Business Law

Opinion No. 73 / 6F

State of California Department of Corporations

Brian R. Van Camp, Commissioner 
In reply refer to: File No. _____

This letter is not an Interpretive Opinion for the reasons stated below.

Mr. Bernard J. Oā€™Malley
Attorney at Law
Connolly, Oā€™Malley & Connolly
420-430 Royal Union Building
Des Moines, IA 50309

Dear Mr. Oā€™Malley:

The request for an expression of our opinion contained in your letter dated April 12, 1972, as supplemented by your undated letter filed in this office on May 5, 1972 and your letter dated June 16, 1972, has been considered by the Commissioner. Your letters raise the question whether the agreements between Willex Products Inc. (ā€œWillexā€) and persons referred to hereinbelow as ā€œdistributorsā€, including those designated by you as ā€œdirect distributorsā€ (also referred to by you as ā€œretailersā€), ā€œwholesale distributorsā€ and ā€œmaster distributorsā€ are ā€œfranchisesā€ within the meaning, and subject to the registration requirement of the California Franchise Investment Law.

The statement of facts hereinafter set forth on which our opinion is based, reflects the Willex marketing program as described in the brochure submitted on May 5, 1972. Any conflicting statements in letters and documents submitted prior to that date have been disregarded.

We understand that Willex merchandises products for industrial, commercial, farm, and household use through a layered distribution system pursuant to a recommended copyrighted marketing plan. The system consists of the three categories of distributors mentioned above. Distributors receive discounts which vary according to their level and according to their monthly sales volume.

An individual may become a direct distributor by paying a $5 membership fee and agreeing to purchase a specified number of Willex products, literature, and sales aids from another distributor in the Willex system, referred to as ā€œsponsorā€. Any direct distributor may become a wholesale distributor by creating $1500 worth of refund volume in one calendar month. Any wholesale distributor may become a master distributor by submitting a letter request and enclosing $500 payable to Willex and copies of reorder sheets showing gross refund volume in excess of $7500 for one calendar month or a personal recommendation from a sponsoring master distributor.

You have represented that payment of a fee of $500 is required of all distributors ā€œfor lifetime accounting purposesā€ California distributors may pay this fee in annual installments of $75. After the first year, a California distributor may, at his option, pay $425 or continue to pay $75 annually. You have not informed us as to the amount, if any, of literature and sales aids which a distributor is required, advised, or otherwise motivated to purchase initially or annually.

Section 31005 of the Franchise Investment Law defines ā€œfranchiseā€ to include an agreement, either oral or written, between two or more persons by which a 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, the operation of the franchiseeā€™s business pursuant to such a plan or system is substantially associated with the franchisorā€™s commercial symbol, such as its trade name or trade mark, and the franchisee is required to pay a franchise fee. Section 31011 defines ā€œfranchise feeā€ to mean 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. Rule 011 of the Commissioner exempts from the registration requirement of Section 31110 of the Law, any offer or sale of a franchise which would be subject to registration solely because the franchisee is required to pay, directly or indirectly, a franchise fee which, on an annual basis, does not exceed $100.

In our opinion arrangements between Willex and the distributors contain all of the essential elements of a ā€œfranchiseā€ as set forth in the aforementioned definition, subject to the following observations.

In connection with the requirement of a franchise fee, you have represented that distributors make no payments to Willex, except as above stated, except for products purchased at their bona fide wholesale price, and except for equipment, such as sample cases, guides, catalogs, and other sales aids sold to distributors at prices reflecting Willex cost. You have invoked the exception which Section 31011(a) makes from the definition of ā€œfranchise feeā€ by providing that the purchase or agreement to purchase goods at a bona fide wholesale price, shall not be considered the payment of a franchise fee. Please note that this exception and that in Rule 011 are based on bona fide wholesale price and amount of payment, respectively, not on the franchisorā€™s cost.

The exception in Section 31011(a) is based on the rationale that no substantial prejudice will come to a person buying a business and paying only the bona fide wholesale price for merchandise which he proposes to sell in that business, since he can readily turn goods of established value into cash, should the franchisor fail, in any way, to provide the promised support. Well-known trade marked goods, of course, can be liquidated much easier than little known products manufactured by a new franchisor not having a substantial market identity.

Therefore, in considering the availability of the exception and in comparing what Willex may assert to be the bona fide wholesale price of its products to other items in the field, the relative value of the respective trademarks, trade names, and market identification must be considered. It is reasonable to assume that Willexā€™s products with little or no market identification, have a lower bona fide wholesale price than items, though of comparable quality, which have a marketing history and a ready identity in the market. In this connection, sales to distributors who are all within the common enterprise or marketing system, do not suffice to substantiate the ultimate marketability and market identification of the products being sold.

Moreover to the extent that distributors under their agreement with Willex are required to purchase specified amounts of products or to purchase such specified amounts within a specified period, the exceptional provision of section 31011(a) in our opinion is not available, if the amount so required to be purchased, exceeds the quantity which a reasonable businessman normally would purchase by way of a starting inventory or to maintain a going inventory. Payment for such excessive purchases is made by the franchisee not because he has a present need for or wants to acquire the goods; it is understandable only as intended to secure the right of selling them under the franchise agreement, and for that reason it constitutes a franchise fee (Mattes, The Franchise Concept, California State Bar Journal, Vol.. 47 , P. 348).

We also note that while the definition of ā€œfranchise feeā€ in Section 31011 contemplates a payment required of the franchisee, and while, therefore, an optional payment which. a distributor might make for sales aids or literature, would not be a ā€œfranchise feeā€, nevertheless if the sales aids are essential for the successful operation of the distributorship, or if they are suggested or recommended to the distributors by Willex as essential for that purpose, payment therefor, in our opinion, is ā€œrequiredā€ within the meaning of Section 31011 for the right to enter into the business and is a franchise fee (Mattes, ibid., p. 349).

In case any franchise fees do not exceed the sum of $100 on an annual basis, the exemption of Rule 011 would be available. However, this rule provides an exemption solely from the registration requirement of Section 31110, and does not affect the nature of the payments as franchise fees.

Of course, the $500 payment required of wholesale distributors who wish to become master distributors
, is a franchise fee; and the exemption of Rule 011 is not applicable to a fee in this amount, regardless of the fact that the $500 obligation may be discharged, at the option of a California distributor by annual installment payments of $75.

Moreover Section 31008 defines ā€œarea franchiseā€ to mean an agreement between a franchisor and a subfranchisor whereby the subfranchisor is granted the right for consideration given in whole or in part for such right, to sell or negotiate the sale of franchises in the name or on behalf of the franchisor. Since pursuant to Section 31010, the word ā€œfranchiseā€ in Section 31110 includes ā€œarea franchiseā€, area franchises granted by Willex are also subject to the registration requirement of that Section. If Willexā€™s arrangements with any of the distributors constitute franchises, its arrangements with distributors on each higher level constitute an ā€œarea franchiseā€ within the definition of Section 31008 of the Law, since each level of distributor makes a payment to Willex for the right to designate lower level distributors and to sell products and such payment, in accordance with the principles above set forth, constitutes a franchise fee.

In accordance with the foregoing we are not in a position to express the opinion that, under the circumstances described by you as outlined above, the arrangements between Willex and the distributors are not ā€œfranchisesā€ or ā€œarea franchisesā€ within the meaning of ,Sections 31005 and 31008 subject to the registration requirement of Section 31110 of the Franchise Investment Law. We are, moreover, of the opinion that the arrangements between Willex and the master distributors calling for a $500 payment to Willex, are ā€œfranchisesā€ and ā€œarea franchisesā€ subject to the registration requirement of Section 31110 since in accordance with Section 31153, Corporations Code, Willex has the burden of proof with respect to the exception provided in Section 31011(a), and since it would appear doubtful whether it is able to meet this burden with respect to any of the distributors, it is our recommendation that application be made for registration of the proposed arrangements with all of the distributors as franchises and area franchises in accordance with the provisions of the Franchise Investment Law.

Because of certain features of the proposed arrangements, your attention is also called to Section 327, Penal code.

Inasmuch as interpretive opinions are issued for the principal purpose of providing a procedure by which members of the public can protect themselves, against liability for acts done or omitted in good faith in reliance upon the administrative determination made in the opinion, and since there can be no such reliance where the Commissioner asserts jurisdiction with respect to a particular situation or determines that a legal requirement is applicable, advice to that effect, as contained in this letter, does not constitute an interpretive opinion.

Dated: San Francisco, California

By order of 
Commissioner of Corporations

By __________________ 
Assistant Commissioner 
Office of Policy

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