify its business to its customers primarily under that trademark” or “otherwise use the franchisor’s mark in a manner likely to convey to the public that it is an outlet of, or represents directly or indirectly, the franchisor.”²⁰ The Michigan Administrative Code provides courts with guidelines to make this determination: whether the mark is used either by the franchisor or franchisee to increase the chances of the franchisee’s success²¹ and whether an agreement or procedure exists for the franchisee to directly or indirectly contribute part of its operating revenue to the franchisor for advertising expenses.²²

In Jerome-Duncan v. Auto-By-Tel,²³ Jerome-Duncan (JDI) entered into an agreement with Auto-By-Tel (ABT) in which JDI would use ABT’s website to promote the sale of Ford cars. JDI used the ABT logo on advertisements signifying it as an ABT-certified dealer and employed an ABT manager to help facilitate sales. The Eastern District of Michigan held there was no franchise agreement because the product being sold was Ford cars; ABT was used as a means of promoting Ford.²⁴ When looking at whether an alleged franchisee’s business is substantially associated with the franchisor’s trademark, the court reviews whether the business would survive if the trademark were to disappear.²⁵ In the hypothetical scenario at the beginning of this article, when a party authorizes another to do business under the franchisor’s trade name and wrap the franchisee’s vehicle with the franchisor’s trade name, the trademark element is clearly met.²⁶

Franchise fees

Finally, the MFIL requires a franchise fee,²⁷ which it defines as “a fee or charge that a franchisee or sub-franchisor is required to pay or agrees to pay for the right to enter into a business under a franchise agreement, including but not limited to payments for goods and services.”²⁸ The MFIL exempts transactions involving franchise fees of less than $500.²⁹ If the fee is greater than $500, there is a presumption that the franchise fee element is met.

Courts have held that a franchise fee is a transfer of wealth from the alleged franchisee to the alleged franchisor and required under the parties’ agreement for the right to engage in the alleged franchisee’s business.³⁰ The transfer of wealth may be a direct payment to the franchisor at the time the agreement is signed or an indirect payment via a required repayment of a loan if the interest rate exceeds that of market value, the purchase of wholesale products at a price more than the bona fide wholesale price, rent paid to the alleged franchisor, fees in connection with services, and other costs.³¹

Under the MFIL, a transfer of wealth to the franchisor or its affiliate must be required by the agreement to constitute a franchise fee; courts consistently reject the argument that such a fee exists when it is not required.³² For example, interest payments on a loan supplied by the franchisor is not a franchise fee if the franchisee is not required to obtain a loan from the franchisor.³³

Additionally, a payment must be made for the right to engage in business to qualify as a franchise fee.³⁴ Franchise fees are more likely when said fees are unrecoverable industry-specific expenses or generally occur at the inception of an agreement.³⁵ Ordinary business expenses are generally not considered franchise fees.³⁶

In Watkins & Son Pet Supplies v. Iams Co., the franchisee was required to maintain a level of excess inventory in operation of a pet supplies store.³⁷ The franchisee argued that the costs associated with required excess inventory qualified as a franchise fee.³⁸ The Eastern District of Michigan rejected that argument, stating that excess inventory was an ordinary business expense which would only be considered a franchise fee if the inventory was excessive and illiquid.³⁹

Although initial franchise fees clearly fall within the franchise fee definition, the Michigan Regulations and courts have developed applicable rules to specific types of alleged indirect franchise fees. The Michigan Administrative Code enumerate payments for services including “ideas, instruction, training, and other programs” as franchise fees.⁴⁰

The MFIL explicitly excludes the purchase or agreement to purchase “goods, equipment, or fixtures directly or on consignment at a bona fide wholesale price” from the franchise fee definition.⁴¹ The bona fide wholesale price refers to a price that constitutes a fair payment for goods purchased at a comparable level of distribution and no part of which constitutes a payment for the right to enter into or continue with the franchise business.⁴²

A bona fide wholesale price is determined by considering “relevant costs, marketing, pricing, or payment information, among other factors.”⁴³ For example, when a franchisee is charged an out-of-pocket markup on goods that consist of the licensor’s shipping and general overhead expenses, payment may qualify as a bona fide wholesale price unless the licensee provides evidence to the contrary.⁴⁴ Conversely, payment falls outside the bona fide wholesale price exception when a franchisee is required to pay an amount exceeding the fair market value.⁴⁵ Interest rates on a franchisor-provided loan may be considered a franchise fee when the rate exceeds the fair market rate.⁴⁶

EXEMPTIONS

Certain situations are exempt from the required disclosures under the MFIL, even when the relationship meets the elements of a franchise.⁴⁷ Among the possible exemptions listed in MFIL Section 6:

(a) The transaction is by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator;

(b) The offer or sale is to a bank, savings institution, trust company, investment company, or other financial institution, association, or institutional buyer or to a broker-dealer where the purchaser is acting for itself or in some fiduciary capacity;

(c) The prospective franchisee is required to pay, directly or indirectly, a franchise fee which does not exceed the $500 threshold to constitute a franchise fee;

(d) The offer or sale is to a franchisee or prospective franchisee who is not domiciled in Michigan and the franchise business will not be operated in Michigan;

(e) There is an extension or renewal of an existing franchise or the exchange or substitution of a modified or amended franchise agreement with no interruption operation, and no material change in the relationship;

(i) The offer or sale of a franchise by a franchisee for the franchisee’s own account if (1) the sale is isolated and not part of a plan of distribution of franchisees; (2) the franchisee provides the prospective purchaser full access to the records and books related to the franchise;

(ii) The offer or sale of a franchise to an existing franchisee if (1) the existing franchisee has actively operated the franchise for the last 18 months; and (2) the franchisee purchases for investment and not the purpose of resale.

(f) The transaction is a fractional franchise where:

(i) The prospective franchisee is presently engaged in an established business of which the franchise will become a component;

(ii) An individual directly responsible for the operation of the franchise, or a person involved in the management of the prospective franchise for at least two years;

(iii) The parties have reasonable grounds to believe, at the time of sale, that the franchisee’s gross sales in dollar volume from the franchise will not represent more than 20% of the franchisee’s gross sales in dollar volume from the franchisee’s combined business operations.

ACCIDENTAL FRANCHISE CONSEQUENCES FOR FRANCHISOR

Section 31 of the MFIL provides a limited private right of action specifically to purchasers of franchises against sellers when the seller violates MFIL sections 5 (fraud), 7(a) (registration requirements), and 8 (disclosure requirements.)⁴⁸ The Michigan Legislature carefully restricts liability to the sale or offer of sale, thus excluding remedies for renewals or extensions of franchise agreements,⁴⁹ and Michigan courts clarify that Section 31 explicitly provides an action only for the purchaser of a franchise against the seller in connection with the sale.⁵⁰

In Franchise Management Unlimited v. America’s Favorite Chicken, a franchisee sued the franchisor for violating the MFIL after the franchisor conditioned consenting to the transfer of one of the franchisee’s stores on the franchisee releasing the franchisor from all future and pending MFIL claims.⁵¹ The Michigan Court of Appeals held that the legislature clearly intended to restrict liability to conduct at the time of sale as evidenced by its specific exclusion of renewals or extensions of a franchise agreement from the definitions of the terms “offer” and “offer to sell.”⁵² Since the franchisor’s alleged breach was not connected with its sale of the franchise to the franchisee, the MFIL did not provide a private right of action for the franchisee to bring a claim.⁵³

The Eastern District of Michigan reaffirmed the Court of Appeals’ limited interpretation of Section 31 in Walker v. Brooke Corp.⁵⁴ In Walker, a franchisee sued the franchisor and an affiliate for fraud under Section 5 of the MFIL.⁵⁵ The court held that the franchisee could not bring suit against the franchisor affiliate because the affiliate was not a party to any contract or agreement selling a franchise or interest in a franchise and did not dispose of a franchise or interest in a franchise for value.⁵⁶ Instead, the affiliate’s sole purpose was providing the funds necessary to complete the acquisition.⁵⁷

Franchisors violating the MFIL may be assessed damages that may include actual damages,⁵⁸ recission of the agreement,⁵⁹ fines,⁶⁰ and imprisonment.⁶¹ Further, the state is not precluded from pursuing charges under any additional statutes the violation falls under. With the severity and range of penalties for operating an accidental franchise, scrutinizing business agreements alongside the MFIL is imperative.

CONCLUSION

The easiest way to avoid an accidental franchise is clearly understanding the business plan of the prospective client and, if necessary, ensuring compliance with the MFIL. It is critical for attorneys and businesses to understand the elements of a franchise to avoid the pitfalls and consequences of forming an accidental franchise.