Licensing is big business. Brands of perfumes, clothing, footwear, foods and many other items are commonly licensed. Brand owners license parts of their product lines or create brand extensions through licensing. But few brand owners know that the New York Franchise Act ("NYFA") regulates licensors who provide no marketing assistance and impose no requirements other than quality control.
The definition of a "franchise" under the NYFA is extremely broad. It covers far more business arrangements than anyone would reasonably consider to be a franchise. This anomaly puts New York franchise law in "left field" as Rupert Barkoff noted in his excellent article published in the New York Law Journal on May 1, 2012. This is an understatement. The NYFA is not even in the same ballpark as similar legislation in other jurisdictions. Barkoff called this anomalous definition of a franchise under the NYFA "terrifying."
Failure to comply with the NYFA can result in enforcement action by the New York State Attorney General's Office and private actions by franchisees for rescission, damages, injunctive or declaratory relief, attorneys' fees, and costs. Willful violation of the NYFA can lead to punitive damages and criminal liability.
Not only is a simple trademark license agreement a franchise in New York. Market consulting agreements can also be franchises. There is also a large "gray" area in which it is not clear whether the arrangement is a franchise.
In short, the NYFA is a trap for the unwary. Most people would not think of consulting with a franchise lawyer before entering into a trademark license agreement or a marketing agreement. Yet failure to comply with the NYFA can give rise to litigation between contract parties or prosecution by the Attorney General's office.
The broad definition of a franchise cries out for change in the law.
Two Prongs vs. Three
The definition of a franchise under most franchise disclosure laws contains three elements: a fee, a trademark and a marketing plan prescribed in substantial part by the franchisor. The California Franchise Investment Law definition of a franchise is typical.
The New York definition of a franchise has just two elements. Under the NYFA, one element in the definition of a franchise is a fee. The second element is either a trademark or a marketing plan prescribed in substantial part by the franchisor.
Both prongs of the NYFA's definition of a franchise raise issues. Starting with the first prong, what does it mean to grant "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" without a trademark? A marketing consultant may provide a marketing plan to a client to enable that client to launch a business. Certainly the client will pay a fee. Is this a franchise? When does such an arrangement constitute a "grant" of the "right" to engage in a business? The statute is not at all clear on what type of arrangement this prong of the definition is intended to cover.
The second prong is easier to understand but is extremely broad. The plain language of the statute covers many license and distribution arrangements that would not be considered franchises in other states. Any trademark license granting someone a right to engage in a business in consideration for a royalty would fall within the definition of a franchise under the NYFA. This is not the type of business arrangement that anyone unfamiliar with New York law would expect to be a franchise.
Impediment to Business
For licensors who do receive proper advice, this broad definition is an impediment to doing business in the state of New York or with a person who is located in New York.
A franchisor is required to prepare a detailed franchise disclosure document that includes audited financials and to register the offering with the state Attorney General's Office. The franchisor must then make the required disclosures and wait 10 business days (or 14 calendar days in other states) before entering into the agreement or accepting any payment. These are costly and time-consuming requirements that can easily kill a deal.
The broad scope of the New York law creates risk and imposes a degree of uncertainty that discourages business in the state. Why would a licensor choose to be subject to the extensive registration and disclosure requirements imposed on franchisors in New York when the company can avoid these requirements by going to any other state?
For those of us who advise clients on the applicability of the NYFA, giving advice to trademark licensors in New York is embarrassing. Clients have a hard time believing that the law applies so broadly.
But most business owners want to comply with applicable laws. If by chance or good fortune they happen to consult with a franchise lawyer before they enter into a trademark license agreement or a market consulting agreement, they may be advised either to seek a discretionary exemption or to locate the business outside the state of New York and not to enter into the contract with anyone who is located in New York. This sounds extreme because it is. I have given this advice more than once and I know other franchise lawyers who have done the same.
Bad Law
In practice, relatively few litigants raise the issue of noncompliance with the NYFA against trademark licensors or marketing consultants, and the Attorney General's Office seldom prosecutes trademark licensors or marketing consultants for violations of the NYFA.
Maybe we should view trademark licensors in New York as we do drivers who speed on a highway. Drivers often speed, but only a small number are prosecuted. But speeding is dangerous. A simple trademark license agreement is not.
And the sparse enforcement of the NYFA does not change the fact that the threat is always there. An enforcer can arbitrarily decide one day to enforce it.
The fact that the Attorney General's Office does not apply the law to arrangements that are not commonly understood to be franchises also indicates that the Attorney General's Office does not view the broad definition as a necessity. Accordingly, cutting back the definition so that it conforms to the laws of other states would not change the enforcement activity at the Attorney General's Office. Nor would it change the way private litigants behave.
No Problem for Traditional Franchisors or Franchisees
Companies that offer traditional franchises have no issue with the broad definition of a franchise under the NYFA. Franchisors prepare franchise disclosure documents in accordance with the Federal Trade Commission's trade regulation rule on franchising, which meets the requirements of the NYFA with minor variations. Franchisors register their franchise offerings in New York as they do in other states and they make the required disclosures to prospective franchisees. For franchisors, then, the broad definition of a franchise in New York is a non-issue.
The broad definition of a franchise under the NYFA also does not adversely affect franchisees or prospective franchisees who expect to enter into a franchise arrangement. They receive the required disclosures from their franchisors regardless of the law's definition of a franchise.
The "terrifying" aspects of the New York definition apply only to those who would not be considered franchisors under federal law or the laws of any other state.
Narrowing New York's broad definition of a "franchise" to conform to the definition in other states would have no effect one way or another on franchisors or franchisees as those terms are commonly understood.
Does the Broad Definition Serve a Useful Purpose?
It is likely that the Attorney General's Office seldom prosecutes business arrangements that are not commonly understood to be franchises because these business arrangements do not require the protections that the NYFA affords to prospective franchisees.
Does the broad definition of a franchise under the NYFA serve any useful purpose at all? Why was the law written so broadly?
The definition of a franchise was written into the NYFA when it was first enacted in 1981. In his gated column published in the New York Law Journal on June 26, 2012, David Kaufmann reminded readers that he authored the NYFA when he served as Special Deputy Attorney General in New York. He noted that the NYFA "was crafted to attack a vast criminal invasion of the franchise arena which transpired in the 1960s and 70s (including significant organized crime involvement) and to safeguard New York's reputation as the financial capital of the world." Fraud was rampant and New York had no franchise-specific law to deal with this fraud. The NYFA was written broadly in order to give the attorney general broad latitude to prosecute scoundrels.
Apparently, Kaufmann wrote the definition broadly in order to be sure to catch franchise schemes labeled as "joint ventures", "employment contracts", "shareholders' agreements" or other terms that did not sound like franchises. But these arrangements can be prosecuted using a more commonly accepted definition of a franchise. Kaufmann's article made no reference to any simple trademark license or market consulting agreement that was prosecuted as a fraudulent scheme. It also made no reference to business opportunities, which a number of states regulate by separate laws that require far less disclosure.
Even if there was a need in 1981 for this broad definition of a franchise in New York, which is doubtful, there is no such need today. Kaufmann points out in his article that the law accomplished its purpose of eradicating the crime that was rampant in the industry. Undoubtedly, the Federal Trade Commission's trade regulation rule on franchising, which went into effect in 1979, also played an important role in cleaning up an industry that was riddled with fraud, as did the franchise laws of other states, which were enacted in the 1970s.
A New Approach
Today, franchising is a respected way of doing business. Franchising is an important part of the U.S. economy, as the International Franchise Association frequently reminds us. The mainstream status of franchising today gives us the luxury of looking at the NYFA calmly in light of three decades of experience. We can analyze the law and seek to update and improve it carefully and thoughtfully.
This is what some of us did in 2009 and 2010. At that time, I was chair of the Franchise Committee of the New York State Bar Association's Business Law Section. I also chaired its Legislation Subcommittee, which issued a report on franchising law and proposed changes in the franchise law and changes in the franchise regulations that the New York State Bar Association's executive committee approved in January 2010. The changes we proposed included a new definition of a franchise to conform to the definition used in other states. The committee was comprised of lawyers who represented both franchisors and those who represented franchisees. The vote was unanimous.
We then sought the support of the New York Attorney General's Office because we thought that their support was necessary to passage of our proposed changes in the law. The Attorney General's Office would also need to issue new regulations. Since then, nothing has happened. The Attorney General's Office has taken no position and our proposed law has not yet been introduced in the state legislature.
In my view, the broad definition of a franchise under the NYFA is the single most important reason to change this law.
Tom, is this anything more than an attempt to regulate franchising and business oportunities unde the same rule?
If so, then is it as a practical matter as tough as lawyers want to make it sound? I am probably off the mark a tad with this comment, but what is really driving this change? If we know what is driving it, we may more constructively be able to deal with it short of panic.
Richard, Tom knows more about this than I do. But, in our conversations, Tom has pointed out that a) in New York the entire fashion industry could be regulated as a franchisor, and b) there is no reason to do so.
My own more cynical take is this: if New York thinks that they can make some easy money shaking down the fashion industry before new Legislation is passed, then they probably will do so. Might even have a civic duty to do so.