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After twenty years in Washington DC, the International Franchise Expo has now moved to New York City.

But, New York State's outdated franchise law is a potential obstacle for exhibitors at the largest franchise expo in the country. New York State, of course, requires franchisors to register with the Attorney General's Office before offering or selling franchises. Registered franchisors will have no problem exhibiting at the show and engaging in discussions with prospective franchisees.

But franchisors that are not registered in New York must clear a regulatory hurdle before they can lawfully exhibit at the Expo. The reason is the "first personal meeting" requirement under the New York Franchise Act.

The New York Attorney General's Office has been working hard to ensure that every exhibitor is either registered or exempt. And this is happening at the busiest time of year for the franchise examiners. They're in the midst of reviewing the annual franchise renewal applications.

The first New York Expo begins June 15, 2012. The Expo also takes place in California and Florida each year.

The "First Personal Meeting" Requirement

Under New York law, a franchise may not be sold without providing to the prospective franchisee a copy of its registered prospectus at the earlier of (a) the first personal meeting between the franchisor or its agent and the prospective franchisee or (b) 10 business days before the parties sign a binding franchise or other agreement or before the franchisor receives any consideration in connection with the sale of a franchise. "First personal meeting" means the first face to face meeting between the franchisor or the franchisor's representative and a prospective franchisee that is held for the purpose of discussing the sale or possible sale of a franchise.

If New York did not have a "first personal meeting" requirement, an unregistered franchisor could exhibit at the trade show and inform each prospective franchisee that the franchisor is not yet registered in the state and that it cannot offer or sell franchises in or from New York until it is. But discussion would be welcome. Just leave your name and we'll get back to you. The franchisor could make the offer at a later date, after the Attorney General's Office approves the franchisor's application for franchise registration and the franchisor has delivered the registered disclosure document to the prospect and waited the required ten business days.

To play it safe, the franchisor could put this in writing in a flier it distributes to prospects. The franchisor could even put a sign on its booth saying it's not registered in New York. The sign and flier would help the franchisor defend against an allegation of making an illegal offer of an unregistered franchise. The sign and flier might also satisfy a New York state regulator prowling the exhibit hall.

New York's Special Expo Exemption

But these steps are not sufficient to meet the requirements of New York law. Fortunately, the New York State Attorney General's Office has devised a solution. In order to facilitate the Expo's move to New York City, the New York State Attorney General's Office offers unregistered franchisors a temporary exemption that specifically covers the Expo in New York City.

An unregistered franchisor needs a special exemption in order to do in New York what franchise trade show exhibitors do everywhere else without an exemption.

While the New York Franchise Act is extremely broad, one saving component of the law is that fact that it allows for discretionary exemptions. The law authorizes the Attorney General's Office to grant a discretionary exemption if it finds that the exemption is not inconsistent with the public interest or the protection of prospective franchisees. In this case, the Attorney General's Office created a specific discretionary exemption for the Expo.

But franchisors must apply for this exemption. It is not self executing. And there is no certainty that it will be granted. The exemption does not allow exhibitors to sell franchises, but only to discuss the possible sale of franchises in person at the Expo in New York City during its three day run. A franchisor who receives this exemption and is registered in other states or only selling franchises in non-registration states may not even provide its franchise disclosure document at the show.

It makes no difference if the recipient is a New Yorker considering opening a franchise location in the state or whether the recipient is a New Jersey resident with no plans to open a location in New York, or whether the franchisor has any connection with the state other than its participation in the expo.

The limited exemption requires the unregistered franchisor to display a standard notice conspicuously at the booth informing visitors that the franchisor is not registered. In order to obtain the exemption, the franchisor must also submit to the Attorney General's Office a copy of any promotional materials to be distributed at the Expo. A special handout must be included with all such materials at the Expo informing recipients that the franchisor is not registered to sell franchises in New York.

The exemption application must include certain information that would normally be included in a franchise disclosure document, such as the names and employment history of the franchisor's managers and the relevant litigation of the franchisor and its affiliates.

The applicant must acknowledge that if franchises are sold without registration, the franchisor and its representatives may be subject to civil and criminal penalties. In fact, the franchisor must agree that if any of its employees or representatives violates a condition of the exemption, the franchisor will pay liquidated damages to the Attorney General's Office in the amount of $10,000 for each violation. In addition, the applicant must acknowledge that the Attorney General's Office may seek injunctive relief, which can bar the franchisor from selling in New York at all. And the applicant company must sign a consent to service of process in the state.

The Attorney General's Office also charges a $450 filing fee for the three-day Expo exemption. The application must also include a Notice of Appearance signed by a representative of the franchisor. This representative may well be the company's attorney, who will also charge legal fees on top of the filing fee.

By the time the process is completed, one might conclude that it would be better to apply for franchise registration.

The Need for a Change

The best approach would be a change in New York law. The New York Franchise Act is an anachronism. An exemption is nice, but New York really should change its law to be consistent with federal law and the laws of most other states that require franchise registration.

The Federal Trade Commission (FTC) eliminated the "first personal meeting" disclosure trigger as one of many changes it made with its 2007 revised trade regulation rule on franchising. Because franchisors and prospective franchisees may have numerous telephone conversations and communications by email longer before any face-to-face meeting occurs, the FTC determined that the "first personal meeting" trigger was an unnecessary requirement.

The FTC also replaced the 10 business day trigger with a 14 calendar day disclosure trigger. California eliminated the first personal meeting requirement in 2008. Other registration states, like Illinois, Maryland and Washington, have also modified their laws to conform to the revised FTC rule. But New York has not.

The "first personal meeting" is what trade shows are all about. It is a shame that New York requires registration or an exemption just to exhibit at a trade show. I wonder how many prospective exhibitors may have been discouraged from appearing at the show because of the requirements of New York law.

Californians need jobs.  Franchising has historically provided those jobs in the hotel, restaurant and service industry. Without a change which rewards franchisees as owners, risk capital will not be attracted to California. California will lose out on job creation, and its budget woes will be worsened if the Level Playing Field for Small Business Act of 2012 is not passed, Bill AB 2305. 

California, the spiritual home of franchising

California and San Bernadino are the spiritual home of franchising.  In the late 50's, the McDonald brother's restaurant routinely recreated the secular miracle of feeding the hungry with a nutritious and delicious 15 cent Hamburger Meal -burger, fries and a milk-shake.

But, it took the owner of a franchised business, franchisee Ray Kroc from Chicago, to export California's golden miracle. Ray Kroc formalized the McDonald's brother's system. Ray Kroc created the scalable restaurant system - as a franchisee.

Before he bought out the McDonald's brothers, Ray was a master franchisee, a company that was granted a master license. Ray was a supply chain genius, and had an operator's understanding of what made a restaurant profitable. He was constantly challenging the supply system to scale and grow the franchise system.

In the 1950's, Ray broke every rule in his license or franchise agreement, and ended up paying a penalty of some $5 million to the McDonald brothers. He was brilliant, ungovernable, yet made many of his operators millionaires — enriching the middle class and contributing to many state's coffers.

Ray could attract a variety of operators in the 1950's and 1960's because he could legitimately offer them the prospect of real wealth. 

Passing Bill 2305 will stimulate job growth

The current franchise legal model allows the franchisor to exercise so much control over the franchisee as to be an employer. This legal model creates employees where there should be owners. This is the fairness issue is being addressed by Bill AB 2305:  the problem of too much control and not enough sharing. Such a model does not attract risk capital.

Today many franchisees are nothing more than employees who pay good cash money to obtain jobs. No serious minded entrepreneur is attracted to this business model. The growth of franchising is largely fueled by those who are seeking to buy a job.

Without AB 2305 being passed, franchising will stagnant because it will not and cannot attract the Ray Kroc's as franchisees - the operators with boots on the ground who have the experience and capital to implement systems that scale and deliver value to the consumer.

It is not merely a matter of downloading these payments to the franchisee/employees.  It is a matter of making the franchisee nothing more than an employee who pays for the right to work.

The California example, United Parcel Service franchises

The widely and rightly praised United Parcel Service Company (UPS) has used the current franchise legal model in this manner.

Prior to acquiring the franchising firm Mailboxes Etc. in San Diego, Atlanta-based UPS had a series of depots and unmanned drop-off boxes to process returns. UPS makes money when more packages are shipped, and their business model is to increase this volume.  Some packages must be returned from where they were shipped to: the part is defective, the address is wrong, or the customer has lost interest in the product.

United Parcel Service would need to recruit employees to man and manage the returns and could have done so by expanding their depots. They did not hire more employees. Instead, they acquired an existing franchise system, Mailboxes Etc. out of bankruptcy. They changed the franchise agreement, giving the franchisor more control. They put their signage in front and the public now believes that they are dealing with UPS employees.

UPS achieved their business goals: they effectively turned these franchisees into employees who will not be a payroll expense to the franchising firm. All of this is currently legal —as many court filings in California's courts show.  It was also a very shrewd business decision.

But it is time to end this overreaching and return balance and fairness to franchising.  

Franchisors avoid taxes due to California

Now, you will hear from franchisors about how important franchising is as an industry. But what you will not hear from the franchisor corporatist apologists is this secret: the current franchise legal model is detrimental to California's public interest.

The current legal model allows the franchisor, which is the company who grants a franchise license to a local business, to escape or evade paying state taxes compared to other firms trading in California.

This is how it is done. A franchisor incorporates a company in Delaware and that company owns the franchisor's trademarks and other intellectual property.  Delaware does not tax royalty payments made to the holders of intellectual property.  A franchisor funnels the royalty payments made by its California franchisees to Delaware - minimizing or sometimes eliminating the correct amount to remit to California for income tax.

This tax issue is not addressed by Bill AB 2305.  But, you need to be aware of it when the franchisor apologist  urges upon you the value of the great economic engine of franchising.  Such industry does exist - what benefit is it to California if the surplus is untaxed and moved out of state?

Proper risk and reward between franchisor and franchisee will create wealth

California, in particular Silicon Valley, creates great immediate weatlh. For that wealth to become capital, it makes sense to woo those individuals into investing into a restaurant, hotel or service franchise — creating permanent jobs in the restaurant, hotel and service industries in California.  

But the current franchise legal model is not hospitable to risk capital. Proper balance between control and reward must be restored.

Bill AB 2305 is aimed at correcting or restoring this imbalance. By returning the franchise legal model model to the correct balance, where the franchisor creates and mantains brand standards, while the franchisee executes those standards and everyone shares in the surplus value as owners, Bill AB 2305 creates a hospitable environment for operator and supply chain geniuses like Ray Kroc.

Jobs and growth will follow.

Kids still read books, but nobody uses Quill pens, the Tennessee Court of Appeals in reversing the lower court and finding that nexus exists even without agents or a physical presence.

Remember Scholastic Book Club? Those were the books you ordered in grade school and your teacher placed the order for the class. A few weeks later, a package arrived and teacher gave you the books.

Sort of like Amazon but a lot easier since you could guilt-trip your parents into buying you some cool mystery paperbacks.

Book clubs may be passe, but empty state coffers are current news.

The State of Tennessee wanted to charge Scholastic sales & use tax.

The company argued that it had no presence in Tennessee, and that teachers who took the book orders were agents of the students. The company also argued that it did not place demands on state services.

In particular, the company relied on Quill v North Dakota (1992) and said that there was no tax nexus that would be recognized under US Supreme Court jurisprudence on the matter.

On appeal, the nexus issue was presented:

Whether the activities of in-state schools and school employees on behalf of an out-of-state seller that enable the seller to establish and maintain a market in Tennessee create sufficient nexus with Tennessee under the Commerce Clause of the United States Constitution to support an assessment of Tennessee sales and use taxes against the seller.

The court opinion is troubling for franchisors. The court held that Quill was dispositive and nevertheless managed to find tax nexus:

the issue in this case is not whether Tennessee teachers may be considered agents of SBC, but whether SBC's connections with Tennessee's schools and teachers establishes a "substantial nexus" such that the Commissioner's assessment may be sustained under the Commerce Clause

The court found:

In short, SBC has created a de facto marketing and distribution mechanism within Tennessee's schools and utilizing Tennessee teachers to sell books to school children and their parents. Contrary to SBC's assertion that it uses no public services in Tennessee, this State's school facilities and teachers are, in large part, funded by taxpayer dollars. We agree with the Commissioner that SBC's connections with its customers in Tennessee do not fall with the narrow safe harbor provisions affirmed in Quill Corp

Of particular interest to franchisors is the court's statement that Quill stands for the proposition that contact may only be via "common carrier or the United States mail."

By the reasoning of the Tennessee appellate court, franchisors with sales agents and support/compliance audits within the state are outside the "narrow safe harbor" of Quill.

Unlike the schoolteachers in Scholastic, the local representatives of franchisors are not working without compensation; in fact their compensation is often tied to a percentage of what the franchisor is earning. It is true that the appellate court noted the taxpayer support of schoolteachers, but a reading of the Opinion suggests that this was not the basis for the decision and more in the nature of dicta than a necessary element of finding nexus.

The court ruling is a roadmap for SCOTUS to gut Quill without actually overturning precedent, and the Scholastic reasoning is likely to be closely read when and if Quill is challenged at the high court.