International franchising: key legal issues

The article is the second in a two-part series on international franchising and looks at some of the key legal issues that often arise in international franchising.^₍₁₎ 

Planning stage

Is it possible to own/license intellectual property in the “system”?
First, it is important that franchisors make sure they own or can license all aspects of the “system”. If they are already franchising in their home market, this is less likely to be an issue, but if international expansion is their first exposure to franchising, they need to carry out a thorough audit of their intellectual property (IP).

A common pitfall is copyright ownership; it must be assigned in writing. Failing to do so means it belongs to the author. If a franchisor has engaged a third party to write their manual, create store designs or marketing materials or software, but the terms of engagement do not cover copyright assignment, they may find themselves having to pay twice.

Trademark strategy
Second, businesses should invest prudently to ensure that each target market will be underpinned by registered trademarks, design rights (if appropriate) and domain name registrations. This is a costly exercise, but the cost (ie, financial, loss and opportunity) of dealing with pirates and cyber squatters or claims from local third parties with prior rights far outweighs the upfront protection costs.

Some international jurisdictions operate a “first to file” system, meaning that if a franchisor does not make its application early, it might have to pay a hefty fee to remove an incumbent registrant. Thus, franchisors should consider registering a version in local language, but ought to beware of transliteration issues. It is also important that they don’t accept franchisee offers to register on their behalf.

Corporate structure
Franchisors ought to think about their structure. As they enter more international deals, they will increase their overall legal risk. Thus, it is sensible for them to ring fence their core IP and trading businesses from their licensing businesses. This exercise can then trigger discussions around intra-company services and money flow, tax and accounting. Getting to this place early can save headaches in the future.

Pre-contract stage

Knowing prospective franchisees
Before entering into a franchise agreement, it is important for a franchisor to know:

• who their prospective franchisee is;
• the identity of their owners; and
• the owners’ business interests

This can be an awkward conversation to have when the parties are still discussing the potential deal, but the sooner it happens, the better. This prior knowledge might have an impact on terms the franchisor needs to include such as the following questions.

• Does the prospective franchisee have any competing business interests?
• Do they operate using affiliated or third-party operators (in which case the documentation needs to regulate the multi-tiered relationship appropriately)?
• Is there an issue under any sanctions laws and do they have sufficient capital?

 It is also important to ensure that any preliminary documentation enables franchisors to back out of a deal without problems.

Agreeing key legal and commercial terms
In several jurisdictions, it is a legal requirement for a franchisor to issue a disclosure document, or make “adequate disclosure,” about a franchise system before the franchise agreement is signed. It serves to protect both franchisor and franchise. From a franchisor’s perspective, a key litigation risk is misrepresentation, and the process of pre-contractual disclosure can help reduce and limit that exposure. It also encourages franchisors:

• not to oversell the franchise;
• to be realistic;
• to manage expectations; and
• to provide honest, reliable financials.

Contracting lifecycle

Regulation of sales process
There isn’t a uniform approach regarding disclosure. Countries such as the United States, Canada, Australia and China require set form pre-contractual disclosure.  Key disclosure issues include:

• the “how” and “when” the disclosure must be made;
• mandatory cooling off periods before the deal can be finalised;
• the scope of the content of the sales; and
• disclosure documentation.

The consequences of failure to comply with disclosure requirements vary. Non-compliance generally entitles the franchisee to walk away from the agreement without restrictions, provided it acts within a reasonable period of entering into the agreement. The franchisee can also sue the franchisor for damages.  Some jurisdictions also impose fines for failure to comply.

Some jurisdictions require the franchisor to register only relevant details, while others require registration of all the documentation. In developing markets, this is to enable the government to monitor franchisors doing business in the market, while in more developed economies (eg, USA and Spain) it is to ensure transparency and maintain a certain level of quality.

In some countries, there are multiple registration requirements.  For instance, franchisors in China who sell franchises in just one province must file the information at the local office of the Ministry of Commerce (MOFCOM) of that province, whereas for cross-province franchising, the papers have to be filed with MOFCOM itself.

Franchising is also regulated by a variety of general laws including consumer law which must be considered. 

Relationship laws
Franchise specific laws in certain countries impose mandatory contractual terms in the franchise agreement.  These often include a minimum term, a duty of good faith and restrictions on termination and post termination non-competition clauses.  These mandatory provisions may impact on the proposed business model and change the terms of the commercial deal on offer.

General commercial laws
Several markets regulate franchising specifically and other markets have general rules and duties which confer certain protections on franchisees, either during the sale process and/or during the term and/or at the end of the relationship

Some markets require franchisor registration and translation of agreements. Some also conflate consumer protection laws with franchising (eg, Germany and South Africa) and a franchisee might get a cooling off period after signed an agreement before it becomes fully enforceable.

During the term, certain restrictions may apply to the freedom to contract, such as:

• general duties of good faith or regulation of specific issues;
• territorial restrictions;
• pricing;
• advertising;
• non-competes; and
• termination rights.

There can even be restrictions on how franchisors get their money out of the market (eg, bank approvals for royalties above a certain threshold).

Other areas of current risk include the application commercial agency rules in the Middle East and joint employer liability in markets (eg, the United States, Canada and Australia).

Comment

In summary, when entering the international franchising arena, franchisors should:

• develop a set of commercial and legal terms which they can then use to benchmark against prospective deals;
• align their trade mark portfolio with their franchise strategy and protect their target markets;
• audit their IP;
• know their franchisee and make sure the franchisee understands the franchisor;
• understand the legal landscape of a market before progressing too far with a deal;
• manage their credit;
• police the network; and
• know their exit strategy.

For further information on this topic please contact Kate Williams or Gordon Drakes at Fieldfisher LLP by telephone (+44 20 7861 4000) or email (kate.williams@fieldfisher.com or gordon.drakes@fieldfisher.com). The Fieldfisher LLP website can be accessed at www.fieldfisher.com.

Endnotes

(1) For the first article in this series see “International franchising expansion: key structures”.