Commissioner's Opinion No. 73 / 41F

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. Michael J. Harbers
Attorney at Law
O'Melveny & Myers
611 West Sixth Street
Los Angeles, CA 90017

Dear Mr. Harbers:

The request for an interpretive opinion, contained in your letter dated April 16, 1973, has been considered by the Commissioner. Your letter raises the question whether the arrangements between Ovation Cosmetics, Inc., a California corporation ("Ovation"), and persons referred to therein and hereinbelow as "Sales directors" and "distributors" are franchises within the meaning of Section 31005, and subject to the provisions of the Franchise Investment Law.

You have represented that Ovation is engaged in the distribution of a diversified line of cosmetics, fragrances and food supplements. These products are sold to independent sales directors who sell the products at retail and also recruit, train, service and sell to independent distributors. In certain instances, such as when a distributor is 50 miles or more from a sales director, Ovation sells its products directly to distributors. Both sales directors and distributors sell the products to the public door-to- door. An individual, desiring to become a distributor, signs an application for appointment as a distributor and for membership in the ovation Distributor Association, a California nonprofit corporation ("Association"), created to protect the rights of the sales directors and distributors and to provide an organization in which they can exchange ideas with respect to the best way to sell ovation products. Agreements with distributors are nonexclusive contain no minimum requirements, no quotas and no specified territories. Distributors are not prohibited from engaging in any other business or selling products competitive with Ovation products.

You have further represented that the ovation marketing plan provides for a basic discount of. 35% of an individual's Total Monthly Refund Volume ("R.V."). R.V. is the suggested retail price of the aggregate monthly sales of the products less a surcharge which varies according to the type and bulk of the products and which represents part of the cost of warehousing, handling and promoting the sales of the products. On an overall basis, the surcharge represents approximately 3% of the suggested retail price. In addition to the basic discount, the sales director and distributor receive a monthly sales bonus in cash based upon the aggregate amount of products the individual purchases and products purchased by other distributors he has recruited. The sales director and distributor, in turn, pay a bonus on the same basis to other distributors they have recruited. The refund ranges from nothing for a monthly R.V. of $49.99 or less to a maximum of 25% of a total monthly R.V. of $2,500 or more.

A distributor may become a sales director if he achieves and sustains prescribed levels of R.V. during each calendar year. Sales directors receive only slight financial benefits over distributors since the cash refund is based upon his monthly R.V. and the monthly R.V. of other distributors and sales directors he has recruited. The sales director does obtain the right to become a voting member of the Association and thus represents his group in establishing policy. The only financial incentive to sales directors, but not to distributors, is a 1/2% bonus paid to "Emerald Directors", who are sales directors who personally sponsor three or more qualified sales directors, each of whom was in the 25% refund bracket at least five months during the preceding calendar year. There are no fees paid to ovation by an individual to become a sales director.

Section 31005 of the Franchise Investment Law defines "franchise" 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 franchisee's business pursuant to such plan or system is substantially associated with the franchisor's commercial symbol, such as its trade name or trademark, and the franchisee is required to pay a franchise fee. Section 31011 defines "franchise fee" 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, including, but not limited to, any such payment for goods and services. The purchase or agreement to purchase goods at a bona fide wholesale price is not considered the payment of a "franchise fee" pursuant to Section 31011(a), and Rule 011 of the Commissioner exempts from the registration requirement of Section 31110 of the Law, an 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.

We do not concur in your opinion that Ovation does not prescribe a marketing plan or system in substantial part. In your letter, you have represented that Ovation's sales plans, also referred to by you as "the Ovation marketing plan", is "basically a method of motivating the distributors to sell the product" through a layered system whereby sales directors and distributors are encouraged, by the prospect of increased R.V., not only to personally sell ovation products but to recruit other individuals to sell Ovation products door to door. In our opinion, such a pyramid plan, especially when it is the only plan of distribution, constitutes a marketing plan or system prescribed in substantial part by ovation. In reaching this conclusion, we have also considered your representations that ovation has suggested retail prices for its products, that sales directors train distributors, and that both sales directors and distributors must join Association.

In connection with the requirement of a franchise fee, you have represented that sales directors and distributors make payments to Ovation, except for a $3 membership fee in the Association and a one-time charge of $44 for the sales kit, only for products at a bona fide wholesale price, and you have invoked .the exception which Par. 2(a) of Section 31011 makes from the definition of a "franchise fee" by providing that the purchase or agreement to purchase goods at a bona fide wholesale price cannot be considered the payment of a franchise fee.

This exception 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 goods 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 trademarked goods, of course, can be liquidated much easier than little-known products manufactured by a new franchisor not having a substantial identity. In this connection, you have represented that Ovation's products are standard products similar to and competitive with those sold by many of the manufacturers but you have failed to supply us with any comparable wholesale retail prices.

We understand that sales directors and distributors pay ovation for its products a price which is computed by applying to the suggested retail prices of the products various discounts. You have further represented that the retail prices, to which these discounts are applied, are competitive. As regards the price variations which you have represented are observed between sales directors and distributors based on volume of purchases, the Commissioner has taken the position that such variance at different levels of distribution does not necessarily lead to the conclusion that the higher price paid by persons on the lower level constitutes a franchise fee.

However, you have represented that included in the price which sales directors and distributors are required to pay, is a 3% surcharge on account of the cost of warehousing, handling, and promoting the sales of Ovation products. In determining whether the prices, which sales directors and distributors under the arrangements in question are required to pay for ovation products, exceed the bona fide wholesale price of such products, this 3% surcharge must be considered as part of the price paid for the products by the sales directors and distributors. Accordingly, Ovation cannot rely upon the exception provided in Paragraph 2(a) of Section 31011 from the "franchise fee" definition, if the price paid by the sales directors and distributors, less all applicable discounts, but increased by the 3% surcharge, exceeds the bona fide wholesale price of such products, even if such excess is attributable only to that 3% surcharge.

Whether the price actually paid by sales directors and distributors after all discounts but, as above stated, increased by the 3% surcharge exceeds the bona fide whole price (or exceeds it by an amount in excess of the tolerance allowed by Rule 011) is a question of fact which we will not resolve in an interpretive opinion, since such opinions are limited to the interpretation of, and the determination of legal questions arising, under the Law (Dept. of Corps. Release No. 2-F).

Section 31153 of the Law imposes the burden of proving an exemption exception or an exemption from a definition upon the person claiming such exception or exemption. Accordingly, the burden of establishing the fact that ovation is selling its products at their bona fide wholesale price is upon Ovation and, in our opinion, your letter does not enable us to conclude whether this burden has or has not been met.

We understand you to also suggest that distributors pay no franchise fee to ovation because, if a distributor wishes to return any Ovation products for credit or cash, he may always do so, less a 10% of R.V. handling charge provided that certain reasonable conditions are met. In our opinion, this arrangement does not, by itself, lead to a conclusion that distributors are not paying franchise fees, since their refund does not include the 10% handling charge and, for a period of time, they lose the use of funds until the refund is made.

Accordingly, it is our opinion that the arrangements between Ovation and the sales directors and distributors are "franchises" within the definition of Section 31005, because of the payment of the $3 membership fee and the $44 charge for the sales kit. Moreover, since we do not know whether ovation is able to meet its burden of proving that prices which it charges for its products to the sales directors and distributors, including as above stated the 3% surcharge, do not exceed the bona fide wholesale price of such products, we cannot conclude that the arrangements are exempt from the registration requirement of Section 31110 of the Law by virtue of Rule 011.

We understand that sales directors may recruit other sales directors and distributors and that distributors may recruit other distributors. Section 31008 defines "area franchise" as an agreement between a franchisor and 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 a franchisor. According to Section 31009, a "subfranchisor" is a person to whom an area franchise is granted. Section 31010 provides that the term "franchises" where used in the Law, unless specially stated otherwise, include "area franchise". Since Ovation's arrangements with the sales directors and distributors constitute franchises, its arrangements with sales directors and distributors whereby sales directors and/or distributors may be· recruited, constitute "area franchises" within the definition of Section 31008 of the Franchise Investment Law.

Because of certain features of the arrangements, your attention is 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
October 29, 1973

By order of
BRIAN R. VAN CAMP
Commissioner of Corporations

By __________________
J. DOMINIQUE OLCOMENDY
Supervising Corporations Counsel
Office of Policy