In California, franchise relationships are governed by statute. See Cal. Bus. & Prof. Code § 20001 et seq. Under the law, for a franchise relationship to exist, there must be an agreement — either in writing or an oral agreement — containing three components and all three must be present. The components are:

• Franchisee is granted the right to engage in the business of offering, selling, or distributing goods or services under a marketing plan or system prescribed in substantial part by a franchisor; and
• Franchisee operates their business in a manner substantially associated with the franchisor’s trademark, service mark, trade name, logotype, advertising, or other commercial symbol; and
• Franchisee is required to pay franchise fee

As California courts have held, failure to satisfy any of these statutory elements of the franchise definition is fatal to the existence of a franchise relationship. See Thueson v. U-Haul International, Inc., 50 Cal. Rptr. 3d 669 (Cal. App. 1st Dist. 2006). Sometimes, a legal dispute arises when one party believes a franchise agreement exists and the other does not. Often, the legal disagreement is over the definition of “franchise fee.” This was the dispute resolved recently by a Wisconsin federal court applying California law. See PW Stoelting, LLC v. Levine, Case No. 16-C-381 (US Dist. E.D. Wisconsin December 17, 2018).

San Diego Franchise Law: What is a Franchise Fee?

In that case, PW Stoelting (“Stoelting”) had a distributor contract with a California company called Advanced Frozen Treat Technology, Inc. (AFTT). Stoelting is a manufacturer of food service and cleaning equipment, including equipment for frozen confections and treats like ice cream bars. The distributor agreement allowed AFTT to sell and service Stoelting machines and equipment. The distributor agreement made California law the applicable law. The distributor agreement allowed Stoelting to terminate the agreement without any cause or reason. In late 2015, Stoelting exercised its right to termination the agreement and specified that the termination was “without cause.”

However, AFTT did not want to be terminated as a distributor and continued to hold itself out as a Stoelting authorized dealer and service/repair provider. Eventually, Stoelting sued and AFTT defended by claiming that the distributor agreement was, in reality, a franchise agreement. Under the California Franchise Act, a franchise cannot be terminated “without cause.” If AFTT was successful with its argument, then the distributor agreement would continue in force unless Stoelting could provide a “for cause” justification for termination.

There was no question that the AFTT-PW Stoelting relationship satisfied the first two components of the franchise definition under California law. AFTT used Stoelting’s business plan and methods and most certainly AFTT’s business was “substantially associated” with the trademarks and logos of Stoelting. However, the case turned on whether any franchise fee was being paid.

The California Franchise Act provides the following definition of “franchise fee:

“… any fee or charge that a franchisee or subfranchisor is required to pay or agrees to pay for the right to enter into a business under a franchise agreement, including, but not limited to, any payment for goods and services.” Cal. Bus. & Prof. Code § 20007 (West).

Subsection (a) of the same statutory section excludes as a “franchise fee” any type of agreement to purchase goods at a “bona fide wholesale price” (as long as there is no obligation to purchase quantities in excess of a “reasonable inventory”).

AFTT argued that it was required to purchase products at prices higher than standard wholesale prices and that they were required to purchase more inventory than was reasonable. However, the trial court granted summary judgment in favor of Stoelting and held that no franchise existed. The wholesale price paid by AFTT was about 45-50% of the manufacturer’s list price. Based on expert opinion, that was within the customary range and consistent with the wholesale pricing system in the frozen treat equipment industry. Furthermore, AFTT was required to have on hand inventory that was equal to 3.8% of AFTT’s expected annual sales goals. The court held that “no reasonable jury” would find that this low level of required inventory would exceed what a reasonable business person would normally purchase, particularly since the inventory was purchased at wholesale prices.

As can be seen, California franchise law can be quite complex. If you are thinking of buying a franchise or are thinking of franchising your business here in San Diego or elsewhere in California, you will need an experienced franchise attorney.

Contact San Diego Corporate Law

For more information, contact franchise law attorney Michael Leonard, Esq. of San Diego Corporate Law by email or by calling (858) 483-9200. Mr. Leonard has the experience to review your franchise disclosure documents and agreements, help with the purchase (or sale) of a San Diego franchise, and/or assist with any business-related matter. Like us on Facebook.

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