When Cannabis and Franchise Laws Collide

Franchising has the potential to solve some of the biggest roadblocks to expansion for businesses

In May 2019, Franchise Times, a respected franchise industry publication, recognized 11 winners of its 2019 Dealmakers Award, spotlighting the “boldest players driving mergers and acquisitions in franchising” during the last year. All but one of the showcased deals involved traditional franchise business sectors including restaurants and senior care. The outlier, ONE Cannabis, is the first cannabis franchisor to gain recognition from a mainstream franchising audience.

It is not headline news that America’s fastest-growing industry has harnessed one of America’s most popular business expansion engines — franchising. The headline is that only a few years ago franchise attorneys questioned if franchising in the cannabis industry was even possible given the significant legal risks and business obstacles preventing cannabis franchisors and franchisees from conducting everyday commercial activities in a regular way.

4 October 2018, Wuhan China : Exterior of KFC franchise.

Why Franchise?

Whether the underlying business involves cannabis, fast food or some other goods or service, franchising solves the two biggest roadblocks to any businesses’ expansion: capital and labor. Franchising enables a brand owner to expand its footprint by using other people’s money (the franchisees’) without taking on debt by awarding a trademark license to an independent business owner (the franchisee) conveying the right to own and operate a cloned replica of the franchisor’s business.

Franchisees hire and supervise their own workforce and must follow the franchisor’s brand standards so that the business operationally is comparable to all other licensed locations that identify themselves by the franchisor’s brand.

The franchise model offers franchisees the opportunity to be in business “for themselves, but not by themselves,” motivated by the opportunity to keep all of the profits of their business after paying the brand owner specified franchise fees. Franchise programs classically offer franchisees benefits of scale that they cannot replicate on their own, like training programs, marketing tools and the purchasing power of a large network that can reduce their overhead costs for inventory and supplies.

Factors commonly associated with successful franchising — having a loyal customer base, brand recognition and a recession-resistant, sustainable business concept — easily translate to cannabis franchising where consumer demand for cannabis and CBD-infused products seems certain to remain vigorous and long-term.

 

Additional legal risks

Compared to their non-franchise competitors, cannabis franchisors face extra regulatory barriers to entry and legal risks due to their franchise status (the same rules apply to franchise arrangements across all industries). Two of the three types of laws, franchise sales and business opportunity laws, require registration with a state agency in order to offer the business program in the state, which gives states gatekeeping authority to keep out programs they consider too risky for their residents. The third law dictates substantive terms for contracts that qualify for protection.

In the five “deep green” jurisdictions — Colorado, District of Columbia, Massachusetts, Nevada and Vermont — cannabis sales are fully legal and no state-level franchise laws exist.

However, in the 24 “light green” jurisdictions, cannabis is fully or partially legal and there is one or more state franchise laws, which presents a whole different set of challenges for cannabis franchisors.

CHONBURI – THAILAND- MARCH 22, 2017 : Restaurants at Motorway Rest Area where located middle way to PATTAYA city. It is the good place for tourist to find familiar food.

Franchise Sales Laws

Franchise sales laws govern the formation of commercial arrangements defined by statute as “franchises” and impose stringent presale disclosure requirements on franchisors. There are both federal and state laws regulating franchise sales. The federal law administered by the Federal Trade Commission (FTC) regulates franchise sales in all 50 states. While the federal law does not preempt state laws, there is no federal filing requirement or registry. There has also been no active FTC enforcement in the last decade.

For cannabis franchisors, the immediate challenge is similar to the one they face in securing banking and insurance services: Even if they comply with the strict letter of the federal franchise sales law, the underlying franchise business is illegal under federal law. It may be no coincidence that cannabis franchisors like ONE Cannabis operate in Colorado, a legalized state with no franchise sales or business opportunity law, and where there is essentially no federal supervision of franchise sales practices. In complying with pre-sale disclosure requirements under the federal franchise sales law, cannabis franchisors reportedly load their disclosure document with cautionary language warning that, despite state legality, technically the federal government could shut down a franchisee’s operation or the franchisor’s (which would have the same effect).

Twelve states (collectively, the “franchise registration states”) add some type of duty to file or register with a designated state franchise agency vested with enforcement authority. There are three franchise registration states where cannabis is fully legal: California, Michigan and Washington. At least one franchisor successfully registered its franchise program in Washington; it is unknown if any franchisor has tried to register in Michigan; and, so far, California’s franchise agency has refused registration to any cannabis franchise. Since franchise registration states have discretion to deny registration to franchises of any kind that they believe present an unacceptable risk to their citizens, it would be difficult to challenge a franchise agency’s decision denying registration to a cannabis franchisor given the federal illegality of cannabis.

If what is past is prologue, the next franchise registration states where cannabis may become fully legal are those where medicinal cannabis is legal now: Hawaii, Illinois, Maryland, Minnesota, New York, North Dakota and Rhode Island (the Illinois governor in June signed a bill that will officially legalize cannabis in 2020). As entrepreneurs seek a piece of the $150 billion and growing cannabis market and test out franchising to accelerate their brand’s growth, pressure will surely mount on state franchise agencies to open their gates to allow cannabis franchises.

 

Business Opportunity Laws

Similar to franchise sales laws, both a federal law and many more states govern the sale of commercial arrangements that qualify as “business opportunities,” which are another type of continuing commercial arrangement that may, or may not, involve a trademark license, and which impose stringent presale disclosure requirements and, at the state level, registration duties.

Companies that comply with franchise sales laws are exempt from business opportunity laws. Like franchise regulation, sellers of cannabis-related business opportunities face a similar federal and state conundrum: Even if they comply with business opportunity laws, the underlying federal illegality of the business may nullify their compliance efforts and prevent state agencies from registering these programs.

 

Franchise or Dealer Relationship Laws

Existing in some form in 24 states, these laws govern the substantive terms of the parties’ relationship with most requiring “good cause” for termination or non-renewal of contract rights.

Relationship laws override any conflicting terms in the parties’ contract. It is often in the context of a termination dispute that a company first discovers that its licensing program is a franchise, with the plaintiff challenging the termination as a violation of a state relationship law’s substantive or procedural protections. A number of relationship laws include choice of law and venue provisions that supersede contract provisions to the contrary. A terminable-at-will contract clause is unenforceable in a good cause jurisdiction even if the franchisee’s attorney actively negotiated the provision and the contract allows the franchisee to terminate without cause.

Cannabis entrepreneurs thinking they can avoid franchise and business opportunity laws by calling their licensing program by another name will suffer the same fate as other so-called “accidental franchisors.” Among other legal risks, violating franchise laws may expose a franchisor’s management and owners to personal, joint and several liability despite the fact the franchisor is a legal entity; lawyers who overlook franchise laws may be guilty of malpractice and potentially liable to victims of their client’s wrongdoing.

 

Conclusion

A rush of new franchisors staking their place in the nascent cannabis marketplace is sure to follow ONE Cannabis’ mainstream recognition. Regulatory complications notwithstanding, the meteoric rise of the cannabis industry offers intrepid entrepreneurs a ground floor opportunity to “McDonaldlize” a highly fragmented collection of small, mom-and-pop players and roll them up under a common brand to sell all sorts of cannabis and CBD-infused products and services to a broadening consumer audience eager to buy.

From cannabis dispensaries and restaurants serving edibles to home health care, pet care and more, there seems boundless potential for franchising.

It remains to be seen if cannabis franchisees will be profitable, if they can compete with non-franchised cannabis businesses after paying royalty and marketing fees on top of the high cannabis taxes and above-normal overhead that plague all cannabis retailers, and if cannabis franchisors can deliver proven business models as promised, factors that will determine if cannabis franchising is sustainable.

However, if cannabis’ regulatory history teaches us anything it is that governments eventually find ways to accommodate public demand so there is every reason to expect the extra regulatory obstacles facing cannabis franchisors will ease at the earliest sign of federal accommodation of cannabis if not before.

 

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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