By: Law Works
Companies who plan on growing their systems sometimes consider expanding through a licence arrangement in order to avoid the high legal and administrative costs of franchise law compliance.
Lawyers are often called upon to advise about whether a proposed or existing arrangement creates a licence or a franchise relationship.
It is important to understand the legal differences between a licence and a franchise. A licence that is deemed to be a franchise relationship can result in severe financial and other consequences to the franchisor, should the franchisee choose to exit the relationship or leverage their legal rights as a negotiation tool. This includes the right of rescission – cancellation of the entire deal and full compensation to the franchisee of their entire investment and losses.
What is a licence agreement?
In the context of franchising v. licensing considerations, a licence agreement provides the licensee with a right to offer a product or service using the trademarks of the licensor, in exchange for payment of licence fees.
The first part is the right to use the licensor’s trademarks in association with the sale of the licensor’s branded products or services. This may include the right to use the trademarks, trade names, logos, advertising or other commercial symbols that the licensor owns.
The second part is the financial consideration that the licensee pays to the licensor. This can be a direct or indirect fee, an upfront payment or a commitment to series of payments, such as ongoing royalties.
Examples of genuine licence arrangements include Disney licensing fast-food operators the use of its brand and characters, and Mattel licensing the use of Barbie to a party decoration manufacturer.
A licensor also has a right to directly or indirectly control the character or quality of the goods or services that it licenses. Section 50 of the federal Trademarks Act states:
Licence to use trademark
50 (1) For the purposes of this Act, if an entity is licensed by or with the authority of the owner of a trademark to use the trademark in a country and the owner has, under the licence, direct or indirect control of the character or quality of the goods or services, then the use, advertisement or display of the trademark in that country as or in a trademark, trade name or otherwise by that entity has, and is deemed always to have had, the same effect as such a use, advertisement or display of the trademark in that country by the owner.
In the scenario of branded toys, the licensor may specify that toys cannot be marketed together with guns. A licensor may pull the right of the licence arrangement if the licensee engages in unlawful operations or conduct that is deemed to be inappropriate or questionable. These are overall rights of a licensor to maintain the quality and reputation of its products or services.
What is a franchise?
A franchise arrangement is all that plus more control – specifically, control of the business that offers the licensed products or services.
A franchise arrangement builds on the licence and takes that relationship a few steps further by imposing significant control of, or providing significant assistance in, the setup or operation of the licensee’s business. The key feature to look out for is whether the licence arrangement gives the licensor significant involvement in these areas. If it gives the licensor the right to impose significant requirements on how the licensee operates their business, or provides significant assistance in the setup or operation of that business, the arrangement will no longer be a genuine licence – it will become a franchise relationship.
More technically, a franchise extends a licence arrangement through significant operational involvement – these are parts of the definition of a “franchise” under Ontario’s franchise legislation, the Arthur Wishart Act (Franchise Disclosure), 2000:
- The licensor grants the licensee the right to engage in a business.
- The licensor (or its affiliate) exercises significant control, or provides significant assistance, in the licensee’s method of operation. The method of operation can include, but is not limited to, building design and furnishings, locations, business organization, marketing techniques or training.
Under Ontario’s franchise legislation, the requirement of significant control or assistance is met even if the licensor does not exercise that right or provide that assistance – as long as the licensor has the right in a contract to do so. In other provinces, such as British Columbia, the Franchises Act does not have this additional feature – a licensor has to exercise significant control or provide significant assistance in order for the arrangement to become a franchise relationship.
The following are examples of what constitutes significant control or assistance from the definition in the legislation:
- site selection: for example, providing specifications for site selection or providing real estate professionals to research and locate potential sites;
- building design: for example, providing or reviewing blueprints;
- business organization: for example, placing conditions on the articles of incorporation or other business structure;
- marketing techniques: for example, requiring weekly flyers or online ads; market launch campaigns, and
- training: for example, requiring successful completion of initial training.
In the toy licensing scenario, if the toy licensor were to impose significant control over how the licensee is required to operate the store or provides significant assistance in the operation of the store, it would turn the relationship into a franchise.
As noted earlier, this level of significant operation control or assistance that is the hallmark of a franchise relationship is to be distinguished from a genuine licence arrangement where the licensor only has a right to control the character or quality of the products or services – those are the licensor’s general rights to the trademarks or tradenames associated with the branded products or services.
How to assess whether a purported licence agreement is a franchise agreement?
The requirement that control or assistance be significant is important. The question is whether the purported licensor had meaningful involvement in the licensee’s operations and, if so, whether that involvement amounted to significant control or assistance in the licensee’s method of operation. The assessment of whether a certain arrangement is a true licence or franchise arrangement requires an analysis of the actual relationship between the parties in the course of the set-up and operation of the business, such as site selection, building design, training, etc. These elements have to be important enough, either individually or collectively, in the method of operating the business, so as to deem this control or assistance significant. It is ultimately a question of degree that a judge or arbitrator will have to assess on a case-by-case basis.
As indicated earlier, in Ontario there is an additional option of a right for significant control or significant assistance. Even if the licensor did not in fact exercise significant control or assistance, if the agreement gives the licensor a right of significant control or assistance that may be sufficient to render the arrangement as a franchise relationship.
What happens if the licence agreement constitutes a franchise agreement?
If a judge or arbitrator determines that the requirements of a franchise relationship exist in the case, the arrangement will be declared a franchise. That will entitle the licensee – now franchisee – to the protection of franchise legislation. Depending on various time limitations and potential statutory disclosure exemptions, the franchisee may have a right to seek rescission of its investment in the setup and operation of the business and for any losses incurred as a result. This can have a devasting financial impact on the “accidental franchisor”.
In Fyfe v Stephens, a 2018 decision of the Ontario Superior Court of Justice, the court deemed the purported licence agreement a franchise. The licensee of a “Dial a Bottle” alcohol delivery system was granted the right to deliver alcohol within an exclusive territory. When a customer would call to place an order for alcohol, the licensor would refer the order to the licensee in that customer’s territory. The licensor charged fees for referring the call and on successful delivery to the customer. The licensor retained control over the website, order-taking, customer service, advertising and marketing. The court ruled that these features constituted significant control or significant assistance in the licensee’s method of operation, and as a result, the arrangement was a franchise, not a licence.
If a rescission claim is successful, the franchisee may be entitled to compensation in the following three categories:
- all franchise fees and royalties paid;
- the cost of all equipment (e.g., freezers, computers/POS systems) and leaseholds (e.g., fixtures like countertops, renovation or building costs) for the franchised store or location, and
- all other losses incurred in purchasing, setting up and operating the franchised business.
In a nutshell, the difference between a licence and franchise relationship is one of control:
- A licence arrangement can only control the character or quality of the product or service that is licensed.
- A franchise arrangement imposes significant control or provides significant assistance in the setup or operation of the business that sells the product or service.
The consequences of non-compliance can have significant and sometimes catastrophic results to the “accidental franchisor”. It is therefore prudent for franchisors and their legal counsel to carefully assess the nature of the proposed relationship with licensees. Businesses considering entering into a licence arrangement, and lawyers advising these parties, ought to carefully examine the difference between a licence and a franchise relationship and the significance of the arrangement being deemed an “accidental franchise”. It will not matter how the parties label their relationship and other superficial badges that they apply. The legal analysis is about the substance of the relationship and whether there is significant control or assistance (and in Ontario whether there is a right for significant control or assistance). This is independent of any artificial labels; the analysis is highly specific to each case.
This article is provided for general information purposes only and is not intended to provide legal advice. Parties in a business dispute should obtain legal advice from a knowledgeable franchise lawyer.
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