Incoterms_® and Commercial Contracts

1.1 SCOPE

The main scope of this publication is to deal with the issues that arise when a company that has a franchising network decides to go international, through the means commonly used for this purpose, such as Master Franchise Agreements (MFA) and Area Development Agreements (ADA).

While the publication is directed mainly to businesses that have developed a franchise system and wish to expand abroad, it may also be of interest to companies that currently do not engage in franchising but sell products or services that can be distributed through a franchising network.

Unless the Franchisor decides to enter the foreign market through a subsidiary, or to directly appoint Franchisees abroad (which may sometimes be feasible in neighboring countries), it will need to have recourse to third parties to manage the foreign local market. The two main options are (i) to appoint a Master Franchisee, who will establish a network of Sub-Franchisees, or (ii) to appoint an Area Developer, who will establish an agreed number of units of its own in the area granted to it.

Whatever the mechanism used, the Franchisor will need to consider the characteristics of the area where the franchising network will be established, in particular possible cultural differences and constraints due to different legal rules, as well as other factors discussed in this publication.

Thus, for instance, the products (or services) or the way they are sold in the Franchisor’s country may not be appropriate for the local market. Or it may be that the service to be provided by the Franchisee is subject to restrictions or prohibition in the target country.

The purpose of this book is not to guide the reader through all the business decisions it may take when going international, but instead to concentrate on the legal implications of such choices. In so doing, however, we will consider business issues relevant to the legal issues that arise.

1.2 TERMINOLOGY

What is Franchising?

The concept of franchising as it is understood in common usage may need to be distinguished from a legal concept that may vary from country to country according to the choices made by domestic legislators.

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The general (non-legal) concept of franchising cannot be defined rigidly since people have different opinions on what characteristics are present in a ‘franchising’ arrangement.

In general terms, franchising can be defined as a distribution system grouping a number of retailers who sell products or provide services in locations characterized by a common image and a uniform format developed by (and imposed by) the Franchisor, and who benefit from the image and the commercial Know-how developed and owned by the Franchisor. Franchisees may have an obligation to pay Franchise Fees (but Franchisees reselling Franchisor’s products may not have this obligation); the Know-how may not always be an essential element. Networks where the only element supplied by the Franchisor is a strong image are called franchising by many people.

This means that when people speak in general terms of franchising, they may mean either a wider concept, covering all types of retail distribution characterized by a common image and format, or a more narrow one, covering only the more typical situations where the Franchisor provides important Know-how in consideration of remuneration (Franchise Fees), sometimes called ‘business format franchising’. In this Guide, we cover the latter, narrower, concept.

The legal concept of franchising is the result of a choice made by the lawmakers in various countries and is determined mainly by the language in the respective statutes.

In some countries the law uses a wide definition, with the purpose of covering all those who need to be protected (e.g. through rules on disclosure), as for instance in France, where the rules on disclosure also apply, under certain circumstances, to distributorship contracts (‘contrats de concession’).

In other countries a narrower definition is used. For example, in Italy the rules on disclosure apply only to franchising contracts that imply the payment of remuneration to the Franchisor and the supply of Know-how to the Franchisee, while less “typical” franchises (Benetton shops, for instance) remain outside the reach of such law.

Likewise, European antitrust rules provide certain benefits only to Franchise Agreements where the Franchisor supplies secret, substantial and identified Know-how.

Consequently, to verify whether a contract complies with a given national law on franchising, the parties must determine whether the agreement falls under the definition of franchising in the applicable laws.

1.3 DEFINITIONS USED IN THIS GUIDE

As in many legal disciplines the terminology in franchising and distribution law varies from country to country, from civil law to common law jurisdictions and among different areas of business. For purposes of this book we have chosen to define some of the concepts frequently used in the legal context of franchising. In some definitions we will mention other terms used for the same concept and try to define the difference in use, if any. This list is not exhaustive and we do not claim that these are the only definitions.

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We have had great help in this section from Canadian attorney Leonard Polsky who wrote about definitions in a paper presented at an IBA/IFA Legal Conference in 2012².

1.3.1 Parties

• Area Developer A Franchisee who has the obligation to open more than one Unit during a specified time within a specific area, and who has no Sub-Franchise rights.
• Area Representative A person or entity (that may be a Franchisee itself) that assists the Franchisor to identify Franchisees and assists in supporting those Franchisees. The representative does not act on its own account but in the name of and on behalf of the Franchisor, thereby creating a franchise relationship between the Franchisor and the Franchisee. The representative can be called different names, such as “Development Agent,” “Franchise Broker” or “Service Provider.”
• Franchisee A Franchisee is the counterpart to the Franchisor in a Franchise Agreement. The Franchisee is allowed by the Franchisor to use the System in exchange for remuneration. The Franchisee can be a single-Unit operator or a Multi-Unit operator.
• Franchisor The Franchisor is the ultimate owner of the System and the one allowing others — Franchisees, Master Franchisees and Area Developers — to use the System, including the trademark, products and other material or immaterial components.
• Master Franchisee A Franchisee who may not only open more than one Unit during a specified time within a specific area, but also has the right to sub-franchise to others — Sub-Franchisees (see below) — to open up Units during that time and within the specified area. In some publications and laws the Master Franchisee may be referred to as sub-franchisor in its relationship to Sub-Franchisees. In this book, we will use only the term Master Franchisee regardless of the situation.
• Sub-Franchisee A Franchisee who has a Franchise Agreement not with the Franchisor but with a Master Franchisee, who in turn, acts like a Franchisor within that relationship.

1.3.2 Agreements

Franchise Agreement — includes each of the following, which can be national or international:

• Area Development Agreement (ADA) A Franchise Agreement between the Franchisor and a Franchisee acting as an Area Developer. This agreement allows the Area Developer the right to open more than one Unit, during a specified time within a Territory. The ADA-Company-Owned Units may be operated either under the terms of the ADA or under Direct Franchise Agreements. In this book our examples will focus on the arrangement where the operation is concluded through Unit Franchise Agreements, which means that the ADA is limited and does not cover the operational issues.

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• Area Representative Agreement (ARA) An agreement whereby an intermediary — the Area Representative — is appointed as the representative for the Franchisor for a certain area. The powers vested in the Area Representative may differ in the agreement. At the early stage, the representative can be the development agent, finding the Franchisees to be contracted directly by the Franchisor, as would a broker or a commercial agent. In the later stage, when the franchise System is up and running, the Area Representative can be the service provider to the Franchisees regarding the support, advice and assistance that the Franchisor is obliged to perform according to the Unit Franchise Agreement.

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Direct Franchise Agreement (DFA) A Unit Franchise Agreement between the Franchisor and an individual Unit operator.

• Master Franchise Agreement (MFA) A Franchise Agreement between the Franchisor and a Master Franchisee. This agreement allows the Master Franchisee the right to own and operate more than one Unit — MF-Company-Owned Units — and the right to sub-franchise the right to open units to other independent businesses — Sub-Franchisees — all during a specified time within a specific area. The MF-Company-Owned Units may be operated either under the terms of the Master Franchise Agreement or under UFAs.

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• Sub-Franchise Agreement (SFA) A Unit Franchise Agreement between the Master Franchisee and a Sub-Franchisee.

• Unit Franchise Agreement (UFA) A Franchise Agreement between the Franchisor and a Franchisee to open and operate a Unit. When this agreement is concluded between a Franchisor and an individual Unit operator it is defined as a DFA, and when it is concluded between a Master Franchisee and a Sub-Franchisee it is called a Sub-Franchise Agreement.

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1.3.3 Fees

Typically there are fees involved in franchising transactions, but they are not obligatory in every situation. However, the most commonly used fees are an Initial Fee, an ongoing fee — here called the Franchise Fee — and a separate Marketing Fee. As these fees have many different names, we have decided, for the purposes of this book, to define them as follows. Fees are not necessarily required or included in all forms of Franchise Agreements and other types of fees may be charged, such as reservation fees (see § 8.2.6).

• Initial Fee Fee paid by Master Franchisee or Area Developer to Franchisor for access to the System in a geographic area. The Initial Fee is usually paid at the inception of the relationship.
  
  When entering a franchise System, most Franchisors and Master Franchisees demand some payment to cover their investment in the System, the cost for recruiting Franchisees and Sub-Franchisees and the cost for preparing the business for franchising. This fee may also be named “up-front fee,” “franchise fee,” “unit franchise fee” etc. We have decided to use the term Initial Fee.
• Franchise Fee Fee paid for the on-going services provided by the Franchisor or Master Franchisee as remuneration for the use of the System. The Franchise Fee may also be called “royalty,” “continuing fee,” “service fee” etc. We have decided to use the term Franchise Fee.
  
  In connection with this definition we would like to stress the importance of seeking tax and legal advice in the target market, especially in international agreements. For example, the Franchise Fee may be differently taxed due to double taxation treaties between different countries. If, for example, a Franchise Fee is called a “royalty,” the double taxation treaty may have a regulation of royalty taxation that will be used on the payment just because of the definition. On the other hand, if the Franchise Fee is called “service fee” the Franchisor may have to prove that services are provided to avoid withholding tax.
• Marketing Fee In many franchise Systems the Franchisor has separated the marketing costs from the costs covered by the Franchise Fee. The purpose of this separation is usually to be able to show that all revenues in this respect are used for marketing purposes. In some Systems the marketing is totally separated in a separate legal entity. To be consistent in this respect, the Franchisor needs to separate the revenues as well and does that by adding a special fee for the joint marketing purpose. This is sometimes called an “advertising fee.” Regarding this fee, we have decided to use the term Marketing Fee.
• Other Fees What is deemed to be a fee in some jurisdictions could be broader than the three direct payments described above. For example, in the United States, the Federal Trade Commission Franchise Rule talks about a “required payment,” which is “all consideration that the franchisee must pay to the franchisor or an affiliate, either by contract or by practical necessity, as a condition of obtaining or commencing operations of the franchise”³. Consideration is not defined, but it implies something more than direct payment. A
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  “required payment” does not include payments for the purchase of reasonable amounts of inventory at a bona fide wholesale price for resale or lease⁴. The FTC Compliance Guide gives examples of various required payments (initial franchise fee, rent, ad assistance, security deposits, promotional literature, continuing royalties, etc.)⁵.
  
  The state laws have additional definitions. In Illinois, for example, the Franchisee must be required, directly or indirectly, to pay a franchise fee6. “Franchise fee” does not include the purchase of goods that have an established market at a bona fide wholesale price7. The regulations say that an indirect franchise fee can include situations where the buyer is required to purchase a quantity of goods so unreasonably large that the goods may not be resold within a reasonable time. There is also a separate regulatory provision describing what constitutes a bona fide wholesale price. Another regulatory provision says a payment for equipment, materials, real estate services or other items is not a franchise fee if the purchase is not required by the Franchisor, or the Franchisee is permitted to purchase the items from other sources and the item is available from other sources. Rental payments for the economic value of property are not indirect franchise fees8. California law, regulations and releases are similar.

1.3.4 Other definitions

• BER The Block Exemption Regulation on Vertical Restraints in the EU (Commission Regulation (EU) No. 330/2010).
• Candidate The subject — a natural person or a legal entity — that might become a Franchisee. In other publications this subject may be named “prospect”, “nominee”, “franchisee-to-be” etc. We have decided to use the term Candidate.
• Company-Owned Unit A Unit operated by a Franchisor or a Master Franchisee on its own.
• Know-how The package of non-patented practical information, resulting from experience and testing by the Franchisor, that is deemed by the Franchisor necessary or useful for the operation of the business. Such information may be in writing (e.g. in the manual) or transmitted orally (e.g. in the context of training).
  Be aware that the definition of ‘Know-how’ is much debated in the context of legislation, disputes and such, and may have different meanings in different statutes and contracts. The term is used frequently throughout this Guide.
• Multi-Unit The Franchisor as well as some Franchisees may operate more than one Unit. They will then be referred to as Multi-Unit operators.
• System The intellectual property rights, Know-how, confidential information and distinctive business format and methods implemented by the Franchisor in connection with the business comprising, without
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  limitation, certain operational methods and techniques, technical assistance and training in the operation, management and promotion of the business, specialized reporting, bookkeeping and accounting methods and documents, and advertising and promotional programs, all of which may be changed, improved and further developed by the Franchisor and part of which is set forth in the manual. In the United States, this is sometimes called a “marketing plan or system.”
• Territory In many Franchise Agreements the Master Franchisee, Area Developer, Area Representative, Sub-Franchisee or Franchisee will be granted a geographic area in which he or she may market and sell the goods or services covered by the Franchise Agreement. We have decided to use the term Territory for this area.
• Unit The place where a Franchisee carries on its business. As different franchise Systems have different types of “units”, other definitions may be used, such as “outlet,” “shop,” “restaurant,” “premises” etc. To keep it neutral regardless of the franchise System, this publication uses the term Unit.

1.4 COUNTRY ASSOCIATIONS, WEBSITES

Many countries have national franchise associations whose members include Franchisors, Franchisees and other organizations involved in franchising. Included in Annex 6 is a list of the franchise associations in 45 countries. The list includes the contact information and websites for each organization and the World Franchise Council, an organization composed of national franchise associations. A link to the World Franchise Council’s membership list is: www.franchiseassociation.org.nz.

1.5 DISCLAIMER FOR FRESHNESS OF INFORMATION

Factual information in the text — such as lists of member states of the European Union — has been updated as of 1 October 2013.

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