Franchise Law Applies to Internet

New Jersey Law Journal September 20, 2004 Copyright 2004 ALM Properties, Inc. All Rights Reserved.

HEADLINE: Franchise Law Applies to Internet; An Internet franchise - created deliberately or inadvertently - has the same legal consequences as a traditional franchise

BYLINE: By Jonathan Bick ; Bick is of counsel to WolfBlock Brach Eichler of Roseland and is an adjunct professor of Internet law at Pace Law School and Rutgers Law School. He is also the author of 101 Things You Need To Know About Internet Law [Random House 2000].

Traditional franchising is an established business technique that brings together the owner of a branded product with another. A franchisor provides a trademark or trade name and a business arrangement; a franchisee pays a royalty and often an initial fee for the right to do business under the franchisor's name and system. The contract binding the two parties is the franchise.

After the downturn in the Internet advertising market, Internet merchants developed the pay-for-performance e-commerce sector. Internet merchants paid a commission to affiliates who directed people to their Web sites. More sophisticated affiliate programs were set up as revenue sharing arrangements. The terms and conditions for these programs began to mimic franchise agreements.

As an affiliate for an online casino, some franchise agreements allow the franchisee to earn 33 percent to 50 percent of the amount of money Internet gamblers lose to the online casino. As an affiliate for a home mortgage seller, some franchise agreements pay the affiliate $30 to $90 per referral. But with reward comes risk. Franchisees become liable for the performance of the services which they promote

Franchise Defined

Existing franchise statutes and regulations apply to the Internet. Court decisions clearly state: suppliers that sell goods and services through the Internet with the assistance of independent distributors, dealers, or sales agents may be franchisors within the meaning of federal or state law.

In Instructional Sys., Inc. v. Computer Curriculum Corp., 130 N.J. 324 [1992], the New Jersey Supreme Court held the defendant, a California company marketing instructional computer hardware and software, violated New Jersey franchise law by having one of its independent distributors contract for an exclusive territory, including New Jersey.

The federal courts later held that extraterritorial application of the New Jersey Franchise Practices Act was unconstitutional under the Commerce Clause. However, the New Jersey Supreme Court's expansive definition of what constitutes a franchise was unaffected by the federal courts' decisions. See Lithuanian Commerce Corp. v. Sara Lee Hosiery, 179 F.R.D. 450 [D.N.J. 1998] and Atlantic City Coin & Slot Serv. Co. v. IGT, 14 F.Supp.2d 644 [D.N.J. 1998].

In Computer Curriculum and subsequent cases, the defendants' contracts were held subject to the New Jersey Franchise Practices Act regardless of choice of law provisions specifying that the law of the supplier's home state controlled. See Kubis & Perszyk Assocs., Inc. v. Sun Microsystems, Inc., 146 N.J. 176, 680 A.2d 618 [1996].

Three elements typically indicate the existence of a traditional or Internet franchise. The first element is a license to use, or some form of association with, the franchisor's trademark. This element is likely to exist in virtually every contract for the distribution of goods or services under the supplier's trademark.

Most courts have found the mere possibility that a distributor could use the manufacturer's trademark suffices to establish a trademark license. A distribution right for the sale of trademarked products also normally results in the establishment of the first element.

The second element is some form of franchisor assistance with, or control over, the franchisee's business. Generally, state statutes and cases have found that a "significant" assistance or control must be found in order to satisfy this second element. Usually, this element is satisfied when goods or services are sold pursuant to a "marketing plan" prescribed by the franchisor, or when the franchisor and franchisee share a "community of interest" in the franchisee's business.

With respect to an Internet related franchise, any one of the following conditions suffices to establish "significant assistance" or control: restricting sales fulfillment to a particular geographical area, such as the United States or New Jersey; furnishing Web site management or marketing advice concerning content or procedures; providing formal training programs; furnishing a detailed Web site operations manual; Web site visitation promoting campaigns requiring participation or financial contribution; mandating Web site policies and practices; and establishing and/or requiring accounting practices.

The third element is some form of payment for the right to operate the franchised business, also referred to as a "franchise fee." This element is not necessary, particularly in the case of distributorships and dealerships.

In Computer Curriculum, the presence or absence of a franchise fee was irrelevant because it was not part of the New Jersey statutory definition. In most states that regulate franchising, however, there can be no franchise relationship without the payment of a "franchise fee." Typically, the "franchise fee" element is defined by statute as any payment above a de minimis threshold [usually $500] required for the right to enter into the franchised business, excluding purchases of goods at bona fide wholesale prices and the purchase or lease of real property.

Under the FTC Franchise Disclosure Rule, [see 16 C.F.R. §[ 436 [1986]] any one of the following required payments may constitute a franchise fee; rental payments; payments for advertising assistance or promotional materials; required purchases of inventory or supplies from the manufacturer or a third party supplier; or payments for training.

Legal Consequences

The existence of franchise relationships has legal consequences. Among the most important of these legal consequences is a disclosure requirement. It is illegal under federal law and the law of many states to "offer a franchise" without having made certain required disclosures in a certain prescribed format.

Another important legal consequence is the termination restrictions. No matter what the distributorship or sales agency agreement might say, including that the agreement is not a franchise, various state franchise laws may restrict the supplier's right to terminate the relationship. Some state franchise laws may even require automatic renewal of the franchise agreement.

The existence of franchise relationships has federal and state legal consequences. In accord with Federal Trade Commission Franchise Disclosure Rule, if a distribution or sales agency relationship is a franchise, the supplier must abide by regulations promulgated by the FTC before the "first personal meeting" to discuss the contract.

Additionally, the FTC Franchise Disclosure Rule requires anyone who offers a franchise to make detailed disclosure of a wide variety of information by means of an "offering circular," the form of which is prescribed by regulation. Anyone who offers a franchise in violation of the FTC Franchise Disclosure Rule is subject to a civil penalty. It should be noted that the federal courts have not allowed a private right of action for violations; however, some states have afforded a private right of action for conduct that violates the FTC Act or is otherwise "unfair" or "deceptive."

Many Web sites merely provide general information about the supplier, its goods and services, and its distribution system. Such a Web site, especially if it is passive, rather than interactive, arguably is analogous to a print advertisement. Most franchisors take the position that as long as they do not respond to inquiries from prospective franchisees in states where the franchisor has not satisfied all regulatory requirements, there has been no offer.

The Internet offers a franchisor an opportunity to do much more than can be accomplished in traditional advertising. Many franchisors use their Internet sites to respond to general inquiries about the franchise system; others post franchise disclosure documents and allow prospective franchisees to download copies. The Internet also affords the franchisor the capability to negotiate and make changes to a standard-form franchise agreement. Franchisees can also make payments electronically.

Through the use of the Internet, the potential for inadvertent franchise law violations is not limited to the formation of relationships for the distribution of goods and services. The Internet gives suppliers the opportunity to market from "virtual stores" to customers located almost anywhere. In the process, suppliers can bypass their pre-existing networks of distributors and dealers. Such action gives rise to potential claims of violations of franchise "relationship laws."

Internet suppliers who do not want to carry the legal baggage associated with being a franchisor may try restructuring their relationships with independent distributors to minimize the risk that their contracts satisfy one or more of the various definitional elements of a franchise.

It should be noted that due to the number of common contractual provisions used by Internet affiliates and related organizations, the increase and the risk of being deemed a franchise may be unavoidable. Under the Federal Trademark Statute, the Lantham Act, the trademark owner has the right and the affirmative duty to control the quality and uniformity of goods and services furnished under its trademark. Failure to exercise such control may even constitute an abandonment of trademark rights.

Internet suppliers can ensure that end-users receive proper service and support, only by imposing various requirements on independent distributors, and only by providing assistance, such as training or promotional materials. Contractual provisions intended to protect trademarks and goodwill, and to ensure customer satisfaction may, therefore, have unintended consequences of imitating a franchise.