When Trademark Licensing looks like Franchising: Avoiding Legal Risk

If anyone doubted that trademark licensing has become an essential part of brand management, the recent Annual Meeting of the International Trademark Assocation (INTA) would have set them straight.  Several high-powered speakers at that event promoted the view that building brands (the goal of every red-blooded American) now also means building partnerships with others who will borrow and help build your brand for you.

You can be sure that 7000 trademark attorneys gathered in one place also noted the biggest risk posed by lending your brand to others: dilution.  But no one (at least no one that I heard over the five-day conference) commented on another risk: that trademark licensing with the controls a brand manager demands may subject it to liability as a franchisor.

Licensing vs. Franchising

Historically, trademark licensing and franchising have been very different legal animals.  A trademark licensee was a company experienced in its core business but able to use the licensor’s brand to its advantage.   The licensor chose the licensee because of its experience in manufacturing and selling such products, and did not try to tell the licensee how to run its business.

A franchisee, on the other hand, sought to borrow not just another company’s name but its entire business concept, and was willing to share its revenues with the franchisor in exchange for reduced business risk.  The franchisor chose a franchisee because it brought financial resources to the deal, but also because the franchisee spared its franchisor the cost of setting up its own business.   A condition of their agreement has always been the franchisee’s agreement to run its business almost exactly as the franchisor requires.

Given these differences, there has historically been little risk that a license agreement would be confused with a franchise agreement.  In a legal franchise relationship, the franchisee must operate its business pursuant to a marketing plan or “system” imposed by the franchisor; the franchisee must pay a franchise fee; and the franchisee’s business must be substantially associated with the franchisor’s trademark.  Imagine the typical McDonald’s restaurant: it operates under rules imposed by the McDonald’s Corp.; it sends a percentage of all revenues to the McDonald’s Corp.; and it exists as a business solely under a trademark borrowed from the McDonald’s Corp.

In contrast, the typical licensee has had a very different job: although it, too, sends  a portion of its revenue based on the licensor’s brand back to the licensor, it has complete freedom in running its own business separate from the licensor.

But these distinctions are narrowing as brand managers grow increasingly excited about the ways that licensing can build their brands.  These brand managers invariably want to exert as much control over their licensees as they exert over their advertising agencies, and as they do so, their licensees look more and more like franchisees.  One day, such a licensor is going to find itself sued by a disgruntled (or terminated) licensee for violating state and federal franchise laws, liability for which can be extensive.

How Not to Be a Franchisor

What can licensors do to limit that risk?

First, they need to make sure that their oversight of the licensee’s marketing efforts remains oversight and does not become control.   This will remain difficult so long as trademark attorneys tell clients that they have to review all uses of their marks on licensed goods and so long as brand managers insist that consistent usage on all licensed products is an essential aspect of good brand management.  Licensors are seeking increasing control over the products their licensees develop, and as that control gets closer to the control a fast-food chain exerts over the pickle slices its operators serve, licensors will be more vulnerable to liability as franchisors.  Licensors need to select aspects of their licensees’ business, product development and marketing over which they do not attempt to exert control.

The same applies for quality control.  The licensor needs assurance that the licensee is manufacturing its products in a safe and consistent manner, and it wants to be the one to decide what safe and consistent means.  Licensors now uniformly develop their own quality control standards for licensees and send their own quality control experts to guarantee their compliance.  When does this behavior cross the line into the kind of control exerted by franchisors?  It is difficult to say, but licensors should think carefully about opening up this process, relying on mutually chosen third parties, and letting licensees at least have input in determining the quality control standards that should apply to them.

Third, licensors need to build in more safeguards in deals where the licensee has little business independent of its license with them.  Such a licensee, one who may even have set itself up in business solely to take advantage of this opportunity, is much more likely to look like a franchisee to courts or attorneys general.  Licensees who hold several other licenses, and have several other lines of their own in addition to the licensed line, will look less vulnerable to risks created by an individual licensor than those whose livelihood depends on the license in question.

If licensors are able to maintain some distance between themselves and their licensees, through these or other methods, licensees will have fewer opportunities to hold them liable for having told them how to run their business.

From the September 2002 issue of The Licensing Letter