Are You Required to Pay a Portion of Your Profits on Extra-Territorial Sales to Another Franchisee? This May Be an Illegal “Profit Passover”

As a franchisee, when you make a sale, you are required to pay a percentage of the revenue to your franchisor. This is known as a “royalty,” and it is a hallmark of the franchise relationship.

But, are you also required to share a portion of your profits with…another franchisee? In some franchise systems, franchisors institute fees that are commonly referred to as “profit passovers.” Essentially, when one franchisee makes a sale in another franchisee’s territory, the selling franchisee must “pass over” a portion of the profits to the owner of the territory. This is most common in systems with what are known as “areas of primary responsibility” – non-exclusive territories in which franchisees are incentivized to focus their marketing activities.

Why Are Profit Passovers Required?

The theory behind profit passovers is that they are intended to compensate the non-selling franchisee for future sale-related obligations. Profit passovers are most common in product-based franchise systems, where franchisees are often responsible for service, warranty and other obligations owed to customers in their areas of primary responsibility. Since the non-selling franchisee now bears a risk of loss in the event of a service or warranty call, that franchisee – at least in theory – deserves to be compensated for the sale.

When is a Profit Passover Requirement in a Franchise Agreement Unlawful?

However, profit passovers can raise certain antitrust implications as well. When franchisees profit less from sales made in other franchisees’ territories, they are disincentivized to make extra-territorial sales. This means that so-called “intrabrand” competition is less likely, and this means that consumers may end up being forced to pay non-competitive pricing.

As a result, in order to be legally enforceable, as a general principle profit passover provisions should be carefully tied to the non-selling franchisee’s actual potential costs. When profit passover provisions bear no demonstrable relation to the non-selling franchisee’s costs, they are more likely to constitute penalties in restraint of trade.

In many cases, franchisors – especially those with immature systems – will essentially choose arbitrary profit passover rates. This can be a mistake, and one that can justify franchisees in bringing antitrust actions against their franchisors.

Do You Need to Challenge the Profit Passover Provision in Your Franchise Agreement?

If your franchise agreement contains a profit passover provision, it is worth having your franchise agreement reviewed by an experienced attorney. Franchise attorney Jeffrey M. Goldstein regularly assesses franchise agreements both for prospective franchisees and in the context of litigation, and with over 30 years of experience, is intimately familiar with the antitrust and other complex issues involved in many one-sided franchise relationships. If your franchise agreement’s profit passover provision is unlawful, you should not have to pay, and Jeffrey M. Goldstein can help you seek appropriate redress through arbitration or in the courts.

Schedule a Free Consultation With Franchise Attorney Jeffrey M. Goldstein

If you would like to speak with franchise lawyer Jeffrey M. Goldstein about the profit passover provision in your franchise agreement, contact the Goldstein Law Firm for a complimentary consultation. With offices in Washington, D.C., the Goldstein Law Firm represents franchisees and dealers nationwide. To request an appointment, call 202-293-3947 or send us your contact information online today.

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