Accidental Franchise If You Do - Naked License If You Don't

Setting the Optimal Level of Quality Control in Trademark Licenses to Protect Trademark Rights While Avoiding the Grasp of Franchise Regulations

by Jon K. Perala, Attorney & Counselor at Law
Copyright 2007-2008 Jon K. Perala

I. Introduction

A licensor of a registered trademark or service mark is required under the federal Lanham Act to control the quality and uniformity of goods and services associated with the licensed mark. Because the purpose of a trademark is to identify goods to consumers by both their origin and their quality, the trademark owner, through proper quality control, must ensure that his mark will not be used by a licensee in "such a manner as to deceive the public." If the trademark owner fails to exercise sufficient control, he may be deemed to have "abandoned" his mark and lose trademark protection. The level of control that is "sufficient" varies widely with the type of product or service and the relationship between the parties involved. A license without sufficient quality controls is termed a "naked" license.

In avoiding a "naked" license by exercising sufficient control over his license, a licensor may fall into another trap: that of having his trademark license being construed as a franchise agreement. If so construed, the ensuing applicable franchise laws may impose significant registration and/or disclosure requirements on the licensor as a "franchisor" or regulate aspects of the "franchise" relationship such as termination and non-renewal. Although there is wide variation among the jurisdictions that regulate franchises, creation of a franchise generally consists of three statutory elements:

1) use of the franchisor's trademark, service mark, or name in association with franchisee's business,
2) payment of a franchise fee, and
3) a significant level of control exerted by the franchisor over the franchisee.

Since most trademark licenses will include some type of payment for use of the licensor's mark which can qualify as a franchise fee, what often differentiates a trademark license from a franchise agreement is the amount of control exerted by the licensor over the licensee. If he imposes enough control to avoid a "naked" license, the unwary licensor may find himself party to a so-called "accidental" franchise. If he attempts to avoid the grasp of the franchise laws by minimizing or eliminating quality controls altogether, a "naked" license may result.

Two situations where the "naked" license and "accidental" franchise problems arise are in defenses to trademark infringement actions. In the first situation, where the alleged infringer is a licensee who continues to use the trademark after termination of the license, the licensee may counterclaim that a franchise was created due to sufficient quality controls imposed on the licensee by the licensor and that the termination itself was in violation of the applicable franchise relationship law. In the second situation, an alleged trademark infringer may challenge infringement by claiming that the licensor failed to impose sufficient quality controls on the licensee resulting in an "abandonment" of the mark and loss of rights to enforce the trademark. The ideal position for the licensor, therefore, is to set quality controls which are sufficient to retain his rights to enforce the trademark yet do not bring the license under the franchise laws.

The purpose of this paper is to set out where the limits of these two types of control lie. The paper's further purpose is to determine at what point, if any, the minimum level of quality control required under the Lanham Act will at the same time be a sufficient amount of control to satisfy the third statutory element of a franchise. In other words, when will mere adherence to the Lanham Act create a concurrent "accidental" franchise? In doing so, first, the purposes and requirements of the Lanham Act will be set out. Second, the statutory elements of franchises under the Federal Trade Commission and various states will be explained, together with what registration, disclosure, or relationship regulations apply. Exemptions under the FTC rule and state franchise laws available to trademark licensees will also be explored. Third, controls which have been deemed adequate to defeat a "naked" license will be compared to similar controls which have been deemed to evidence a franchise relationship. Finally, advice on how to avoid both "naked" licenses and "accidental" franchises will be offered.

II. The "Naked" Licensing Restriction of the Lanham Act

The owner of a trademark has the right to license others to use his mark. Concurrently, the owner has a duty to exercise control over and supervise the licensee's use of the mark. Both the right and the duty are found in the Lanham Act. The Act provides for cancellation of a trademark that has been "abandoned". Abandonment is defined as including any "act or omission" by the owner which results in the trademark losing its "significance as an indication of origin." The origin of goods and services conveys to the consumer indications of the products' quality and it "this information …not their sellers' reputations, that trademark law primarily protects."

Licensing of a trademark is permitted under § 1055 of the Lanham Act which states that use of a registered mark by a "related company" will not affect the mark's validity "provided such mark is not used in such a manner as to deceive the public" where a "related company" is anyone controlled by the trademark owner "in respect to the nature and quality of the goods or services in connection with which the mark is used." As the Second Circuit pointed out in Dawn Donut Co. v. Hart's Food Stores, "the only effective way to protect the public where a trademark is used by licensees is to place on the licensor the affirmative duty of policing in a reasonable manner the activities of his licensees."

The amount of control required by the licensor is limited to that which is necessary to prevent public deception. The failure of a licensor to exercise control does not necessarily result in deception and will not in itself be enough to warrant cancellation of a trademark. The public must also be deceived as to the quality of the product or service. In a case involving national collegiate "Greek" fraternities enforcing their trademarked logos, the alleged infringer's "naked" licensing defense was defeated when the court held that there could be no consumer deceit because the consumers of the products in question (items such as coffee mugs and t-shirts bearing Greek letters) were the trademark owners themselves, the members of the fraternities.

What type and manner of controls is sufficient? There is a split in authority on this fundamental question. Some jurisdictions hold that there must exist in the license agreement an explicit right to control. In other jurisdictions the absence of an explicit right will not create a "naked" license if the licensor can demonstrate that he has exerted actual control over the licensee. Another line of authority, such as that held by the Seventh Circuit, allows a licensor to rely on a licensee's own quality control program to ensure consistent quality when the licensee has an established track record of quality such as a long-standing business or familial relationship between licensor and licensee . Depending on the jurisdiction, a finding of sufficient controls may involve a combination of explicit terms, active policing, and reliance on licensee's quality control procedures. However, since the scope of this paper is only concerned with the types of quality control that may lead to the creation of a franchise, i.e. those controls which are imposed on the licensee by the licensor, cases in which the licensor relied on licensee's self-policing will not be discussed.

III. Federal and State Franchising Laws

Franchises are regulated and defined by both federal and state laws and generally cover three areas of concern: disclosure, registration, and franchisor-franchisee relationship. Half of the states now regulate franchises in some manner. Disclosure laws require franchisors to make detailed pre-sale disclosures to prospective franchisees. Disclosure is required under the Federal Trade Commission's franchise rule (the "FTC rule") and the laws of over a dozen states. Some states also require franchise systems to be registered before they can be offered or sold. Registration is not required under the FTC rule. Relationship laws regulate various aspects of the franchisor-franchisee relationship such as the terms under which the relationship may be terminated. Franchise disclosure, registration, and relationship laws were promulgated to protect the potential franchisee. A franchisor's failure to abide by the franchise laws may result in the franchisee rescinding the agreement, being awarded injunctive relief to enjoin a wrongful termination, or recovering damages. The FTC rule applies in all fifty states and preempts state franchise law unless the state takes a more strident approach. Whether certain licenses will be deemed to be franchises under the FTC rule, a state law, or both, is dependent on the business relationship and is largely determined by the level of controls placed on the licensee.

Franchises can generally be classified into three types: product distribution franchises, manufacturing franchises, and business format or "package" franchises. In a product distribution franchise, the franchisee sells or services goods produced by the franchisor under the franchisor's trademark. The franchisee is often granted the right to identify his business with the franchisor's trademark. Usually, the franchisee will not deal in competing products. The primary purpose of a product distribution franchise is to provide the franchisor with a distribution system to market his goods. Common examples of product distribution franchises are gasoline stations and car dealerships. The "naked" licensing problem is less likely to arise in a product distribution franchise. Because the franchisor manufactures the goods himself, he is able to directly control the quality of the product at his own end.

A franchise system where the franchisor licenses others to use a trade secret or process to manufacture a product under the franchisor's trademark is a classified as a manufacturing franchise. One example of a manufacturing franchise is a soft drink bottler. Unlike a product distribution franchise, in which the franchisor produces the goods himself, a manufacturing franchise requires a larger involvement by the franchisor to police the franchisee's operations in order to maintain quality and retain his trademark rights. If the use of the licensor's trademark adds only minor value to the agreement as compared to the trade secret or process, it may be preferable to eliminate the grant of the trademark entirely, therefore avoiding the franchise laws. However, even if the right to use the trademark is not expressly granted in the license agreement, any acquiescence by the licensor in the licensee's actual use of the mark may be enough to evidence a franchise relationship.

The third type of franchise, the business format franchise, is one in which the franchisee operates his business under the franchisor's trademark according to a system established by the franchisor. The franchisor substantially controls the method of operation or offers substantial assistance to the franchisee. The franchisor may provide operating manuals or marketing plans and may dictate that the franchisee's place of business be decorated in a certain manner or that his employees wear a particular uniform. The franchisee often produces the products with ingredients or components either supplied or approved by the franchisor. Typical business format franchises are fast food restaurants and motels.

The Federal Trade Commission franchise rule defines a franchise as a "continuing commercial relationship" created by an arrangement in which:

1) a franchisee offers, sells, or distributes goods or services supplied by a franchisor where either a) such goods are identified by franchisor's trademark, service mark, trade name, advertising or other commercial symbol, or b) such goods are required to meet quality control standards prescribed by the franchisor and the franchisee operates under franchisor's trademark;

2) the franchisor exercises "significant control" or provides "significant assistance" in the franchisee's business; and

3) the franchisee is required to pay the franchisor a franchise fee, either directly or indirectly, of $500 or more within six months of the commencement of franchisee's operation.

As for what constitutes "significant control or assistance", the FTC has issued "Interpretive Guides" to address this and other issues. According to these guidelines, any one of the following may suggest "significant control": furnishing a detailed operating manual, selecting site locations, setting hours of operation, establishing production techniques, and restricting customers, among others. Other controls such as inventory control, and on-site assistance in sales or repairs will be considered "to a lesser extent" in determining whether "significant" control is present.

Most importantly to the trademark licensor, the interpretive guidelines also contain language which seems to be critical to the "naked" licensing meets "accidental" franchising problem. The guidelines state that the FTC, in determining whether "significant" control or assistance is present, will not consider "as a matter of policy…trademark controls designed solely to protect the trademark owner's legal ownership rights in the mark under state or federal trademark laws (such as display of the mark or right of inspection)." Additionally, in order for controls to be deemed "significant" they must be related to the franchisee's entire method of operation, not just one particular product or service. Therefore, if the licensee has other products or services which are not offered or sold under the licensor's trademark, and the licensor keeps his quality controls to the minimum amount required to protect the validity of his mark, making sure that they do not carry over into other areas of the licensee's operation, the licensor can avoid inadvertently creating a franchise relationship under the FTC rule. Yet, knowing exactly how much control is the minimum amount may still be difficult for the trademark licensor to estimate.

If a trademark licensor imposes controls on his licensee which the FTC deems are not designed solely to protect the licensor's ownership rights and which appear to overstep the minimum amount required, the licensor still has two additional avenues of escape: the "single license" exception and the "fractional franchise" exception. The single license exception is found in the FTC rule and reads that a franchise will not be created solely by "an agreement between a licensor and a single licensee to license a trademark, trade name, service mark, advertising or other commercial symbol where such license is the only one of its general nature and type to be granted by the licensor with respect to that trademark, trade name, service mark, advertising, or other commercial symbol."

The fractional franchise exception applies to relationships where the potential franchisee has continued in the same type of business as the potential franchise for more than two years prior to the arrangement, and the prospective sales of the licensed product will account for no more than 20% of the licensee's sales. A similar exception exists in many of the state franchise laws.

B. Franchise Definition Under State Franchise Laws
Of the states that regulate the offer and sale of franchises through registration and disclosure laws, almost all define franchises in somewhat similar terms to the FTC rule. Like the FTC rule, all require that goods or services be offered or sold under the franchisor's trademark or service mark, and, most provide that some payment which can qualify as a franchisee fee be paid to the franchisor. If all three statutory elements are present, a franchise relationship exists regardless of the intentions of the parties. The parties can not avoid a franchise by calling their agreement by another name or by including language in the agreement which disclaims the existence of a franchise. The main difference between the state franchise laws and the FTC law is the manner in which the states define the amount of control or assistance provided by the franchisor.

State franchise laws generally define the control element as either a "marketing plan" or a "community of interest". The majority of states with franchise specific laws follow the "marketing plan" definition. These states currently include California, Illinois, Indiana, Iowa, Maryland, Michigan, New York, North Dakota, Oregon, Rhode Island, Virginia, Washington, and Wisconsin. The number of states that follow the "community of interest" definition continues to grow and presently includes Hawaii, Minnesota, Mississippi, Missouri, Nebraska, New Jersey, and South Dakota. Other states have franchise laws that contain characteristics of both definitions and a few states, such as Florida regulate franchises in their own unique manner.

1. Marketing Plan or System
Under the typical "marketing plan" definition of franchise, the franchisee is granted the right to sell or distribute goods "under a marketing plan or system prescribed or suggested in substantial part by a franchisor." Generally, the "marketing plan" states define franchises in substantially similar language. However, substantial differences do occur in how the various states define "marketing plan", both statutorily and in case law. The franchise acts of Indiana, Michigan, North Dakota, and Virginia do not define "marketing plan".

What will qualify as a "marketing plan or system"? In order for a trademark license to create an "accidental" franchise, the licensor's quality controls must fit into the particular state's definition of "marketing plan". The Illinois Franchise Disclosure Act defines a "marketing plan or system" as relating to some aspect of conducting business including, but not limited to 1) specification of prices, 2) use of merchandising devices or particular sales or display equipment, 3) use of specific sales techniques, and 4) use of advertising or promotional materials.

At first glance, it is difficult to see how the type of quality controls imposed on a licensee by a trademark licensee would follow under this definition of "marketing plan" unless the quality controls carry over into the advertisement of the licensed product. However, because of the language "not limited to" the courts are able to find a broader range of controls sufficient to qualify as marketing plans. The United States District Court for the Southern District of Illinois, in applying the Illinois Franchise Disclosure Act, held that a franchise relationship existed between a national furniture manufacturer and a dealer, because the license agreement required the licensee to abide by the licensor's quality control standards which were reflected in its operation manual. The court found this sufficient to satisfy the marketing plan element. Another U.S. District Court held a trademark license to be a franchise relationship under the Illinois act, finding the existence of a marketing plan in the trademark licensor's offer to provide the licensee access to management personnel and operational help.

Other states' definitions of "marketing plan" are explicitly broader. Washington's Franchise Investment Protection Act defines "marketing plan" as a "plan or system concerning an aspect of conducting business". It then includes examples of such plans which are substantially similar to the Illinois act, but adds to those the following: "training regarding the promotion, operation, or management of the business", and "operational, managerial, technical, or financial guidelines or assistance". Iowa's Franchise Act defines "marketing plan" as a plan or system concerning a "material aspect of conducting business" and offers examples which are identical to those in the Washington act. A trademark licensor's quality control plan which requires the licensor to train licensee's employees could quite readily fall under these definitions of marketing plan.

2. Community of Interest
Under the "community of interest" definition of franchise, a franchise is an arrangement in which a franchisor grants to a franchisee a license to use a trademark and in which there is a "community of interest in the marketing of goods or services". A community of interest exists when the agreement of the parties requires the franchisee to make substantial franchise-specific investments to further the licensed business. Franchise-specific investments are those which have little or no use outside of the franchise.

A trademark licensor may be more susceptible to an "accidental" franchise under the community of interest system of franchise laws. Any substantial quality control measure imposed on the licensee to avoid a "naked" license which the licensee is unable to utilize in other parts of his business may be deemed a franchise-specific investment. Further, the Third Circuit Court of Appeals has held that a franchise-specific investment need not be money but could also be a licensee's time spent obtaining specialized skills or knowledge valuable to market the licensed product. Therefore a quality control measure that requires a licensee to undergo training specific to the licensed product may create a franchise-specific investment even if the licensor pays all costs of the training - the licensee's time is the investment.

If the key to control under this definition of "community of interest" is that the control be franchise-specific, can a licensee attempt to avoid a franchise relationship by imposing a greater amount of control than necessary? If the scope of the control, such as training of licensee's personnel, is enlarged to carry into areas of the licensee's business other than the licensed product, the investment will lose its "franchise-specific" character. However, there are other risks in imposing more control than is necessary to protect a trademark. In avoiding the "community of interest" type state franchise law, the licensor may lose one of his safe harbors under the FTC rule: the exemption for trademark controls designed solely to protect the trademark owner's legal ownership rights.

3. State Exemptions Applicable to Trademark Licenses
A variety of exemptions may be available to avoid the "accidental" franchise. The Arkansas Franchise Practices Act contains an exemption for "any business relationship subject to the FTC regulation". Other states have fractional franchise exemptions similar to that of the FTC rule. Generally, to be eligible for the fractional franchise exemption, the licensee must have continuously been in business for a period of time (usually two years) and the new licensed product must be similar to the licensee's existing business. The fractional franchise exemption under California's Franchise Investment Law adds that the licensee not be "controlled" by the franchisor. Both the Indiana and Illinois fractional franchise exemptions require that the anticipated total sales of the newly licensed product amount to no more than 20% of the total business sales.

IV. "Naked" License or "Accidental" Franchise? - The Problem in Selecting the Appropriate Amount of Control

It can be very difficult for licensors to properly determine the correct level of controls to impose on a licensee. By selecting an inappropriate amount of control, a licensor who enters into a licensing agreement may either find that he has become party to an unwanted franchise relationship or find that he has lost his trademark registration due to a "naked" license. Where do the courts draw the line between the two? And will merely avoiding a "naked" license automatically create a franchise? A definitive answer may not be available. Because the "naked" licensing and "accidental" franchising problems almost always arise through private litigation, the nature of the parties to such litigation will usually preclude the two issues from arising simultaneously before the same court in the same case.

First, it would be highly unlikely and unusual for a licensee-plaintiff, whether as a cause of action or as an affirmative defense, to plead that both a franchise relationship has been established AND a trademark owner has issued a "naked" license. The grant of a license to use a trademark is a necessary element of all franchise relationships. If a licensee succeeds in getting a court to cancel a licensor's trademark through a "naked" license, the licensee has also lost the ability to prove one of the necessary statutory elements of a franchise. Second, although it is preferable for a licensor to do what he can to avoid a franchise relationship, it is equally unlikely that a defendant-licensor would go so far as to ask the court to find a "naked" license in order to defeat a licensee's claim that such a franchise relationship has been created. After all, under the Lanham Act, the owner of a trademark is permitted to simply surrender his mark to the Trademark Office for cancellation.

The available appellate decisions which have decided the "naked" license and "accidental" franchise issues by analyzing a licensor's quality control measures are summarized in the following two tables. Table 1 lists cases by jurisdiction where courts have ruled that licensor's quality control measures were sufficient to defeat a "naked" licensing claim. Cases are limited to those in which the licensor imposed controls on the licensee; cases in which the licensor relied on self-policing by the licensee have been excluded. Table 2 lists cases in which a franchise relationship was found to exist due to the quality controls imposed on a licensee. Many of the cases from both tables have been discussed previously in this paper. By comparing the types of controls listed, counsel for the prospective licensor can get a better picture of how to choose appropriate controls.

One thing is apparent: the greater the amount of quality control necessary to maintain quality, the greater the danger of creating a franchise situation. The key to the problem of selecting the appropriate level of controls, therefore, would appear to lie in the relationship between the licensed trademark and the licensed product. Remember, the duty of the trademark licensor is to avoid consumer deception. Consumers are only deceived when the licensed product is of a different quality than the trademark demands. If the trademark demands low or medium quality, less quality control may be required of the licensee. If the trademark demands a higher quality, higher controls may be necessary. However, complex technical aspects of manufacturing a product may necessitate a higher degree of control, even if the trademark itself does not demand that a high level of quality be maintained.

V. How to Avoid Both "Naked" Licenses And "Accidental" Franchises

The licensor has several options to avoid an "accidental" franchise while protecting his trademark against cancellation through a "naked" licensing claim:
1) Do no more than necessary to maintain quality. Remember, the key is "deception". The licensor needs only to impose enough control to avoid consumer deception. And, the licensor must be careful that the control not carry over into other areas of the licensee's operation. The FTC will not impose a franchise relationship on the basis of controls whose sole purpose is to maintain the licensor's trademark rights. Direct regular inspection by licensor may be the best method of achieving this goal. The licensor must show active control.
2) Know the exemptions. A licensor should absolutely be aware and take advantage of any applicable exemptions under the statutes such as the single license and fractional franchise exemptions. He should structure his license agreements carefully, doing nothing to jeopardize coverage under these exemptions.
3) Avoid the franchise fee. If significant amounts of quality control are absolutely necessary to maintain a trademark registration, a licensor, if possible, should avoid paying anything that can be construed as a "franchise" fee. In order to avoid coverage under the FTC rule, defer any royalty payments until at least six months have passed.
4) Avoid litigation. A licensor can also preempt a future franchise claim by knowing and unilaterally abiding by his jurisdiction's franchise relationship law, such as only terminating a licensee according to such law. Relationship laws often require good cause for termination, trumping any express termination clause in the license agreement. This is often a terminated licensee's motive for claiming that a franchise relationship exists. If it looks like the licensor may be faced with the choice of being forced into a franchise relationship or risk losing his trademark, he should prepare and make all disclosures under the appropriate franchise laws. Again, this preemptive action takes away any motive for the licensee to litigate.
5) Finally, as always, keep up with developments in both trademark and franchising laws as they continue to evolve. Both licensing and franchising continue to grow and the courts are sure to provide more clarity over time.

Copyright 2007-2008 Jon K. Perala

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