Restaurant Joint Ventures. Is Your Joint Venture an Inadvertent Franchise?

By Rochelle Spandorf

Restaurant owners have many motivations for forming joint ventures; a primary one is to finance expansion.  These arrangements go by many names, including strategic alliances and corporate partnerships, and they join complementary strengths: a restaurateur may be looking for money sources or an experienced local partner to replicate the restaurant concept in an unfamiliar market or nontraditional venue.

The joint venture participants move forward together as a new legal entity.  It is irrelevant whether they choose to form a corporation, LLC, or partnership: What is relevant is that the joint venture entity is separate and apart from the legal entity through which the restaurateur owns the flagship restaurant.  In the common scenario, the restaurateur retains ownership of the trademarks, brand features, and any trade secrets that make the restaurant concept special and trusts the joint venture to replicate the restaurant concept and use its brand name in a manner that upholds the high operating standards that customers associate with the restaurateur.  Seldom will a restaurateur transfer ownership of the intellectual property to the new joint venture entity.  Consequently, in its relationship with other venture participants, the restaurateur will wear two hats: co-owner of the new venture and intellectual property licensor.  Even if the parties do not memorialize the trademark license in writing, the trademark license is implied in the joint venture arrangement. 

By virtue of the trademark license, the restaurateur has probably unknowingly awarded the joint venture a franchise.  It is irrelevant that the restaurateur did not intend to create a franchise, knew nothing about franchise laws, or never used the “F” word in conversations with joint-venture partners.  By forming a relationship that qualifies as a franchise, the restaurateur has violated federal franchise sales laws and, depending on where the venture operates, may have violated state franchise sales laws as well. 

It does not take much to turn a trademark license into a franchise: significant operating assistance or controls that affect the core of the licensed business and required payments to the trademark licensor which can take any number of forms, including profit participation.  Federal law imposes an affirmative duty on trademark licensors to control the quality and uniformity of the goods and services associated with their trademarks. A licensor that fails to do so may risk abandoning its trademark rights.  As a practical matter, it is often impossible to distinguish trademark quality controls that licensors must impose to protect their trademark rights from the factors that identify a franchise.  As consumer-protection statutes, franchise laws are liberally construed.  Furthermore, franchise laws cannot be waived by joint venture participants even if the participants are represented by legal counsel.
 
In some cases, joint ventures may be structured to avoid classification as a franchise or to qualify for exemptions from franchise regulations.  Not infrequently, however, a single solution will not work in all jurisdictions.

Restaurant owners are mistaken if they assume that by investing in the joint venture the venture cannot be a franchise.  Unless the other venture participants are truly passive investors with no say in day-to-day management and only a limited right to vote on extraordinary events such as admitting new members, significant financing transactions, or the sale of the restaurant, the venture may be a franchise regardless of whether the restaurateur is a minority or majority joint-venture investor.  If the other venture participants are truly passive, the restaurateur may have violated federal and state security laws with equally serious repercussions.
 
So what if the restaurateur has sold a franchise? 
 
Franchise law violations carry significant penalties even if the inadvertent franchisor knew nothing about franchise laws and had no intention of violating them.  Not only is it a felony to sell a franchise without complying with a franchise sales law, but federal and state franchise agencies can freeze assets, order restitution, issue cease and desist orders, ban violators from selling franchises, and recover substantial penalties.  Franchisees have private remedies for state franchise law violations entitling them to compensatory damages, attorney’s fees, and rescission.  And if all that does not grab a restaurant owner’s attention, federal and state franchise laws impose personal, joint, and several liability on a franchisor’s key management and owners even when the concept owner is a business entity.

Franchise and security laws should be carefully considered when joint venture plans are first formulated so that structuring solutions and regulatory exemptions can be explored to their fullest potential to allow restaurant owners to achieve their business expansion goals without legal exposure.  If the joint venture fails and participants look for ways to recover their investment, it will be too late at that point to cure inadvertent franchise status.  Proper structuring requires a separate analysis of the laws in each state where the joint venture will operate or the joint-venture participants reside.  While the restaurateur may complain that its competitors, indeed the entire restaurant industry, engage in these arrangements routinely, unfortunately the fact that everyone else is breaking the law will not excuse the restaurateur’s own noncompliance.

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