Cannabis Entrepreneurs: Know the Perils of ‘Accidental Franchising’

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Business owners must be aware of the perils of ‘accidental franchising’

Cannabis, the fastest growing industry in the U.S. job market today, is embracing one of America’s most popular business expansion engines — franchising. Denver-based ONE Cannabis and Florida-based Miracle Leaf each claim to be awarding franchises to catapult their growth, the former franchising cannabis dispensaries and the latter medical marijuana clinics. Undoubtedly, other cannabis franchisors are following suit to capture a piece of the $150 billion industry. It is a predictable combination — franchising and cannabis — and probably just a matter of time until franchise outlets dominate the Green Rush landscape as they have done in diverse business sectors like restaurants, fitness, real estate and senior care. What makes franchising such a natural fit is that cannabis retailing today consists largely of mom-and-pop independents that should be eager to convert their operation to a common brand name and retail identity to improve consumer recognition of their business, leading to higher sales and profits.

Based in Denver, Colorado, ONE Cannabis advertises itself as the “world’s most experienced cannabis business franchise system” and offers franchise opportunities to prospective entrepreneurs in states with legal cannabis markets.

Franchising with the established company — either cultivation or retail — provides buyers with a roadmap for success that includes operational systems, best practices, depth of resources and business relationships, as well as national brand recognition and marketing support that allows entrepreneurs to flourish in the budding cannabis industry.

According to Forbes magazine, as of May 31, ONE Cannabis has sold the rights to five Colorado locations, each for a franchise fee of $130,000, though the company estimates it costs franchisees between $325,000 and $1.13 million in startup costs to open a shop, depending on the location. The company’s website, ocginc.com, lists required liquid capital at $750,000 and total investment of up to $2.5 million.

Why Franchise?

Consumer demand for all types of cannabis and CBD products makes franchising a natural growth vehicle for the cannabis industry. For a promoter looking to capitalize on cannabis’ meteoric rise, franchising a branded cannabis chain solves the two biggest roadblocks to any business expansion: capital and labor. Franchising enables a cannabis brand to expand its footprint without taking on debt by using other people’s money (the franchisees’), awarding a trademark license to a franchisee conveying the right to own and operate their own cannabis business identified by the franchisor’s trademark and trade dress. The franchisee hires and supervises its own workforce, must follow the franchisor’s brand standards so it operates comparably to all other licensed locations, and pays the brand owner licensing fees off its top-line revenue.

For entrepreneurs and existing independents, franchising offers a stake in the explosive cannabis market, an opportunity to be in business “for themselves, but not by themselves” with the right to keep the profits after paying licensing fees to the brand owner. Franchise programs classically offer benefits of scale that sole proprietors cannot replicate, like training programs, marketing tools and the purchasing power of a larger network that can reduce overhead costs for inventory and supplies.

Overarching Risks

It is impossible to ignore the serious legal and business complications of franchising a cannabis business due to marijuana being illegal under federal law. Banks, landlords, insurance companies and other service providers remain skittish about doing business with companies that are essentially breaking federal law.

Most industry analysts expect the federal government’s policies eventually will change and ultimately accommodate cannabis retailing within the bounds of reasonable regulations. For the here and now, however, franchisors must contend with the fallout from regulatory uncertainty in trying to register their trademarks, conduct normal banking transactions, insure their operations and sell franchises.

Once federal uncertainty is removed, everyone expects the cannabis industry to grow exponentially in revenue, jobs and opportunities, which bodes well for franchisors that set up networks now and get their brands well established with consumers before floodgates open. In the short run, cannabis franchisors looking to gain early traction with consumers as a go-to brand for cannabis products will need to help their franchisees find work-around solutions to reduce everyday burdens, like operating without immediate access to bank accounts or ordinary non-cash payments systems like debit and credit cards.

The Significance of Franchise Status

Of the many legal risks associated with cannabis franchising, brand owners may not appreciate the fine points of what distinguishes a franchise from a non-franchise trademark license in the eyes of the law. As a result, they may give short shrift to the legal consequences of awarding franchises without complying with franchise sales laws.

Significant penalties potentially flow from the unlawful offer or sale of a franchise even if the inadvertent franchisor truly did not know about the law and had no intention to violate it. The same penalties apply whether the underlying franchise involves cannabis, hamburgers, children’s programs or something else.

Though not the first, the most famous franchise in the world — and No. 1 once again on this year’s Entrepreneur magazine Franchise 500 — is McDonald’s, which has more than 13,000 U.S. franchises and another 21,000 worldwide, compared to just 2,885 restaurants owned by the company.

The company’s terms for franchises are a $45,000 initial franchising fee, a 4% ongoing fee and a 4% ad royalty fee, for which the company provides myriad ongoing and marketing support options. According to Entrepreneur, McDonald’s constant reinvention to keep up with modern design and customer expectations has led to 13 consecutive quarters of positive growth for the 64-year-old company.

Dunkin Donuts, Sonic Drive-In, Taco Bell and UPS round out the magazine’s Top 5 for 2019.

To underscore the magnitude of franchise status, it is a felony to sell a franchise without complying with a franchise sales law (although criminal prosecutions are rare). Federal and state franchise agencies have broad powers to punish franchise law violators and may freeze assets, order restitution, issue cease-and-desist orders, ban violators from selling franchises and recover substantial penalties. In states with franchise laws, franchisees have private remedies for statutory violations including compensatory damages and possibly rescission, which means that an unhappy plaintiff may be able to unwind an illegal franchise sale and recover its investment and operating losses from the brand owner. Even in states without a franchise sales law, a franchisee may be able to pursue a claim for violation of a state unfair trade practices and recover treble damages and attorneys’ fees based on the promoter’s violation of the federal franchise sales law. State franchise laws impose personal, joint and several liability on the franchisor’s management and owners even if the franchisor is a legal entity. Because a franchise finding is highly fact-specific, seldom are franchise allegations dismissed early in a case on a motion to dismiss, which significantly adds to the nuisance value of franchise disputes.

For cannabis franchisors, there is the added complication of how to comply with the dozen-plus state franchise laws that impose a registration duty on franchisors and allow state franchise agencies to function as gatekeepers. As long as federal policy criminalizes cannabis, franchisors may not have success getting registered even in the three franchise registration states where cannabis is fully legal (California, Michigan and Washington). This probably explains why companies that openly embrace franchising as a growth model currently operate outside of states with franchise sales laws where promoters only need to worry about complying with the federal franchise sales law, which has no federal filing requirement allowing franchisors to operate relatively undetected by the Federal Trade Commission, the agency that oversees compliance with the federal franchise sales law.

What is an Accidental Franchise?

An “accidentalfranchiseis a euphemism for a franchise that a brand owner knowingly or unknowingly sells in violation of federal and state franchise laws. Lack of knowledge of a franchise law is not a legal defense to liability. Also called “inadvertent franchises” or “hidden franchises,” accidental franchises are not always accidental. Franchise sales laws are strict liability laws, which means that it makes no difference if a company knows that it is violating the law when it commits the act constituting the violation. A company also cannot defend its own wrongdoing by pointing to its competitors engaged in similar behavior. A licensing program that walks and quacks like a franchise, but goes by a different name, is still a franchise.

Outside of the cannabis industry, plaintiffs have challenged remarkably diverse business arrangements as franchises, including established organizations and sophisticated companies. The best-known accidental franchise case involved the Girl Scouts’ national organization found to be in a franchise relationship with one of its local Wisconsin chapters under Wisconsin’s Fair Dealership Law, which protects dealers and franchisees alike against termination without good cause.

The 3 components of a franchise

*The third leg in the franchise definition varies by jurisdiction: all variations involve an inherently subjective legal standard described as a “marketing plan,” “community of interest” or “significant assistance or substantial control” with each variation as intrinsically imprecise as the next. As a result, all franchise definitions are murky around the edges.

If any leg of the franchise stool is missing, the arrangement is not a franchise regardless of how obviously the other two legs are present.

When is a Brand License a Franchise?

Franchising is a business method, not a particular industry. Franchises are strictly creatures of statute, which means that any commercial arrangement is a franchise if it meets the definition of “franchise” in the federal franchise sales law or a state franchise law with jurisdiction over the parties’ activities. The statutes themselves embrace different jurisdictional rules, but all apply to franchise businesses that operate within their borders even if neither the franchisor nor franchisee reside or maintain their principal place of business in the state.

There is no universal definition of a franchise. The federal franchise sales law, which regulates franchise sales in all 50 states, does not preempt state franchise sales laws. There are both marked and subtle differences in how franchise laws define a franchise.

Most franchise definitions are a three-legged stool that require some type of express or implied trademark license and payment of a direct or indirect fee. The third leg in the franchise definition varies by jurisdiction: all variations involve an inherently subjective legal standard described as a “marketing plan,” “community of interest” or “significant assistance or substantial control” with each variation as intrinsically imprecise as the next. As a result, all franchise definitions are murky around the edges.

If any leg of the franchise stool is missing, the arrangement is not a franchise regardless of how obviously the other two legs are present. However, it is not always possible for a brand owner to achieve its business goals by eliminating one of the legs of the franchise stool.

Not only are the contours of defining a franchise confusing, but the mismatch between federal and state franchise definitions creates enormous uncertainty over when and where a promoter must qualify as a franchise. The upshot is that the same licensing program may be a franchise at the federal level, but not in any or every regulating state where the promoter offers its opportunity, or vice-versa.

The name promoters give to their business opportunity is immaterial to its franchise status; only facts matter. Every franchise includes a trademark license, but not every trademark license is a franchise. Sorting the two apart is a risky and highly uncertain process.

The importance of branding to consumer purchasing decisions, combined with the inexactitude of franchise definitions, fuels the so-called accidental franchise problem. This problem exists for not only franchisees and law enforcement but also for law-abiding franchisors, which must compete in the marketplace for prospective licensees with companies that ignore or deny their franchise status, incur no expense for franchise sales compliance and fly below regulatory radar.

Putting It All Together

Accidental franchisors have operated in franchising’s shadows ever since the arrival of franchise sales laws in the 1970s. A business sector as prime for franchising as the cannabis industry will undoubtedly attract its share of accidental franchisors, including brand owners that may be genuinely unaware that their licensing program qualifies as a franchise under federal or state laws as well as those who are disingenuous about their ignorance. This distinction has no relevance to culpability.

If franchising will ultimately dominate the Green Rush, it is equally likely that accidental franchisors will begin popping up, promoting their cannabis opportunity as something less than a full-fledge franchise and calling their program by names that avoid the “F word.” This has been the historical experience on the non-cannabis side of franchising.

The franchise definitional element that is the most subjective and least precise — the middle variable expressed as a “marketing plan, community of interest or significant assistance or substantial control”— is not one that a brand owner looking to launch a cannabis retail chain can reliably eliminate. Trying to do so creates an uncomfortable dilemma: the types of restrictions cannabis brand owners need to impose on their licensees to protect the quality and uniformity of the services offered under their brand are often indistinguishable from the indicia that establish a “marketing plan, community of interest or significant assistance or substantial control.”

A cannabis franchisor willing or tempted to eliminate or reduce assistance or controls in order to avoid franchise status may sacrifice important core values vital to their brand’s reputation. Indeed, the cannabis franchisor may risk abandoning its trademark rights.

The most sure-footed way for a cannabis company (or any brand owner) to set up a licensing program that avoids franchise status is to eliminate the “required fee” element of the franchise definition. In the cannabis market, eliminating the required fee may only be a viable solution for cannabis producers that enter into commercial arrangements with independent distributors. This is because all jurisdictions exclude from the definition of a required fee payments that do not exceed the bona fide wholesale price of inventory (goods bought for resale) if there is no accompanying obligation to purchase excessive quantities. The bona fide wholesale price exclusion means that a cannabis grower or producer operating a supply chain network may sell product at wholesale prices downstream to branded distributors for resale. However, they may not receive fees for delivering other types of services for things like delivery van rentals, training programs, brand identity materials or marketing support unless the services are truly optional. Calling something “optional” is not the test. The law classifies payments denominated as optional as “required” if the service is essential for the successful operation of a distributor’s business. Fees for optional training services or marketing support risk treatment as “required fees” especially if most distributors opt in and buy the service.

Eliminating the “required fee” element is not a practical option for a cannabis brand that licenses a service business, not a supply chain. Dispensaries and other retail businesses that sell cannabis or CBD products under the brand owner’s trademark and business concept are service businesses. A cannabis brand owner that collects a fee for brand affiliation rights is likely in a franchise relationship regardless of whether the fee is lump sum, paid in installments or involves fixed, fluctuating, up-front, periodic or even refundable payments.

In short, cannabis brands looking to launch a retail franchise program in order to roll up independent mom-and-pop dispensaries and compete with ONE Cannabis, Miracle Leaf and other cannabis chains may have no practical way to avoid franchise status lawfully.

Because franchise status requires a technical evaluation of a commercial arrangement under potentially multiple laws with subtle distinctions, accidental franchises are a trap for the unwary. The trap is sure to attract cannabis entrepreneurs looking for a quick footing in the burgeoning cannabis industry. They would do well to keep the burdens of being a franchisor in perspective.

More than 3,000 franchise brands operate in the U.S. and presumably manage to comply with franchise sales laws. The consequences flowing from accidentally franchising are simply too serious to look the other way.

Rochelle Spandorf is a partner in the Los Angeles office of Davis Wright Tremaine. A certified specialist in franchise and distribution law in California, she has dedicated her legal practice to representing primarily franchisors, suppliers and other brand owners expand through trademark licensing. She is the first woman to chair the American Bar Association’s Forum on Franchising, the nation’s preeminent association of franchise attorneys, and has twice chaired the Franchise Law Committee of the California Lawyers Association.

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