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Copyright © International Chamber of Commerce (ICC). All rights reserved. ( Source of the document: ICC Digital Library )
by Emily O’Connor
Chapters 7, 8 and 9 discuss some of the issues arising in the preparation of MFAs, ADAs and SFAs, respectively. Note that this discussion does not set out every business term typically included in such contracts, but rather highlights only those warranting particular explanation. At Annex 4, you will find more comprehensive checklists of provisions typically to be included in each of the three kinds of agreement.
The purpose of an introduction/preamble is to provide information on core issues in such a way that it describes the key elements of the agreement and accurately reflects the intentions of the parties when entering into the agreement. As such the introduction/preamble can serve as the general context within which the entire agreement is to be interpreted and thus as a reference tool in the event of disputes.
With a view to the general purpose of the introduction/preamble, it is recommended that the following key elements be included:
The mutual objective of the agreement will typically be to further develop the System in a specific geographical Territory and to make this possible by the Franchisor granting the Master Franchisee the right to use the System, a trademark license and a license for the use of any other intellectual property right and to grant franchises to Sub- Franchisees within the limits provided for in the agreement.
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With regard to the above, key issues that need to be addressed generally include:
The geographic Territory assigned to the Master Franchisee should be clearly defined. The parties can opt for expansion and/or reduction of the Territory dependent on the attainment or non-attainment of specific and clearly defined targets (either in terms of turnover realized or the number of sub-franchised Units opened or a combination thereof).
In general Master Franchisees will want to be granted exclusivity for the assigned Territory in return for the investments they are to make for the development of the franchise business in that Territory. If no limitations are made with regard to the exclusivity, this usually means that the Master Franchisee has the unconditional right to franchise the business in the assigned Territory to the exclusion of any other third parties including the Franchisor itself.
It is not uncommon that the Franchisor already operates its own Units in the Territory. In such cases it is advisable to make it clear in the contract that the Master Franchisee is granted the sole rights for the assigned Territory so as to distinguish from exclusive rights as referred to above.
Although not very common, it may also happen that no form of exclusivity is granted for the assigned Territory and that competition from the Franchisor and other Franchisees either in the same or in a different business format is included. In such cases it is recommended to define the rights as shared rights.
It is therefore important to clearly define the character of the rights granted in order to avoid potential disputes regarding its scope.
The use of the Know-how constitutes the core of a System consisting of commercial and/or technical information that usually is secret, substantial and indispensable for operating the franchise. The Know-how covers written materials such as the operation manual but can also be provided orally in the form of training programs. The use of the Know-how can be protected through confidentiality obligations in conjunction with non-compete obligations. Confidentiality obligations should survive the term of the agreement and remain in force until (parts of) the Know-how has entered into the public domain. Non-compete clauses should usually cover the entire term of the agreement and for a certain post-contractual period depending on the applicable legal rules in that area51.
License of the trademark and a right of the Master Franchisee to sub-license the trademark is, like the Know-how, a vital element of a System. Attention should be paid to the limits within which the license and the right to sub-license may be used. It is, for instance, important that neither[Page90:]the Master Franchisee nor the Sub-Franchisees use the trademark in their company or business name since this may lead to confusion as to the legal status of the companies (i.e. their being independent from the Franchisor). Additionally it may create unnecessary difficulties for the Franchisor to force the Master Franchisee and/or the Sub-Franchisees to change their company or business name. It is of the essence that the trademark is well protected after the termination (for whatever reason) of the agreement and that appropriate and enforceable provisions are included in the agreement for that purpose.
In general the Franchisor should clearly define the nature of the intellectual property rights that are licensed and may be sub-licensed (e.g. trademarks, patents, copyrights, trade secrets, designs, logos, etc.).
In addition, the MFA and SFA both should address use by the Master Franchisee and its Sub-Franchisees of domain names based on the Franchisor’s trademarks. See § 4.3.2 above.
The parties’ obligations are not only restricted to the grant of rights by the Franchisor. As is the case with national and international DFAs, MFAs contain many mutual rights and obligations, the most important of which will be outlined briefly below.
The grant of rights concerning Know-how and trademarks constitutes the most important obligation of the Franchisor. However, the Franchisor’s obligations go far beyond this as it is also obliged to support the Master Franchisee in part by ensuring initial and on-going training. The Franchisor may also be obliged to supply the Master Franchisee and its Sub-Franchisees with products or raw materials, technical and/or commercial assistance, and to correct errors within the System.
The details concerning the obligation to provide training and support vary among different franchise Systems. As a result, it is necessary to negotiate the terms of this obligation beforehand and to specify them in the MFA. These specifications should include the extent and manner of training and support that the Franchisor has to provide to Master Franchisees. In this context, it is worth remembering that the terms concerning training and support should not be restricted to the operation of a franchised Unit but also include the operation of a national or regional franchise System.
Concerning the Franchisor’s obligation to provide supplies, it may be worthwhile to consider whether the Franchisor should supply Master Franchisees directly. If the parties opt for direct supply, it may be advisable for the Franchisor to reserve the right also to directly supply to the Sub-Franchisees.
However, if the parties want to provide for the grant of direct rights from Franchisor to Sub-Franchisees they should determine whether the applicable legal system permits the granting of rights to third parties not party to the MFA.
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In addition to the payment of the Franchise Fee, the Master Franchisee is also obliged to promote and apply the franchise concept. The Master Franchisee’s obligation to pay the Franchise Fee is outlined in more detail in § 7.6.
The Master Franchisee’s obligation to promote and apply the franchise concept and System is quite abstract and it is therefore necessary to specify the terms of this obligation explicitly in the MFA.
One common element of the obligation to promote and apply the franchise concept and System is the obligation for the Master Franchisee to search for suitable Sub-Franchisees and to integrate them in the System. In order to set out this obligation, the parties can agree upon a development schedule, discussed in § 7.5.
The promotion and application of the franchise System is carried out not only by the Master Franchisee itself, but also by the Sub-Franchisees selected and controlled by the Master Franchisee. As a result, the MFA usually includes an obligation that the Master Franchisee ensure that its Sub-Franchisees apply and promote the System. This obligation should be carefully articulated in the MFA to ensure that the franchise System is applied correctly by the Sub-Franchisees.
The Franchisor often wants to reserve the right to claim against the Master Franchisee for serious breaches of contract committed by Sub-Franchisees and may even insist on no-fault liability on the part of the Master Franchisee for the misconduct of its Sub-Franchisees. On the other hand, the Master Franchisee will be interested in restricting its liability towards the Franchisor for the conduct of its Sub-Franchisees to cases in which only the Master Franchisee itself can be accused of misconduct. From a legal point of view it has to be examined whether and to what extent the applicable legal system allows for no-fault liability or presumption of fault of the Master Franchisee in cases of defaults by its Sub-Franchisees. In Anglo-American legal language the liability of the Master Franchisee for the misconduct of its Sub-Franchisees is frequently called “vicarious liability”.
The liability of the Master Franchisee for the misconduct of its Sub-Franchisees may be taken quite far and some may even try to extend it to the point that in certain circumstances the misconduct of a Sub-Franchisee that would entitle the Master Franchisee to terminate the Sub-Franchisee Agreement for cause would also entitle the Franchisor to terminate the MFA for cause.
When initiating activity in a new country, the parties may decide first to conclude a short-term agreement to see how the market responds before entering into a full MFA. Comparatively long terms of duration are common in MFAs to enable the Master Franchisee to recoup its investments. In general an initial term of five years can be recommended as a starting point.
Renewal terms are usually part of the agreement according to which a renewal of the term is made subject to certain conditions (e.g. no[Page92:]material default, no payment default, the obligation to sign the standard agreement in effect at the time of renewal, a deadline or calling the option to renew).
One issue that needs to be addressed in both the MFA and SFAs is what happens when the initial term of the MFA expires or is terminated. In some situations, the Franchisor may give the Master Franchisee a renewal right to continue to develop additional SFAs and operate its sub-franchise system, and in other situations the Master Franchisee will have no additional development rights but the ability to continue to operate its Sub-Franchise system. In either of these situations, the Sub-Franchisees with existing SFAs will continue to deal with the Master Franchisee.
If, however, the Franchisor does not renew the MFA or it is terminated or expires, the issue is what impact that will have on the existing SFAs. This could happen, for example, if the Master Franchisee can grant SFAs that have a term that extends beyond the term of the MFA. Often, both the MFA and SFAs will provide that on non-renewal, expiration or termination, all or selected SFAs will be assigned to the Franchisor or its nominee, or will automatically terminate, at the Franchisor’s discretion. If the SFAs are silent as to what happens in such a situation, the Sub- Franchisees likely will have the right to continue to operate using the marks and the System until their SFA expires. It is important for the MFA and SFAs to explain clearly what happens if the MFA is not renewed, expires or is terminated, or there may be a risk in some countries that the Sub-Franchisee may be able to track back to the Franchisor where the SFA is silent on this issue.
Issues relevant to termination of MFAs are discussed further in § 2.5.
MFAs will usually contain a development schedule in which the developments of the number of franchise Units to be opened in the assigned Territory are listed. It is in the interest of all parties involved to approach this subject in a realistic manner in order to keep potential conflicts to a minimum. The contract should provide solutions for the situation where realistic minimum developments are not obtained (e.g. limiting the scope of the exclusivity granted for termination of the agreement).
There is a tendency for development schedules to be overly optimistic as to the number of Units the Master Franchisee or Area Developer can actually open. A Cornell University study conducted in 2005 of international restaurant franchises found that development commitments in most MFAs are excessively large relative to the number of Units actually built by the Master Franchisee and that the development commitments are usually not fulfilled or enforced52. This can have severe consequences for both parties to the MFA unless its provisions provide[Page93:]flexible remedies or relief in such situations. Often the failure to meet the development schedule can be a non-curable breach of the MFA.
MFAs typically cover two types of franchise fees to be paid by Master Franchisee to Franchisor. The first is an Initial Fee for the rights granted. The second is an ongoing Franchise Fee (often also referred to as a royalty or continuing fee) for the use of the System and ongoing support service of the Franchisor.
The Initial Fee is to be considered as a realistic fee for the rights of the access to the System, trademark license, Know-how, etc. An Initial Fee does not have to be a lump sum all paid up front. In many franchise Systems the Initial Fee is divided into sub-components, paid in a variety of ways — for example, divided into equal tranches, or small first payment and then pay per-Unit opened, or some other schedule, or with certain triggering events, e.g. opening of every third Unit. Consider tax implications when structuring the Initial Fee (See § 4.4.5). It is in the interest of all parties involved that this Initial Fee is negotiated in a realistic manner to avoid problems and disputes later on as a result of the fact that the Master Franchisee is unable to recoup the initial investment within a reasonable period of time. The Initial Fee should not reflect the value only of the System, Know-how, and trademark license in the assigned Territory but also of the training and support provided by the Franchisor during the start-up phase.
The Franchise Fee is charged for the continuing use of the rights granted and support provided. It is quite common that the Franchise Fee is calculated in the form of a percentage of the revenues of the Master Franchisee. However, parties are free to agree on and use different methods to determine this fee. These may vary from payment of monthly fixed fees to variable fees (either on sliding scales or not) calculated on the basis of revenues, purchases or sales, etc. Again it should be emphasized that the Franchise Fee should be realistic, taking the relevant circumstances of the assigned Territory into consideration in order to minimize the risk of re-negotiations or disputes later on.
In many cases the Master Franchisee is put under an obligation to use the standard SFA of the Franchisor and to ensure that it complies with local (mandatory) laws. Another option is that the Master Franchisee may have the right to draft a standard SFA provided that this standard agreement contains a number of clauses that are considered as mandatory by the Franchisor.
It is usually the Master Franchisee that undertakes that Sub-Franchisees will operate in compliance with the sub-franchise and that, when necessary, it will enforce compliance. MFAs also typically include provisions that amendments of the standard SFA must be approved by the Franchisor and, when necessary, that the standard agreement will be translated into the local language.
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Both the MFA and SFAs should address what happens to the SFAs once the MFA expires or is terminated. See the discussion in § 9.5 for some options and § 2.5 on the Franchisor’s exit strategy should it decide to withdraw from the target country.
MFAs have the potential to affect competition since they usually contain territorial restrictions, obligations regarding the pricing, (post-term) non-compete obligations, etc. In large parts of the world antitrust/ competition laws apply to MFAs. In the United States, antitrust laws such as the Sherman Act, the Clayton Act and the Robinson-Patman Act apply to Franchise Agreements. These federal laws have as their purpose to prevent unreasonable trade restraints and/or price-discrimination. In addition, the individual states in the United States have antitrust laws. In the EU, the Treaty for the Functioning of the European Union (TFEU) contains provisions that regulate agreements, decisions or concerted practices that may affect trade between Member States and have the object of distorting competition. National laws in the EU Member States are generally modeled on the provisions of the TFEU. When drafting an MFA, care must be taken that the contents are in compliance with the applicable antitrust/competition rules. (See § 4.4.10.)
Advertising is one of the vital factors that determine the success of a System. MFAs usually contain provisions on how to structure the advertising by specific standards on respective obligations/ responsibilities, control and financing of advertising.
MFAs typically provide that the Master Franchisee and the Sub- Franchisees must contribute to a local advertising fund set up by the Master Franchisee, as well as a regional or global advertising fund administered by the Franchisor.
The MFA should clearly describe any applicable restrictive covenants against competition. Some jurisdictions distinguish between in-term restrictive covenants and post-term restrictive convents, so local counsel must be consulted to determine if they are treated differently. Typically the Master Franchisee will be prohibited from owning, operating or investing in a competing business during the term of the MFA. Such in-term restrictive covenants are generally unlimited in terms of space and time. For post-term restrictive covenants, in some countries (such as the United States) the restrictive covenant must have a reasonable space and time limitation. In other words, the area in which the restrictive covenant applies must be reasonably related to the area in which the Master Franchisee operated and there must be reasonable time restraints. In the United States, the ABA Forum on Franchising has published a detailed state-by-state survey of the applicable law on restrictive covenants against competition53.
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In the EU, the BER provides that the exemption does not apply to any direct or indirect non-compete obligation that has an indefinite duration or exceeds five years54. A non-compete obligation that is renewable beyond five years is deemed to have been concluded for an indefinite duration.
MFAs usually contain a provision that makes the renewal subject to specific conditions. Aside from usual conditions such as that there must not have been any material default, no payment default, etc., typically there will be a condition that the Master Franchisee agrees to sign the standard MFA in effect at the time of renewal. When inserting such a clause, parties must realize that the agreements concluded between the Master Franchisee and the Sub-Franchisees are based on the first MFA. This issue should therefore be carefully taken into consideration before inserting this kind of a condition.
Aside from a provision which regulates that the MFA will automatically terminate at the expiry of the agreed term (unless the conditions for a renewal, if agreed, have been met), termination by either party is to be provided for in the MFA. Early termination by the Franchisor in the event of a material breach by the Master Franchisee or automatic termination in the event of bankruptcy, insolvency, etc. of the Master Franchisee are usually included, though local bankruptcy law may determine the effectiveness of termination. Termination by the Master Franchisee for breach by the Franchisor is not a usual type of provision in MFAs. If such a provision is included, one typically also includes a provision that the Master Franchisee is not entitled to continue operating the local franchise network with the use of the System, trademarks and any other intellectual property rights of the Franchisor but rather to claim damages for a material breach.
The effects of termination should usually include an obligation on the Master Franchisee to:
In principle SFAs will terminate on the termination (or expiry) of the MFA. This issue must be addressed in the agreement and typically includes a[Page96:]provision in the MFA that the Master Franchisee is under the obligation to assign the SFAs to the Franchisor. Issues that need to be addressed are inter alia whether the Franchisor’s option covers the whole franchise network developed by the Master Franchisee or only those SFAs it wishes to continue, whether to compensate the Master Franchisee for assignment of the SFAs, etc.
The MFA should include in the introduction/preamble that both parties explicitly acknowledge that the System is likely to undergo changes during the course of the agreement and that they explicitly confirm that they agree with changes to be made by the Franchisor during the lifetime of the agreement. The agreement itself should also contain a chapter dealing with the right of the Franchisor at its discretion to modify unless this right is exercised arbitrarily and unreasonably towards the Master Franchisee. This right should also include the right of the Franchisor to introduce changes in the operating manual.
The choice for the law applicable to an MFA will usually be the law of the country in which the Franchisor is domiciled. However, careful consideration must always be given first to a number of relevant factors in order to arrive at a well-motivated and useful choice55.
International commercial arbitration will typically be the most appropriate solution when a dispute arises under an international MFA. Arbitration is generally less costly and time-consuming than litigation; offers a flexible, neutral forum and process; and allows the parties to choose an arbitrator or arbitrators with relevant subject-matter expertise. Importantly, international arbitration often results in a binding award that is generally more easily enforced than a judgment at the end of a court proceeding would be. The 1958 United Nations New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards requires courts of contracting states all over the world to give effect to private agreements to arbitrate and to recognize and enforce arbitration awards made in other contracting states.
Arbitration at the ICC International Court of Arbitration gives parties access to a range of unique services, including secretariat support at all stages of the arbitral process, scrutiny of awards, and tools to help parties predict and manage arbitration costs, such as a cost calculator (http://www.iccwbo.org/products-and-services/arbitration-and-adr/arbitration/cost-and-payment/cost-calculator/), and ICC’s brochure Techniques for Controlling Time and Costs in Arbitration (ICC publication N°843).
51 See § 4.4.8 on non-compete and confidentiality clauses.
52 Arthurs Kalnins, “Biting Off More Than They Can Chew: Unfilled Development Commitments in International Master Franchising Ventures”, CHR Reports, Cornell University School of Hotel Administration, The Center For Hospitality Research (2005). See also Carl E. Zwisler, “How Franchisors Have Failed at International Master Franchising, and What They Can Do to Succeed in the Future”, Franchise Update, http://www.franchising.com/articles/how_franchisors_have_failed_at_international_master_(2007).
53 Michael Gray and Natalma McKnew, Editors, Covenants Against Competition in Franchise Agreements, ABA Forum on Franchising (3d Ed. 2012)
54 Commission Regulation (EU) No. 330/2010, Art. 5.1(a). See Also the Guidelines on Vertical Restraints, paragraphs (65) to (69) (2010).
55 See §4.4.8 of this document.