June 16, 2008

Franchise Laws and Hotel Management Relationships: A Rose by Any Other Name …

Holland & Knight Alert
Tammy Knight | Allison McCarthy

Franchise relationships are subject to various laws generally intended to be protective of the franchisee. If the franchisor does not comply with these laws the result may be very undesirable consequences, including liability for damages and attorneys’ fees, rescission rights for the franchisee, and potential civil and criminal liabilities. If a hotel manager is not familiar with the legal attributes that constitute a franchise, it may unwittingly enter into a franchise relationship where a hotel management relationship was intended and thus be subject to franchise laws. Any agreement that meets the definition of a “franchise” can be subject to franchise regulation regardless of what the agreement is called, whether it is a management agreement, license, sublicense, venture, or any other name.
As the role of hotel management companies has evolved over time from the leasing and ownership of hotels, to entering into agency management agreements, to now entering into management agreements with no agency disclaimers, the relationship between the hotel owner and hotel management company has adopted several of the attributes of a franchise relationship. If the substance of these relationships are not kept distinct from that of a franchise, they may become subject to the obligations of franchise laws.

Franchise Laws

Franchise laws were generally adopted to protect franchisees from certain perceived abuses by franchisors due to the greater bargaining power of the franchisors. There are generally two types of franchise laws: disclosure laws and relationship laws.

  • Disclosure laws require franchisors to make pre-sale disclosures to potential franchisees to allow the franchisee to make an informed investment decision based on more complete and reliable information.
  • Relationship laws govern the terms of the franchise relationship to address certain perceived abuses by franchisors. The areas of primary concern under the relationship laws are the termination, renewal and transfer of franchise rights. For example, most franchise relationship laws require the franchisor to have good cause before terminating a franchise agreement and to comply with certain procedural requirements for

The Federal Trade Commission (FTC) has adopted and enforces a trade regulation rule, which is commonly referred to as the “FTC Rule” (16 C.F.R. Part 436), relating to franchise disclosure regulation that requires disclosure by franchisors before any offer or sale is made unless an exemption applies. The FTC Rule was recently amended in 2007. The amended rule, which applies only to the sale of franchises to be located in the United States and its territories, may be used effective July 1, 2007, and must be used for all franchises offered or sold after July 1, 2008. The amended rule created several new exemptions for sophisticated franchise purchases including exemptions for large investments and large franchisees with sufficient net worth and prior experience. The majority of franchisors choose to fulfill the disclosure requirements of the FTC Rule by preparing a franchise disclosure document, which was referred to as a uniform franchise offering circular prior to the amended rule. No federal filing or registration is required in connection with the FTC Rule.
A number of states also have franchise laws relating to disclosure requirements (which may also require prior registration or filing with a state agency), relationship requirements, or both. Although the elements of a franchise under these state laws are similar to those of the FTC Rule, there are variations among the different states in such definitions and the applicable exemptions. It is important to consider each state law that may potentially apply to a given transaction.
Although the franchise laws vary in their specific definition of a franchise, generally the definition of a franchise consists of the following three elements:

  1. the use by the franchisee of the franchisor’s mark or name
  2. significant control exerted by the franchisor or significant assistance given by the franchisor to the franchisee concerning the operation of the franchised business
  3. the franchisor must charge the franchisee a fee

Application to Hotel Management Relationships

A hotel manager’s franchise counsel is frequently not involved in the structuring and negotiation of hotel management relationships as a franchise relationship is not intended. However, if the parties modify the branding and operating structure of a hotel project in response to certain business, taxation, or other circumstances, the hotel management company should ensure that the modified terms of the arrangement are not such that the threshold has unwittingly been crossed and a franchise relationship established. For example, to address taxation concerns, a hotel management company may attempt to separate the use of the hotel brand and related marks from its obligations to be performed under the management agreement and instead license the rights to use such brand and marks to the property, which arrangement, if not structured correctly, may trigger the application of the franchise laws. Furthermore, in an effort to ensure that a certain property remain in its system, the hotel management company may also cause an offer or sale of a franchise by including an obligation on the part of the hotel owner to convert to a franchise arrangement upon an early termination of the hotel management agreement.
In the FTC’s Advisory Opinion 95-8 (dated August 29, 1995), the franchise rule staff was requested to provide general guidance in determining whether a proposed agreement regarding the operation of the Parker-Meridien Hotel in New York City would create a franchise relationship between the parties. Meridien had been the management company for the hotel and the parties were modifying the existing agreement so that the hotel owner would assume all operational and management functions of the hotel while Meridien would continue to provide certain marketing and sales assistance and reservation services and allow the hotel to continue using its trademarks, trade names and service marks. The franchise rule staff of the FTC determined that the first and third of the definitional elements described above were satisfied and that based on the specifics of this proposed relationship, including the sophistication of the hotel owner, the long involvement of the owner in the operation of the hotel, and the limited role that Meridien would assume in the future operation of the hotel, that it did not appear that the owner was relying on Meridien’s superior expertise in order to be successful. It was determined that in such circumstances the revised agreement did not appear to satisfy the significant control and assistance requirement of the FTC Rule.

What Matters Most

The significance of Meridien’s assistance to the hotel owner illustrates the exercise of weighing the characteristics in a relationship to determine whether the relationship has crossed the threshold that creates a franchise relationship. The structuring of the branding of the hotel, the sophistication of the hotel owner and the level of involvement by the manager are all factors to consider in determining whether the proposed relationship constitutes a franchise. In negotiating the agreements governing the operation and branding of hotel projects, if the parties’ advisors are not familiar with the requirements of the applicable franchise laws, then the terms of the arrangement may be such that a franchise relationship is unintentionally established.
The only way to avoid the requirements of the franchise statutory and regulatory schemes is to structure the arrangement so that the substance of the arrangement is not that of a franchise. Simply labeling the relationship as an arrangement other than a franchise is not enough. To quote Shakespeare, “A rose by any other name would smell as sweet” – which applied to franchise laws means that what matters most is what something is, not what it is called.

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