Wisconsin Lawyer: Avoiding the Accidental Franchise:

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    Avoiding the Accidental Franchise

    Whenever drafting licensing and dealer arrangements, cautious practitioners should consider whether the Wisconsin Franchise Investment and Fair Dealership laws apply. Both laws offer a potential trap for the unwary - the creation of an accidental franchise, with resulting severe penalties and restrictions.

    Charles ModellJoseph Fittante Jr.

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    Wisconsin Lawyer
    Vol. 76, No. 5, May 2003

    Avoiding the Accidental Franchise


    Whenever drafting licensing and dealer arrangements, cautious practitioners should consider whether the Wisconsin Franchise Investment and Fair Dealership laws apply. Both laws offer a potential trap for the unwary - the creation of an accidental franchise, with resulting severe penalties and restrictions.

    man in a giant suitcase by Charles S. Modell & Joseph J. Fittante Jr.

    "M"any persons who distribute goods and services do so through distributors, dealers, and licensees. Typically, the grantor will provide marketing materials or product training to a licensee who, in turn, pays a fee to the grantor. If you have ever drafted such an agreement for a client and not taken into account the Wisconsin Franchise Investment Law (WFIL) and the Wisconsin Fair Dealership Law (WFDL), you may be subjecting yourself and your client to significant business and legal risks, because the WFIL provides severe penalties for the unregistered sale of relationships falling within the purview of the law, and the WFDL severely limits the grantor's ability to terminate or not renew the relationship.

    This article is not intended as a complete primer on the WFIL or the WFDL. Rather, this article alerts counsel to the laws that must be considered whenever a client grants others the right to distribute the client's goods or services or to use its trademark. Unfortunately, the terminology used to describe a relationship,

    such as "license," "distributorship," "joint venture," or even "partnership," will not keep the relationship from being regulated under these laws. Moreover, once an agreement has been signed that is subject to the WFIL, or a termination takes effect without compliance with the WFDL, it may be impossible to "put the toothpaste back into the tube." Under those circumstances, the client may hold the attorney responsible for failing to provide the proper advice.

    Wisconsin Franchise Investment Law

    Under the WFIL,1 a license, a dealership agreement, or any business contract can be deemed a franchise if: 1) the grantee is given the right to offer, sell, or distribute goods or services offered by the grantor; 2) the business is associated with a trademark, service mark, or advertising; and 3) the grantee is required to pay a fee. While these elements are not present in every commercial transaction, they may be present in license arrangements that one would never consider to be franchises. For example, consider a situation in which a software developer licenses its software to a seller who will be selling (or licensing) that software to others. Such an arrangement is documented by intellectual property lawyers every day. However, in Current Technology Concepts Inc. v. Irie Enterprises Inc.,2 the Minnesota Supreme Court concluded that one such arrangement was a franchise and held the franchisor liable for damages in the amount of $1.3 million for violating the Minnesota Franchise Law.

    Although the Current Technology decision arose under Minnesota law, if this same fact pattern were presented to a Wisconsin court, the result likely would be the same under the WFIL. Any time a grantor or licensor helps someone get into a business involving the offer or sale of products or services generated by the grantor, the lawyer must consider whether a franchise is present.

    Although Wisconsin's franchise law provides that a franchise will exist only if the goods or services are to be distributed "under a marketing plan or system prescribed or suggested in substantial part by [the grantor]," it may not take much to find that this element exists.3 Under the Wisconsin Administrative Code, a marketing plan will be deemed to be "prescribed in substantial part" by the licensor if the agreement between the licensor and licensee: 1) requires the licensee to operate a business that purchases a substantial portion of its goods solely from sources the licensor designates; 2) requires the licensee to follow an operating plan or training manual the licensor issues, the violation of which may, under the terms of the arrangement, permit the licensor to terminate the agreement; 3) limits the type, quantity, quality, or sources of goods or products the licensee may purchase; 4) permits the licensor, at any time, to terminate the agreement, to repurchase the license rights, or to refuse to renew the rights; or 5) requires the licensor to assist the licensee in training, obtaining locations or facilities for the operation of the business, or marketing of the licensor's products.

    Once a marketing plan is found to exist, it will not be unusual to find that the goods are identified by the franchisor's trademark, or that the franchisor provides advertising materials for the goods or services, thus meeting the second element of the test for a franchise. Finally, few commercial transactions do not meet the third element, the payment of a franchise fee. Under Wisconsin law, such a fee will be found any time a fee or charge is paid as a condition for entering into the business, including payment for goods and services.4 Thus, whether the fees are characterized as development fees, training fees, marketing fees, license fees, royalties, or fees for the purchase of products and services, they will be considered franchise fees under the law.5

    If the lawyer and client do not identify the license arrangement in question as being a franchise subject to the WFIL, neither person will then comply with the pre-sale registration and disclosure requirements under that law.6 Under the WFIL, a person who fails to comply with the registration and disclosure requirements of Wisconsin law is liable to the purchaser for damages, rescission, and attorney fees,7 and can be fined up to $5,000 for each violation and imprisoned for not more than five years.8 Clearly, neither the attorney nor the client wants to hear "after the fact" that the arrangement was an "accidental" franchise.

    To ensure that the relationship does not fall within the confines of the WFIL, attorneys and their clients must eliminate from the business transaction one of the elements of a franchise. For example, all marketing materials, sales programs, training programs, manuals, buying requirements, and advertising could be eliminated so as to eliminate the "marketing plan" element of a franchise. In the alternative, the contract could prohibit the licensee, distributor, or dealer from using the licensor's, manufacturer's, or grantor's trademark or trade name. The transaction also could be structured so that the only fees paid to the manufacturer are for the bona fide wholesale price of goods for resale so that all payments made by the licensee, distributor, or dealer to the licensor, manufacturer, or grantor fall within one of the statutory exceptions to the payment of a franchise fee.9 If at least one of these elements is not addressed and eliminated, the transaction will fall within the regulation of the WFIL and the client will need to register the offer as a franchise and make all proper disclosures before entering into the transaction.

    Wisconsin Fair Dealership Law

    While the WFIL will regulate the initiation of many license and dealer arrangements, another trap awaits the grantor later in the relationship when the grantor seeks to exercise rights it may have under the agreement to terminate or otherwise change the arrangement. These traps are found under the WFDL,10 which purports to regulate dealerships and requires that before there can be a termination of the relationship or a change in competitive circumstances, the dealer must be in default and must have had an opportunity to cure that default as provided by the statute.

    The WFDL defines a "dealership" as any agreement between two or more persons by which a person is granted the right to sell or distribute goods or services or use a trademark and in which there is a community of interest in the business of "offering, selling or distributing goods or services at wholesale, retail, by lease, agreement or otherwise."11 Most arrangements that fall within the definition of a franchise also will be governed by the WFDL, since that law applies to arrangements whereby a person is granted the right to sell or distribute goods or services, even absent the trademark element required for a franchise. The key question to answer in determining whether the WFDL applies to the arrangement is whether there is a "community of interest" between the grantor and the grantee. The WFDL defines that term as a "continuing financial interest between the grantor and grantee in either the operation of the dealership business or the marketing of such goods and services."12 Unfortunately, the definition does little to enlighten the practitioner as to when the WFDL will apply. In fact, Wisconsin state courts may not even agree with Seventh Circuit courts as to the provision's meaning.

    The Wisconsin Supreme Court sought to clarify the concept of a "community of interest" in Ziegler Co. v. Rexnord Inc.13 Ziegler was a distributor for Rexnord's products. Rexnord lost more than $8 million over a three-year span under the relationship and decided to terminate the relationship. Although the contract between the parties did not prevent Rexnord from terminating the contract, nor was there any question that Rexnord made a valid business decision in concluding that the agreement should be terminated, Ziegler claimed the WFDL applied and the relationship could not be terminated under that law absent a breach by Ziegler.

    The Wisconsin Supreme Court held that a community of interest will exist when there is interdependence between the parties, along with a continuing financial interest in the marketing of goods and services. The court established a list of 10 nonexclusive factors (the Ziegler factors) to be analyzed, including: 1) the length of the parties' relationship; 2) the extent and nature of the parties' obligations under their agreement; 3) the percentage of time the grantee devotes to selling the grantor's products; 4) the percentage of revenue the grantee derives from the grantor's products; 5) whether a territory has been granted and, if so, whether the territory is exclusive; 6) the extent and nature of the grantee's use of the grantor's marks; 7) the extent and nature of the grantee's financial investment in the dealership; 8) the number of personnel the grantee devotes to selling the grantor's products; 9) the amount spent by the grantee on advertising the grantor's products; and 10) the type and amount of ancillary services provided by the grantee to consumers who purchased the grantor's products from the dealer.14 The court then overruled the previous court's finding that a community of interest did not exist as a matter of law and remanded for application of these factors.

    It is arguable that the Seventh Circuit does not apply the Ziegler factors in determining whether a community of interest exists under the WFDL. Instead, the Seventh Circuit emphasizes that the alleged dealer must demonstrate sizeable investments in specialized equipment or goods related to the grantor's goods or services that the grantee would not fully recover on termination and the generation of a significant amount of revenue from the relationship.15 The federal courts have even criticized the Ziegler approach, reasoning that "[t]he problem with the 'totality of the circumstances' approach involving so many factors is it becomes easy to miss the main thrust of the statute."16

    The U.S. District Court for the Eastern District of Wisconsin may have opted for a third approach to determining whether a community of interest is present in a relationship. In Super Natural Distributors Inc. v. MuscleTech Research & Development,17 the district court stated: "[t]he Seventh Circuit Court of Appeals has suggested that it may be more useful to focus one's attention on whether a) the revocation of the dealership would pose a threat to the company's economic health ..., or b) the revocation would result in a loss of considerable 'sunk costs.'"18

    In this case, Super Natural was granted a distributorship to distribute MuscleTech's dietary products. MuscleTech terminated the distributorship after learning that Super Natural had obtained approximately $1 million of allegedly counterfeit MuscleTech product from an offshore supplier. Upon termination of the relationship, Super Natural sought an injunction requiring MuscleTech to continue to supply Super Natural with product during the pendency of the lawsuit. Super Natural claimed that the relationship was a dealership under the WFDL, and that MuscleTech failed to comply with the WFDL termination provisions. The court determined that Super Natural was not likely to be able to show that termination of the distributorship would pose a threat to Super Natural's economic health, because Super Natural's sale of MuscleTech's products accounted for only 13 percent of its revenues. The court also found that Super Natural was unable to prove loss of sunk investments because its investments in items used to operate its business, including a warehouse and tradeshow booth, were not unique to this business and therefore could be sold or dedicated to another product line. The court therefore denied Super Natural's motion for a preliminary injunction.

    By employing all of the Ziegler factors to determine whether a community of interest exists, Wisconsin state courts analyze all facets of the relationship between the grantor and grantee. The federal courts may have narrowed the inquiry. However, given the difficulty the courts have had interpreting whether a "community of interest" will lie in a grantor/grantee relationship, a careful practitioner should err on the side of assuming the statute is applicable whenever consulted by a client who wants to terminate, cancel, not renew, or substantially change the competitive circumstances of a distributorship or license it has granted. The grantor would then provide the grantee with notice of its intent, and an opportunity to cure, thus protecting itself against a claim for damages and attorney fees as a result of its failure to comply with WFDL requirements.

    Conclusion

    Clients seeking to distribute goods or services to others need counsel who can advise them on the applicability of the WFIL to their transaction and the alternatives available to them to avoid application of that law. Clients also need to understand their obligations under the WFDL. The recent Super Natural case confirms that the applicability of these laws may sometimes represent a moving target. Some aspects of the franchise and dealership definitions contained within these laws are imprecise, making it difficult to render an opinion to a client that an arrangement does or does not fall within the definition of a franchise or dealership under these laws. In those instances, it may be prudent to retain special franchise counsel to analyze all the facts and determine whether compliance with these laws is necessary. Unless counsel is reasonably certain the relationship does not fall within these laws, counsel should advise the client to comply with the laws in order to avoid liability for failure to do so. Clearly, the consequences of being held subject to these laws but failing to comply with them are substantial both for the grantor and for counsel.


    Charles S. ModellCharles S. Modell, Univ. of Florida 1977, is head of the franchise practice group at Larkin, Hoffman, Daly & Lindgren Ltd., Minneapolis.

    Joseph J. FittanteJoseph J. Fittante, William Mitchell 1996, is an associate in the same group, and a native of Wisconsin.


    Endnotes

    1 Wis. Stat. § 553.01 et seq.

    2 Bus. Franchise Guide (CCH) ¶10,673 (Minn. 1995).

    3 Wis. Admin. Code § DFI-Sec 31.01(4).

    4 Wis. Stat. § 553.03(4), (5m).

    5 One significant exception is for the purchase of goods at a bona fide wholesale price. Wis. Admin. Code § DFI-Sec 31.01(1)(b)2.

    6 Although the discussion centers around the Wisconsin Franchise Investment Law, the federal franchise law, the FTC Franchise Disclosure Rule (formally titled the Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures) contains a similar definition of a franchise, and a similar disclosure scheme. 16 C.F.R. part 436 (2001).

    7 Wis. Stat. § 553.51.

    8 Wis. Stat. § 553.52.

    9 The two most common types of payments that do not constitute payment of a franchise fee are bona fide wholesale price payment for goods and payment of the bona fide retail price for goods, subject to the payment of a commission that results in the transaction constituting a bona fide wholesale transaction. See Wis. Admin. Code § DFI-Sec 31.01(1)(b).

    10 Wis. Stat. § 135.02.

    11 Wis. Stat. § 135.02 (3)

    12 Wis. Stat. § 135.02 (1).

    13 139 Wis. 2d 593, 407 N.W.2d 873 (1987).

    14 Id. at 606.

    15 Frieburg Farm Equip. v. Van Dale Inc., Bus. Franchise Guide (CCH) ¶10,109, at 23,769-70, citing Michael Bowen & Brian Butler, The Wisconsin Fair Dealership Law §3.34 at 3-[14] (Supp. 1991).

    16 Beloit Beverage Co. v. Winterbrook Corp., Bus. Franchise Guide (CCH) ¶ 10,783, at 27,355 (E.D. Wis. 1995).

    17 Bus. Franchise Guide (CCH) ¶12,039 (E.D. 2001).

    18 Bus. Franchise Guide (CCH) ¶ 12,039, at 34,041 (E.D. 2001); see also Cabintree of Wis. Inc. v. Kraftmaid Cabinetry Inc., Bus. Franchise Guide (CCH) ¶ 10,938, at 28,236 (E.D. Wis. 1996) (parties' efforts arguing over Ziegler factors were misplaced because Ziegler factors are not "elements;" the court is not required to consider each factor and consideration of every factor is not "necessarily dispositive of the issue."); Beloit Beverage Co., Bus. Franchise Guide (CCH) ¶ 10,783, at 7,355 (E.D. Wis. 1995) (Ziegler factors, although relevant, should not be applied in a way to broaden scope of statute). But see Beer Capitol Distributing Inc. v. Guinness Bass Import Co., Bus. Franchise Guide (CCH) ¶ 12,155 (E.D. Wis. 2001) (employing Ziegler factors, but focusing on percentage of alleged dealer's business attributable to grantor's products and amount of alleged dealer's sunk investments).




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