Seal-a-Fridge: even franchising has its limits

One of the best ways of generating quality earnings from a trade mark is by licensing its use under a business format franchise. In theory, once the business formula is tried and tested, the franchise becomes a licence to print money: the licensee invests in premises, equipment, hardware and labour, while the licensor -- while receiving sign-on fees, possible service and consultancy retainers and regular royalty payments --advertises the franchised service and reaps the benefit as the brand equity just keeps rising.

There are however limits to the money-making potential of the franchise format, as can be seen from a recent episode in Australia. In "Court decision brings cold comfort to franchisor", Tim Golder, Robyn Chatwood and Ben Mee (Allens Arthur Robinson) discuss in their firm's Intellectual Property Focus a complaint made against Seal-A-Fridge, in which the Federal Court ruled that the franchisor had abused its position of strength in order to impose significant increases in fees payable by its franchisees. This case also tested out the legality of a franchisor withholding its consent to assignment of a franchisee's interest to a new licensee unless the latter executes a franchise agreement which gives the franchisor additional benefits.

After explaining the facts of the complaint, the relevant legal principles and the outcome, the authors conclude as follows:

"... the case serves as a warning to franchisors who seek to take advantage of a franchisee's request for consent to an assignment of the franchise agreement. A court may find unconscionable conduct if consent is used as a lever to extract a better bargain than was originally made by the parties to the agreement, although it appears that evidence of bad faith may be required, as an erroneous construction of a contractual right will not in itself be unconscionable. However, careful drafting of the franchisor's contractual rights with a consideration of both this decision and Clause 20 of the Franchising Code may provide franchisors with greater flexibility in relation to the terms by which 'new' franchisees introduced under a transfer are bound".

Non-reliance clauses in UK franchise agreements: how effective are they?

Intellectual Property Office carried a recent article by UK solicitors Richard Little and Vanessa Smith (Eversheds), "Franchise Agreements: How Effective Are Non-reliance Clauses?". This item explains that, should the relationship between franchisor and franchisee break down, the failing franchisee often alleges that the franchisor mis-sold the franchise by understating the risks of the business:

"This can trigger an examination by both parties of what exactly was said by the franchisor to the prospective franchisee in pre-contractual discussions, on the basis of which the latter decided to enter into the franchise agreement. The franchisor should be confident that the information given to the prospective franchisee at that stage was entirely accurate. However, in the event of any doubt, a franchisor may well point to any non-reliance clause in the franchise agreement. Non-reliance clauses are commonly used to seek to limit the franchisor’s liability for any representations made to a prospective franchisee except those expressly contained in the contract, and may state that the franchisor makes no representations or guarantees as to the profitability or any other aspect of the franchise business".

The article then goes on to discuss, among other things, the ruling of Deputy Judge Richard Seymour QC, the High Court for England and Wales, in Peart Stevenson Associates Limited v Brian Holland, a case arising out of a franchise for The Power Service.

I found myself thinking that the representation by the franchisor that a franchise can be expected to generate a specific range of income is not merely a representation of probability with regard to the earnings of a business format -- it's also a form of self-assessment intellectual property valuation, placing a value in terms of earnings on the combination of brand name, know-how and other IP elements that may be combined with the rest of the business proposition. Do any readers of this blog have any special interest or expertise in business format franchise-related IP valuation, either in respect of the value of the franchised brand as a whole or in terms of the value to the franchisee of buying into an existing branded franchise rather than investing in its generic equivalent?

Franchisors may be obliged to give financial information to their franchisees, rules Japanese court

Earlier this year the Japanese Supreme Court rendered a highly significant judgment in a case concerning a business format franchise. Under the terms laid down by the franchisor, each franchisee ran its own store but was unaware of the details of the franchisor's payments to the vendors from which franchisees procured products for sale. In this action the franchisees filed suit against the franchisor, demanding that it disclose certain information, including details of the products purchased for sale, payment dates and amounts and the names of the parties that received such payments. The franchisees argued that the franchisor had a duty to disclose these payment details under the Civil Code. The Tokyo High Court found that no such duty existed. The Supreme Court has now reversed the decision and remitted the action to the High Court for further consideration.

The court held that the purchase of products was essential to the franchisees' operations and that it would not have been difficult for the franchisor to inform the franchisees of the details of its payments to recommended vendors. Accordingly, although the franchise agreement did not explicitly impose a duty on the franchisor to disclose such information to its franchisees, the agreement could be interpreted as imposing a mandatory duty to make disclosures to the franchisees at the latter's request. The court added that, in general, a franchisor is subject to a duty to report information to its franchisees, but it did not specify the information that may be withheld from franchisees.

[source: Kenichi Sadaka, Aoi Inoue and Taisuke Yamamoto (Anderson Mori & Tomotsune), writing for International Law Office].

Illegality doesn't prevent franchisor recovering sums owed under a contract

The latest Allens Arthur Robinson Focus on Franchising carries a note by Andrew Wiseman and Tim Holden on Master of Education Services Pty Ltd v Ketchell, an important decision on illegality and its effect on the ability of the parties to seek or reclaim money from one another.

In short, franchisor Master of Education sued Ketchell, the franchisee, before a local court in order to recover for money due under a franchise agreement. Ketchell claimed that since Master of Education failed to comply with clause 11 of the Australian Franchising Code, the franchise contract became unenforceable for statutory illegality. At trial the court concluded that, while Master of Education did not comply with the Code, its failure to do so did not render the receipt of the non-refundable payment illegal.

The New South Wales Court of Appeal concluded that the franchise agreement was effectively prohibited by the law; accordingly Master of Education could not recover the moneys claimed. The High Court has since unanimously upheld Master of Education's appeal, much to the great relief, presumably, of many a worried franchisor.

After bankruptcy: what happens to the Italian business format franchise?

Although, once a business format is successfully trialled, a franchise contract runs a heavily reduced risk of encountering an episode of bankruptcy on either side, this event can still occur. The Italian Bankruptcy Law (267/1942) divides business contracts into three categories:

* contracts that terminate on an adjudication of bankruptcy;

* contracts to which the bankruptcy trustee automatically succeeds the bankrupt because continued performance is to the creditors' advantage;

* contracts that are suspended until the bankruptcy trustee decides whether to terminate or continue them.

Franchise agreements, despite their ubiquity, are not however mentioned -- an oversight that was not addressed when the Franchising Law was revised in 2004. This means that their regulation on bankruptcy must be handled by analogising them to one of the three categories mentioned above.

In intellectual property terms, franchise agreements can span a number of elements of the contractual relationship:

* the use of trade marks and other signs belonging to the franchisor;

* the transfer of the franchisor's know-how to the franchisee;

* the sale by the franchisee of products and services and

* the payment by the franchisee of agreed royalties or fees.

The diverse nature of these provisions makes franchise agreements comparable to several types of contract, such as licence, agency, distribution, supply and commission agreements.

Some commentators consider the franchise relationship to be one of personal trust, which automatically terminates in the event of either party's bankruptcy, in the same manner as agency and commission agreements. Case law from the Court of Turin in January 1995 however construed the franchise as a supply agreement in which the franchisor supplied services, rather than goods. On this basis it was regulated by the provisions of the Bankruptcy Law that provide for the suspension of performance of mutual obligations until the bankruptcy trustee decides whether to terminate or continue the contract. This ruling has however been questioned on practical grounds.

Ultimately each case will be decided on its own facts and its own merits. Parties are advised to stipulate the consequences of bankruptcy in advance, to avoid undertainties and undesired consequences [source: Marco De Leo and Beatrice Masi, of Rinaldi e Associati, writing in International Law Office].

Must franchisors remit purchase benefits to their franchisees?

Writing in International Law Office, Karsten Metzlaff and Karl Rauser (Nörr Stiefenhofer Lutz) discuss some significant implications for the passing back to franchisees of benefits obtained by franchisors ("Purchasing Benefits in Franchise Systems: The Praktiker Case", 20 May 2008). The authors explain that, under earlier case law of the German Bundesgerichtshof (Supreme Court), franchisors were not obliged to pass benefits to franchisees, whose entitlement depended solely on the existence of contract provisions to that effect. However, a Federal Cartel Office decision on the repayment systems of the Praktiker of do-it-yourself franchise almost exactly two years ago appeared to have changed the position. In this decision the Office ruled that a refusal to pass on to franchisees purchasing benefits which were linked to the franchisees' obligation to purchase all goods for the franchise system from specified suppliers constituted an "inequitable, and therefore forbidden, impediment to dependent companies" under Section 20(1) of the Act against Restrictions on Competition.

Praktiker's appeal has since been allowed by the Dusseldorf Higher Regional Court, but the matter awaits the further attention of the Bundesgerichtshof .

Comment: presumably most business format franchisors seek to leverage the maximum purchasing power from their brands so that, by further advertising their franchised brands, they will stimulate further consumer commitment to them. Praktiker have more to gain by reinvesting their savings in further marketing since their profits come ultimately from cash flow from their franchisees, not from the gains they can make in sales to their franchisees.

Franchising into Canada

"Considerations for Franchising in Canada" is the title of an article on International Law Office by Bruno Floriani and Marvin Liebman (Lapointe Rosenstein). This article, an earlier version of which was published on Getting the Deal Through, explains the different vehicles available to foreign franchisors who wish to carry on business in Canada, in terms of their fiscal and corporate consequences. The authors say that the preferred choice of vehicle for the expansion of a foreign franchise system into Canada is the incorporation of a Canadian subsidiary, but recognise that foreign franchisors may prefer to enter the Canadian market by franchising directly from their country without setting up a permanent establishment in Canada, thus avoiding being considered by Canadian tax authorities as carrying on business in Canada. They write:

" ... a franchisor may choose to contract with its Canadian franchisees directly without having a permanent establishment in Canada. As the franchisor will be only minimally involved in the operations conducted by an arm’s-length entity, income earned in Canada by the franchisor through royalty payments and rent will be qualified as passive income and subject, in Canada, to a withholding tax only.

Second, a franchisor may opt to carry on business in Canada using a Canadian branch or division. If the franchisor actively participates in the operation of the Canadian franchise, any income derived therefrom will qualify as business income which is taxable in Canada on a net income basis. Furthermore, the income of a non-resident franchisor carrying on business through a Canadian branch will typically be subject to a branch tax which is payable at the time the earnings of the subsidiary are accrued (and not at the time the income is paid to the foreign franchisor). In light of the foregoing, few franchisors choose to establish a branch office or division for the purpose of expanding into the Canadian market.

Third, a franchisor may choose to carry on business in Canada through a federally or provincially incorporated subsidiary. This is the most frequently used vehicle by non-resident franchisors wishing to export a franchise system into Canada.The incorporation of a subsidiary presents certain advantages, including the avoidance of Canadian withholding tax on passive income. Nonetheless, the subsidiary’s income will be taxable in Canada on a net income basis and dividends paid to its parent will be subject to a withholding tax. The franchisor may also charge a reasonable fee for providing assistance to its Canadian subsidiary in the operation of its business activities, with the expectation that a reasonable portion of such fee may then be deducted from the subsidiary’s income for tax purposes".

They then warn:

"Significant business and tax consequences arise from each of the above-mentioned structures and a careful review of all relevant legislation pertaining to each is highly advised. In addition, fiscal treaties ratified by Canada may substantially derogate from the tax considerations set out above and should therefore be consulted where applicable".

What constitutes a "franchise" may be defined differently according to the law of individual provinces and, while pan-Canadian trade mark protection is available, remedies for the protection of assets such as licensed know-how may vary across the provinces too.

Obviously, while tax-efficiency and the protection of IP will be a matter of concern to any ambitious franchisor seeking to extend an existing franchise formula into uncharted territory, they are not normally matters that make or break a decision as to whether to franchise. For this reason they are sometimes starved of adequate attention until relatively late in the creation and implementation of the business plan. This in turn may force belated business plans changes, with all the uncertainty and inconvenience that such belated changes inflict. Prudent planning will factor both these issues in at the earliest convenience, since they are the twin pillars upon which every solid franchising infrastructure rests.