Franchising

Mater Franchising arrangements are the flavor of the day as it provides the franchisor the benefit of the franchisee's knowledge of the local environment; provides access to local sales and marketing expertise and channels; reduces investment; requires negligible government approvals; provides freedom from recruitment of local workforce and consequently lowers the financial risk of the franchisor. The current regulatory restrictions on retail trading by foreign companies coupled with sustained economic growth; ever expanding market with a thriving class of urban consumers; quality consciousness amongst India consumers are some of the factors contribution to franchising being increasingly used as a model by foreign companies for entering India for the first time. A typical master franchise arrangement enables the master franchisee to develop the business in a given territory under the franchisor's brand name and trademark with or without the right to manufacture the products in accordance with the franchisors' operating guidelines coupled with assured financial returns to the franchisor.

There is a lot of discussion on the requirement of enacting a specialized law to regulate this growing sector in India. Before I proceed with my thoughts on the subject, I would like to quote a few lines from a report presented by the International Institute for the Unification of Private Law (UNIDROIT, an independent intergovernmental organization of which India is a member) which states that "the foundation of a successful franchising industry in any country lies in the existence of a "healthy commercial law environment" which has been defined as one with a 'general legislation on commercial contracts, with an adequate company law, where there are sufficient notions of joint ventures, where intellectual property rights are in place and enforced and where companies can rely on ownership of trademarks and know-how as well as on confidentiality agreements'. The Indian legal environment is characterized by all these key attributes, a fact established by ever expanding international franchise relationships with India.

To evaluate the need for a new legislation, let us first understand some of the keys issues/concerns involving a franchising arrangement that generally leads to potential disputes or disconnects between the parties and how they are protected or can be protected within the realm of current Indian legislation:

(1) Licensing and Use of Intellectual Property Rights: IP rights are an integral part of all franchising arrangements and every franchising agreement involves transfer of some form of IP right, either as a license of a trademark/service mark/trade name, or a copyright, or a patent, invention, design or a trade secrets. The manner of use of the IP rights and their protection against misuse is one of the most important concerns of the Franchisor. Some of the disputes that arise during implementation of the franchise agreement relate to the scope and purpose of the trademark license, exclusivity of use and geographical scope, protection of confidentiality, extent of transfer of the know-how, misuse and damage caused to the brand and goodwill of the franchisor, etc. Similarly, post termination related issues include unauthorized use of the trademarks post termination, limited right to use the trademarks for the purposes of disposal of pending inventory (in the absence of which the inventory may go waste), destruction of stationary containing trademarks/trade names, return and ceassation of use of IP rights. India already has a host of IPR related laws including the Trademark Act of 1940, Copyright Act, 1957, the Patent Act, etc that provide for extensive protection and enforcement mechanism for the intellectual property rights including permanent and mandatory injunctions against infringement and passing off. India is also a signatory to the international conventions on intellectual property rights including the Agreement on Trade Related Aspects of Intellectual Property Rights (TRIPS), thereby offering protection to trademarks or brand names, as well as copyright and designs of the foreign franchisor. Recognition and protection is also extended to service marks in India enabling the foreign franchisor to license its mark to a franchisee to provide the services synonymous with him to the consumers in India. IPR laws have also been recently amended to make them compliant with exclusive right obligations under TRIPS and accordingly, the laws meet international standards for IPR protection. Even the Indian courts are quite sensitive and proactive with regard to enforcement of infringement actions. It is therefore evident it is not the absence of IPR laws or its enforcement that lead to potential disputes but lack of carefully drafted and negotiated agreements between the franchisor and the franchisee related to IPR issues that lead to potential IP related litigations.

(2) Obligations of Franchisor and Franchisee: Another crucial issue that lead to potential disputes amongst the parties relate to implementation of the obligations of a franchisee such as the duties and services to be rendered by the franchisee, the investment and infrastructure of the franchise, adherence to specific operating guidelines or manual to maintain uniformity, reporting requirements, quality maintenance of the product or services delivered; creation of an agency between franchisor and franchisee, appointment of sub-contractors to manufacture and sub-franchisee to sell the products and franchisor and franchisee's liability owing to their acts/omissions; meeting of annual market penetration targets; minimum stock purchase/import obligations; financial returns to the franchisor, including royalty and fee. Similarly, obligations of the franchisor related to periodic training as to the conduct of business, upgrading the franchisee with new methods and technologies, ongoing support, recommendations on general operational, management, accounting and administrative practices, joint marketing and advertising campaigns, sharing of advertising costs generally cause heart burns to the franchisee.

The Indian Contract Act, 1872 is applicable to all the franchise arrangements and provides for specific parameters for legally enforceable agreements, lawful object and purpose of an agreement, lawful consideration for an agreement, performance of an agreement, statutory interventions in unfair or unconscionable transactions, consequences of fraud, misrepresentation and undue influence, voidability and rescission/repudiation of agreement, contracts in restraint of trade, contingent and conditional contracts, performance of reciprocal promises, discharge and frustration of contracts, consequences of breach and rights related to liquidated damages, enforcement of indemnification rights, agents and principal relationship and obligations thereto. It is not the lack of commercial law but lack of carefully drafted agreements that generally fail the parties. It is therefore important that a franchisee tries to bridge all potential gaps by identifying and analyzing "what if?" situations keeping in perspective the franchisee's financial, technical, manufacturing, marketing, human resource, sales and business planning capabilities.

All of this does not require a specialized law which is already in existence in the form of the Indian Contract Act but a fairly detailed and well negotiated contract. In any case even a specialized law can only provide a broad frame work, the details and the nitty-gritty of the relationship has to be always contractually agreed.

(3) Payment Terms: Delay in payment or non-payment of license and/or royalty payments could be another area of concern for the franchisor. Therefore the manner in which and the times at which such payments are to be made must be carefully addressed. In the event the franchisor is a foreign entity, applicability of prior approvals and terms and conditions for foreign remittance should be informed to the foreign party. The Foreign Exchange Management Act, 1999 and the Regulations made there under specifically address the outbound payment related issues. For instance, an Indian franchisee can remit royalty towards license of trademark upto the amount of 1% of domestic sales and 2% of exports without prior government approval. If the licensor also provides technical know how to the Indian licensee, the Indian company can remit royalty upto 5% of domestic sales and 8% of exports and lump sum payment of upto US$ 2 million without prior government approval. Payment of royalty above the percentages specified above would need prior government approval. Detailed tax laws are already in place to deal with the withholding tax liability on such payments which may get reduced depending upon the provisions in the applicable double taxation avoidance agreement. The key issue is that both the franchisor and franchisee should be made aware before hand on the payment and taxation related regulations.

(4) Duration, Renewal and Termination and its Consequences: Another serious concern of a franchisee is the extendibility of the term of the franchising and licensing agreement. Typically, extension of the term is within the sole discretion of the franchisor based on annual sales turnovers and performance of the franchisee. Quite often a franchisee struggles with the franchisor for renewal of the term especially when the franchisor is lined up with many other franchisees offering higher royalties. The other possible scenario is when a franchisee is suddenly informed of an abrupt termination of the franchise agreement leaving the franchisee with costs of salaries, infrastructure and interest on working capital and other debts. Now do we need a law to tackle with this abrupt termination or non-renewal situations. First of all, it should be clearly understood that all agreements entered into between private parties (whether under franchise domain or any other commercial arrangements) are terminable in nature. This is regardless of the terms in the franchise agreement that the contract is interminable. The Indian Contract Act 1872 and the Specific Relief Act, 1963 supported by various Supreme Court judgments are clear that even in the absence of specific clause authorizing and enabling either party to terminate the agreement, from the very nature of the agreement, which is private commercial transaction, the same could be terminated even without assigning any reason by serving a reasonable notice.

Keeping this in perspective, it is advisable to negotiate for an open ended term (i.e., no fixed term) agreement with suitable termination clauses on breach with adequate notice period for rectification of breach/default. Though non-provision of the agreed notice will render the franchisor liable for damages under the Indian Contract Act, it is advisable to stipulate liquidated damages or substantial termination fees payable by the franchisor on breach of express termination provisions. Suitable exit options should also be provided if both parties are not willing to continue. Some of the key post termination issues that lead to potential dispute and are adequately protected by the existing Indian laws include:

(i) Misuse of IPR rights and Confidential Information post termination is generally a mater of concern for the franchisor. While there are adequate IPR protection laws against misuse and consequent infringement/passing off actions coupled with rights for permanent and mandatory injunctions under the Specific Relief Act, it is important to provide provisions constraining the franchisee from using the IP rights of the franchisor and return of all confidential information obtained during the term of the agreement.

(ii) Protection of franchisees against negative covenants particularly relating to non-competition post termination. It should be understood that a negative covenant restraining the franchisee from directly or indirectly undertaking business competing with the business of the franchisor during the subsistence of the agreement may not be violative of section 27 of the Contract Act, but post termination negative covenants may not be enforceable under Indian laws. This in turn protects the franchisee against unreasonable negative covenants imposed by the franchisor post termination.

(iii) Inventory handling: Inventory handling is a definite pain area issue post termination. Provisions related to re-purchase of the unsold inventory/raw material post termination, destruction of sub-standard products or extension of the trade mark license to enable the franchisee sell the products with in an agreed time period are essential. Vague clauses such as inventory shall be disposed as per mutually agreed terms and conditions should be strictly avoided.

(5) Governing laws and implementation of laws: Choice of governing law and place of jurisdiction is another crucial issue that should be carefully thought upon before being documented. Often jurisdictional hardships deter the parties from taking corrective actions against breach of the franchisee agreement. Indian Code of Civil Procedure confers authority to a court to adjudicate upon a dispute either based on territorial jurisdiction; personal jurisdiction; subject-matter jurisdiction, etc. Detailed provisions supported by judicial precedents are already available to correctly guide the parties to deal with the jurisdiction issues and it is pointless to consolidate all the available laws under a specialized law.

In nutshell, most of the crucial issues that are matter of concern to the franchisee and franchisor can be dealt under a carefully drafted and negotiated franchise agreement.

I am aware that there would be certain concerns with regard to the bargaining power of the franchisee to firmly negotiate the agreement against an established franchisor. In this regard, associations such as Franchising Association of India can play an important role. For example, FAI can prepare and introduce a code of conduct for franchise arrangement wherein the franchisors should provide comprehensive disclosures to each prospective franchisee, so that each prospective franchise can make a well informed decision. For e.g., the Uniform Franchise Offering Circular (UFOC) format in the USA, approved by the Federal Trade Commission includes 23 categories of information that must be provided by the franchisor to a prospective franchisee at least 10 business days before it makes any payment to the franchisor or signs the contract. As stated above, this does not require legislation of a new law but implementation of a code of conduct by Franchising Association of India. The Association can prepare and require Franchisors to mandatory provide information such as corporate history and financial statements of the franchisor, the litigation it faces, intellectual property and proprietary information, etc. Similarly, members of FAI should be able to guide the small franchisees about the potential exposure in the given franchise arrangement and if required negotiate on behalf of the franchisee.

If you are looking from the consumer stand point, we have consumer protection laws that enable a consumer to file complaints with the consumer forums for unfair or restrictive trade practices adopted by franchisee in supply of goods or services by the franchisee. Similarly, antitrust or restrictive trade practices promoted by the franchise arrangement can be addressed through Monopolies and Restrictive Trade Practices Act, 1969 and to be implemented proposed Competition Act. The franchisor and the franchisee would need to ensure that their practices do not classify as monopolistic or restrictive or else the Commission under the MRTP Act can grant injunction to prevent such trade practices and may award compensation for any losses or damage suffered thereby. Tortious liability could also arise out a franchise relationship in the event of negligence leading to loss or damages to third parties or in the event of principal-agent relationship between the franchisor and the franchisee. In such cases the franchisor could be held liable for any torts committed by the franchisee during the course of his business.

Cons of a New Law: Having a host of laws, I personally feel that introduction of specialized law at this stage will rather have a negative impact on the growth on the franchise industry:

- Most developed countries do not have franchise specific law or was introduced much later: The United States of America which is the inventor of all types of franchise arrangements did not have any franchise specific law for good 50 years. Since the time of development of the concept during 1938 till 1993, there was no attempt made to regulate franchising in the U.S. It was only in 1993 that the Uniform Franchising Offering Circular ("UFOC") Guidelines were adopted in USA as the recommended format for franchise disclosure documents at the State level. By 1995, the new UFOC Guidelines were adopted by each of the state franchise regulatory authorities that required registration of franchise offerings.

United Kingdom does not have any specific legislation or regulation, which regulates franchising or foreign franchising companies. The European Franchise Federation has however prescribed "European Code of Ethics for Franchising" that facilitates prospective franchisee to enter into any binding franchise relationship with full prior knowledge. Similarly, UNIDROIT has in September 2002 adopted a Model Franchise Disclosure Law requiring the franchisors to provide extensive written disclosures to prospective franchisees at a pre-contractual stage.

Even Singapore which is home to many franchises from around the world, there does not exist any specific legislation on franchising in Singapore.

Even in the countries where there are franchise specific laws, the purpose is to require extensive disclosures to the prospective franchisees which in my opinion can be introduced through an association like Franchising Association of India, whereby the franchisor and franchisee adhere to the code of conduct specified by the Association.

- Will hamper the growth of the industry: Given the fact that the franchising sector is still in the nascent stage of evolution and development, we are still not ceased with most of the practical issues involved in implementing and managing a franchise relationship. Therefore, introduction of a specific law may not only fail to address all the issues but may even have an adverse effect by unnecessarily burdening the franchisor and franchises with regulatory and reporting compliance/requirements and may also deter the prospective international franchisor to come to India. It may prove a very theoretical legislation without any practical implementation background of the situations and may need frequent modifications and amendments.

- Most issues can be contractually negotiated and taken care off by contractual arrangement: As already discussed, most of the concerns of the parties can be mutually discussed and agreed upon a negotiated contract. Even otherwise, no single law can deal with the complex nature of issues involved in a franchise arrangement which ranges from protection of IP rights to product liability, exchange control issues, labour laws, enforcement of contractual rights, etc. Further, enforcement issues between the parties to the agreement i.e. the franchisor and the franchisee would be governed by the substantive law of the territory and dispute resolution mechanism agreed between the parties, would take care of the enforcement of such rights. Compulsory resolution of dispute through a self imposed regulator may not be healthy for rapid growth of this sector. I feel that the day and time for a specialized franchise law is yet to come and it may even be pre-mature to enact such a law.

o Conclusion

In view of the foregoing, the time has as yet not arrived to have a franchise specific legislation. It would be in the interest of the franchise industry, which is still evolving and is miles away from reaching its highest potential, that instead of advocating a need for a new legislation to regulate the franchise industry, it would be advisable to let the industry breath, feel, learn, grow and develop in an environment of freedom and competitiveness (though regulated by the present legislation).