International Franchising Agreements: Legal Regulation

 

February 10, 2025

BRACE Law Firm ©

 

Franchising as a form of doing business is used in all countries with developed market economies. Due to foreign companies, franchising appeared in Russia, where it has become quite widespread today. Many entrepreneurs wish to develop their businesses using franchising schemes but have an insufficient understanding of the prospects and economic advantages that arise for participants in franchising relations.

What is the Purpose of International Franchise?

The goal of many entrepreneurs is to promote their business not only within their own country but also to enter the international arena, develop and expand foreign economic relations, and achieve global recognition for their brand. However, achieving this goal requires significant financial investment in creating and promoting a trademark: production organization, marketing activities, and time costs. Many business entities, such as individual entrepreneurs and small enterprises, do not possess such resources. It is easier for such entities to acquire the rights to use a famous trademark under a franchising agreement.

A franchising agreement signed between companies from different countries assumes that one party (the "Franchisee") receives from the main firm the right to conduct business for a set time using the name of that trademark in a specific territory. A large company—the "Franchisor" — provides, for a fee, the right to use a complex of exclusive rights to the results of intellectual activity and equivalent means of individualization, the necessary equipment, and technology, and organizes staff training for the purpose of selling the Franchisor's products or services. In turn, the party acquiring these rights — the Franchisee — undertakes to use the trademark of only that company within the scope and for the period of the agreement specifically concluded between the parties. In this case, the Franchisor achieves its goals of conquering new international markets with minimal risks. A striking example of such a Franchisor is the American fast-food restaurant chain McDonald’s.

Thus, international franchising acts as a form of long-term cooperation between the parties (the Franchisor and the Franchisee) aimed at achieving common goals, such as producing goods, selling products, or providing services under the trademark of the right holder in a specific territory of a foreign state for a specific term and on conditions established by the international franchising agreement. This cooperation is implemented through the use of a number of civil law contracts, which may include a premises lease agreement, a supply agreement for products under the Franchisor's trademark, a marketing services agreement, a staff training services agreement, and several other types of contracts.

International franchising is understood not only as a complex of rights but also as a system of mutual obligations regulated by the provisions of civil legislation. The agreement for the transfer of exclusive rights acts as the primary link for other contractual obligations that facilitate the comprehensive cooperation of the parties to the agreement.

International Franchising and Its Types

International franchising can be understood directly as an agreement for the transfer of a set of exclusive rights, accompanied by the transfer of rights to sell products, provide services, or perform work in a specific territory.

The legislation of foreign countries addresses the issue of legal regulation of franchising agreements differently. For example, in the US, franchising laws have been developed at both the federal and state levels, but they focus on pre-contractual franchising relations. Franchising relations themselves are regulated by the norms of contract and obligation law. The minimum volume of disclosure that must be provided to a potential Franchisee in the United States is contained in the disclosure requirements and prohibitions regarding franchising established by the US Federal Trade Commission (FTC). In addition to these requirements, many states have adopted their own rules and regulations concerning the offer and sale of franchises in their territories [1]

India lacks specific regulation for franchising; franchise transactions are carried out on the basis of good faith. As a general rule, contractual relations are governed by the Contract Act of 1872, which regulates the contractual aspects of agreements. In India, a Franchisor is not subject to any pre-contractual disclosure requirements. A franchising agreement does not need to be notarized or registered, but to transfer intellectual property objects, separate license agreements should be concluded and registered with the intellectual property authorities of India. In India, it is common practice to conclude a comprehensive franchising agreement that also covers the licensing of any technologies, processes, know-how, trademarks, and more. [2]

In China, the institution of franchising is carried out based on the Regulations on Administering Commercial Franchises dated February 6, 2007. These regulations came into force on May 1, 2007, and apply to franchising relations in China. The implementation of franchising must comply with the principles of free will, fairness, honesty, and good faith. These regulations aim to regulate commercial franchising activities, promote the healthy and orderly development of commercial franchises, and ensure market order. [3]

A franchise in China is understood as a business activity in which a Franchisor, possessing a registered trademark, enterprise logo, patent, know-how, or any other business resource, transfers the aforementioned business format to another Franchisee by contract. The Franchisee conducts business in a uniform business format in accordance with a uniform business model, as provided by the contract, and pays franchising fees to the Franchisor. [4]

Franchise agreements are often referred to as "franchise contracts" An analysis of foreign practice in using the terms "franchise" and "franchising" leads to the conclusion that both terms—"franchising agreement" and "franchise agreement" — are permissible with respect to the contract. It should be understood that the terms "franchising" and "franchise" are by no means identical. Franchising is a system of relations mediated by a franchising agreement. A franchise (from the French franchise – "privilege") is the complex of exclusive rights transferred under such an agreement.[5]

In practice, the following forms of franchising are distinguished:

• Direct franchising, which implies the transfer of rights to conduct business to one person with territorial restrictions;
• Sub-franchising, where the Franchisor transfers most of its rights in a designated territory to a sub-franchisor, including the right to open its own enterprises and sell franchises to third parties;
• Master franchise, which is close in form to sub-franchising and is used, as a rule, in the activities of large international chains.[6]

The following types of franchising are distinguished:

• Manufacturing (industrial) franchising, in which the Franchisee receives the right to produce and sell products under the Franchisor's brand name. Additionally, the Franchisee receives the technology and key raw materials. The parties agree on requirements for the production process, output volume, quality, sales plans, staff qualifications, and reporting. Manufacturing franchising can be applied to various industries, such as food production or furniture manufacturing.
• Product franchising is primarily used in the trade sector. The Franchisee receives the right to sell goods produced by the Franchisor or under its trademark. The agreement regulates sales technology, the range of services and goods, and clear rules for using the manufacturer's trademark. A brand-name store selling shoes or clothing is an example of product franchising.
• Service franchising provides the Franchisee the right to engage in a specific type of service under the Franchisor's trademark, with the Franchisor providing the partner with equipment, advertising, and marketing technology. In addition to support, the Franchisor monitors performance. A chain of dry cleaners is an example of service franchising.
• Reverse franchising, in which the Franchisor transfers the rights to conduct business under its brand, but the Franchisor provides the Franchisee with a full range of goods according to an agency agreement.
• Business franchising. The Franchisor transfers not only the right to sell but also a license to organize this type of business. The documents specify the business concept, provide detailed instructions for training employees, and state requirements for interior design and staff uniforms. Advertising policy, reporting, and relationships with suppliers are regulated. Business franchising, due to its comprehensive nature, has various applications: grocery supermarkets, retail stores, hotels, catering points, and educational centers. [7]

Advantages and Disadvantages of International Franchise

For the Franchisee, the advantages of franchising include:

• Use of a proven business model, as before promoting its franchise in the market, the Franchisor must refine all business processes and prove the success and efficiency of its business. Furthermore, to develop a franchising network, the Franchisor must have a flagship enterprise upon which the "cloning" of the business is based. By acquiring a franchise, the entrepreneur receives a proven and refined business model that has demonstrated its effectiveness.
• Opportunity to choose an industry. A potential Franchisee can familiarize themselves with the Franchisor's business before the stage of investing their own funds, which can be done based on the Franchisor's commercial proposal and by studying its existing enterprises, both owned and partnered.
• Risk reduction, because by opening a partner enterprise, the Franchisee becomes part of a network. Unlike an independent enterprise, the Franchisor does not leave partners alone with the emerging problems and risks of a starting business.
• Market entry. One of the basic requirements for a franchise business is the demand for the Franchisor's goods or services. By the time the enterprise opens, the Franchisee already has a circle of consumers loyal to the brand.
• Minimal costs for advertising and marketing. Since the Franchisee operates within a specific network, its advertising costs are limited to the opening of the franchising enterprise and current advertising aimed at promoting the franchising network in a specific region.
• Franchisor's knowledge base. When providing partners with its business model, the Franchisor transfers not only a refined mechanism but also instructions for its effective use.
• Guaranteed supply system, as the Franchisor seeks to provide its direction with the greatest resources, including supply issues.

In turn, for the Franchisor, the advantages include:

• Business growth does not require expanding management, as business partners take on the functions of regional managers and bear part of the business risks. This simplifies administration for the Franchisor;
• Each Franchisee independently bears the costs for personnel selection and training, quality control, advertising, and the purchase of equipment and consumables, which does not require the right holder's effort or investment in recruitment or monitoring usage;
• Royalties and increased sales. In addition to the franchise fee itself, sales of key products may grow, as Franchisees are obliged to purchase batches of goods, consumables, or other products/services defined by the agreement. Stable income allows for future planning and the development of new directions;
• Advertising, as the development of a franchising network is in itself excellent advertising that requires no special financial investment.

However, franchising is not without disadvantages, which include:

• Brand quality reduction. Due to the lack of full control over the franchise, the quality of products and services when entering a foreign market may decrease. International franchising is less controllable due to distance and different regulations. If a Franchisee's enterprise ceases to meet brand standards, it will affect the Franchisor's activities and its company. However, a loss of trust in the Franchisor will also negatively impact franchise holders.
• Future competition. Monitoring the Franchisee's activities by the Franchisor may be seen as an advantage in the initial stages of cooperation; however, the Franchisee, in turn, gains experience and knowledge about the franchise. The Franchisee may decide to break away and continue its own business direction, consisting of the Franchisor's secrets and minor adjustments called innovations. Franchisors try to limit the Franchisee's independence because the seller drafts the franchise agreement and includes terms favorable to itself, regulating the choice of suppliers and restricting the scope of franchise service distribution. Thus, Franchisees are often obliged to purchase raw materials and products from suppliers designated by the Franchisor, which may limit their access to the open market and force them to buy at inflated prices. Additionally, Franchisees must follow the rules and restrictions established by the Franchisor. Strict restrictions on exiting the business may also be set for Franchisees, including a ban on opening competing organizations for a specific period or in a specific territory.[8]
• Differences in culture and business organization may create problems with branding, public relations, and corporate culture. No matter how well-thought-out a franchise is, its activities in another country will differ from the country of origin. Business laws and regulations vary significantly not only between countries but also between regions, and these differences affect all aspects of business, including personnel policy and employee rights and benefits.
• Cultural barriers. What is acceptable in one country does not necessarily mean it will be acceptable in others. Each country has its own culture, and it is impossible to accurately predict what people in that culture will like and what they will not.
• Franchisees can rarely influence centralized marketing and advertising issues but may be forced to pay for centralized marketing and advertising campaigns. Thus, their funds may be used not in their best interests.[9]

National Legal Regulation of Franchising Agreements in Russia

The term "franchising" is practically not used in the legislation of the Russian Federation. To date, the only type of civil law contract that most closely corresponds to global practice, principles, and mechanisms of franchising is the commercial concession agreement provided for by Chapter 54 of the Civil Code of the Russian Federation (the "Civil Code"). The use of a license agreement is also possible.

In accordance with Article 1027 of the Civil Code, under a commercial concession agreement, one party (the right holder) undertakes to provide the other party (the user), for a fee and for a term or without a term, the right to use in the user's business activity a complex of exclusive rights belonging to the right holder, including the right to a trademark, a service mark, as well as rights to other objects of exclusive rights provided for by the agreement, in particular a commercial designation and a secret of production (know-how).

A commercial concession agreement provides for the use of a complex of exclusive rights, business reputation, and commercial experience of the right holder in a specific volume (in particular, with the establishment of a minimum and/or maximum volume of use), with or without an indication of the territory of use relative to a specific sphere of business activity (sale of goods received from the right holder or produced by the user, implementation of other trade activities, performance of work, or provision of services).

According to Article 1028, a commercial concession agreement must be concluded in writing. Failure to comply with the written form of the agreement entails its invalidity. Such an agreement is considered void. Furthermore, the granting of the right of use in the user's business activity of a complex of exclusive rights belonging to the right holder under a commercial concession agreement is subject to state registration with the federal executive body for intellectual property. If the state registration requirement is not met, the granting of the right of use is considered not to have taken place. Importantly, it is not the commercial concession agreement itself that is subject to registration, but the granting of the right of use in business activity of the complex of exclusive rights of the right holder under the agreement.

The procedure for such registration is established by the Government of Russia,[10] which provides that in the case of registration of the right of use of intellectual property objects, documents informing of the following must be attached to the application of the parties:

• The term of the agreement, if the term is defined;
• The territory in which the right is granted;
• The methods of using the provided objects as stipulated by the agreement.

Speaking of franchising, some aspects of antimonopoly regulation should be addressed. By virtue of Article 11 of Federal Law No. 135-FZ dated July 26, 2006, On Protection of Competition (the "Law on Competition"), a ban is established on the conclusion of agreements between entities where one supplies goods and the other acquires them — so-called "vertical agreements" — which may lead to a restriction of competition. In practice, the following are recognized as such:

• Agreements that result in the establishment of the resale price of goods (except for the maximum price);
• Agreements containing an obligation for the buyer not to purchase similar goods from other sellers;
• Other agreements that in one way or another restrict one of the parties in the independent choice of counterparties or the conduct of certain types of activities or the conclusion of certain transactions.

At the same time, Article 12 of the Law on Competition stipulates that "vertical agreements" in writing are permitted if they are commercial concession agreements.

Direct permissions to establish restrictions and prohibitions for the parties to a commercial concession agreement are contained in Article 1033 of the Civil Code, according to which the following restrictions on the rights of the parties may be provided:

• The right holder's obligation not to provide other persons with similar complexes of exclusive rights for use in the territory assigned to the user or to refrain from its own similar activity in this territory;
• The user's obligation not to compete with the right holder in the territory covered by the commercial concession agreement regarding business activities carried out by the user using the exclusive rights belonging to the right holder;
• The user's refusal to receive similar rights from competitors (potential competitors) of the right holder under commercial concession agreements;
• The user's obligation to sell, including resale, products produced and/or purchased, perform work, or provide services using the exclusive rights belonging to the right holder at prices set by the right holder, as well as the user's obligation not to sell similar goods, perform similar work, or provide similar services using trademarks or commercial designations of other right holders;
• The user's obligation to sell goods, perform work, or provide services exclusively within a specific territory;
• The user's obligation to coordinate with the right holder the location of commercial premises used in exercising the exclusive rights provided under the agreement, as well as their external and internal design.

Within the framework of antimonopoly legislation, the business of the Franchisor and the Franchisee is not considered competing. In this case, both parties to such an agreement act primarily in common interests aimed at the development and expansion of the joint business. However, this does not mean that the rights of one of the parties to a franchising agreement can be restricted in absolutely any form or volume. According to Article 1033 of the Civil Code, restrictive terms may be declared invalid at the request of the antimonopoly authority (or another interested person) if these terms contradict antimonopoly legislation, taking into account the state of the relevant market and the economic position of the parties.

Tax law issues are also important regarding franchising agreements. Article 149(26.1) of the Tax Code of the Russian Federation (the "Tax Code") contains a provision for exemption from VAT on operations for the alienation of exclusive rights to inventions, utility models, industrial designs, topologies of integrated circuits, and secrets of production (know-how), as well as the rights to use these results of intellectual activity on the basis of a commercial concession agreement.

This provision applies on the condition that the remuneration for the transfer of exclusive rights to inventions, utility models, industrial designs, topologies of integrated circuits, secrets of production (know-how), and the rights to use these results of intellectual activity is allocated within the price of the agreement.

The tax risk for participants in a franchising agreement is associated with the untimely state registration of the granting of the right to use the complex of rights. The Franchisee may pay a lump-sum fee under such an unregistered agreement and pay royalties to the Franchisor. In such a case, the Franchisee may have a dispute with the tax authority regarding the lawfulness of deducting such payments as expenses under an unregistered agreement.

According to Article 264 of the Tax Code, periodic (current) payments for the use of rights to results of intellectual activity and rights to means of individualization (in particular, rights arising from patents for inventions, utility models, and industrial designs) are classified as other expenses related to production and sales for corporate income tax purposes.

In accordance with Article 252 of the Tax Code, expenses are recognized as justified and documented costs carried out (incurred) by the taxpayer. Justified expenses are understood as economically justified costs, the valuation of which is expressed in monetary form. Documented expenses are costs confirmed by documents drawn up in accordance with the legislation of the Russian Federation.

It is important to note that judicial practice related to this problem was formed in favor of taxpayers after the adoption of Ruling of the Supreme Arbitration Court of the Russian Federation No. VAS-11175/09 dated September 1, 2009, where the court pointed to the "necessity of considering primarily the facts of using the relevant objects—for the use of the rights to which royalties are paid—in the taxpayer's income-generating activity." It is assumed that the agreement subject to registration will be properly registered.

International Legal Regulation of Franchising (Franchise)

International sources of franchising regulation are recommendatory in nature, are not mandatory for application, and are represented by four main documents:

• UNIDROIT Model Franchise Disclosure Law of 2002 (the "UNIDROIT Model Law of 2002"), which contains its own definitions of "Franchisor," "Franchisee," "Franchise," and "Franchise Agreement," and establishes the form of the agreement, pre-contractual disclosure requirements, exceptions to this requirement, and other provisions. We note that this model law is a model not mandatory for states. Its norms are recommendatory for states that decide to adopt special legislation on franchising;
• WIPO Franchise Guide of 1994, which also contains a brief explanation of the term "franchise," franchise types, comparison of retail trade agreements, standard licenses, and franchises, model franchise agreement terms, and so on;
• UNIDROIT Guide to International Master Franchise Arrangements of 1998 represents, on one hand, a summary of contractual practice and, on the other, discloses the main elements of these contractual relations, highlighting the features and principles of implementing specific rights and obligations of the parties;
• Model International Franchising Contract, effective in the updated 2011 edition (ICC Publication No. 712), developed by the International Chamber of Commerce, contains uniform prescriptions recommended for participants in franchising relations. The main reason for drafting this document is the lack of unification of international legal regulation of franchising relations and the need to refer to national law.

The Model International Franchising Contract offers two options for the parties to agree on the applicable law:

• The agreement is governed by rules and principles of law universally recognized in international trade, including the UNIDROIT Principles of International Commercial Contracts;
• The agreement is governed by the law of a specific country. With the consent of the parties for their agreement to be governed by more specific rules, they have the right to choose the law of a certain country.[11]

Thus, the parties are entitled to choose as the applicable law the Model International Franchising Contract itself or the law of the country of one of the parties to the agreement.

A special role in the international legal regulation of relations under a franchising agreement is assigned to the International Franchise Association. However, acts developed by this organization are also only recommendatory in nature.

The Civil Code does not explicitly establish the volume of information that must be transferred to the user. It should be noted that in countries where franchising is regulated by special legislative acts, primary attention is paid to issues of mandatory full disclosure of information by Franchisors about their business for potential Franchisees. [12]

The UNIDROIT Model Law of 2002 on disclosure takes into account pre-contractual relations for disclosure by the Franchisor. This law can be applied to both domestic and international franchising, to various types of franchising agreements (unit franchising agreement, master franchising, development agreement), and to new forms that may appear in the future.

The Model Law on disclosure uses the term "franchise", which is understood as a right granted by one party (the Franchisor) that allows the other party (the Franchisee), in exchange for direct or indirect financial compensation, to conduct business activity selling goods or services on its behalf in accordance with a system developed by the Franchisor. Such a system includes know-how and assistance from the Franchisor, prescribes the main methods by which the activity should be carried out, provides for ongoing monitoring by the Franchisor, and the use of a trademark, service mark, firm name, or logo belonging to the Franchisor. The concept of franchising also includes:

• Rights granted by a Franchisor to a sub-franchisor in accordance with a master franchise agreement;
• Rights granted by a sub-franchisor to a sub-franchisee in accordance with a sub-franchise agreement;
• Rights granted by a Franchisor to another party in accordance with a development agreement.

In accordance with Article 1 of the UNIDROIT Model Law of 2002, this law applies to franchises that will be re-granted or renewed within the framework of one or more franchising enterprises in a conditional territory.

The UNIDROIT Model Law of 2002 provides for special conditions for information disclosure. The disclosure of franchise information must be in writing. The Franchisor may use any format for the disclosure document provided that the information contained therein is presented simultaneously in one document and meets the requirements set out in this law. A potential Franchisee must, at the Franchisor's request, confirm in writing the receipt of the disclosure document. Article 8 of the UNIDROIT Model Law of 2002 addresses remedies for a Franchisee's violated rights. In the event that a disclosure document or notice of a material change in information was not provided or contains incorrect information about material facts or does not contain information about material facts, the Franchisee has the right to terminate the franchise agreement with written notice to the Franchisor 30 days before the termination date. The Franchisee also has the right to demand compensation for damages, except in cases where the Franchisee received this information from other sources or does not rely on false information, or if termination of the agreement would be a disproportionate measure under the circumstances.

The UNIDROIT Model Law of 2002 considers the inadmissibility of restricting the Franchisee's rights, and any restriction of the Franchisee's rights compared to the rights provided by this law (including with the consent of the Franchisee itself) is insignificant.

What to Include in an International Franchising Agreement?

The aforementioned 2000 Model International Franchising Contract (the "ICC Model Contract") was developed by the International Chamber of Commerce and contains uniform rules recommended by the ICC for participants in these legal relations. In drafting the model contract, the authors sought to concentrate the main rights and obligations of the parties within it and avoid the application of the national legislation of any country.

The ICC Model Contract is intended for international distribution relations implemented through the conclusion of distribution franchise agreements and does not apply to other types of franchising agreements, including master franchising agreements. It contains two main sections: the first section is devoted to defining the main rights and obligations of the parties under a franchising agreement, and the second to the supply of goods sold under this agreement.

The franchising agreement provides a dispute resolution system for both parties, including a defect notification procedure and methods for remedying them. The ICC Model Contract is based on the assumption that it is governed not by any national legislation but by the provisions of the contract itself and the universally accepted principles of law in international trade. The purpose of this solution is to avoid, based on conflict-of-law rules, the application of any national legislation and to use the provisions of the Model Contract between Franchisors and Franchisees from different countries without providing advantages to one party, and not infringing on each other when applying the law of one of the parties, which is intended to provide the parties to the franchising agreement with greater legal certainty.

The question of the terms and the formation of a franchise agreement is resolved in accordance with the law applicable to it. Since in Russian law, as mentioned earlier, the closest form to a franchising agreement is a commercial concession agreement, let us consider what terms should be included using it as an example.

The essential terms of a commercial concession (franchising) agreement include the subject of the agreement, in which it is necessary to list the rights to intellectual activity objects. Note that the subject of the agreement must necessarily include the right to a trademark. Without this, the agreement will not be considered a commercial concession agreement. [13] For each object subject to registration, the details of the document certifying the exclusive right should be indicated. This could be, for example, a patent, a certificate, or a trademark certificate. If an object is not subject to registration, such as know-how, then it is necessary to describe in as much detail as possible what it includes.

Classes of goods in respect of which the right holder permits the user to use the trademark according to the unified International Classification of Goods and Services must also be included in the agreement.

Note that the right to use a brand name cannot be transferred under the agreement, whereas a commercial designation can (Articles 1474, 1538 of the Civil Code).

The right holder may transfer the entire volume of rights it possesses or only part of them. For example, it may have rights regarding several groups of goods but grant the user the right to use them only regarding one of them. In this case, the volume of rights transferred is no more than what the right holder has; otherwise, the agreement in this part may be recognized as not formed. A minimum and/or maximum volume of rights use can also be defined in the agreement (Article 1027 of the Civil Code).

An essential term of a franchising agreement under Russian law is also the price. An international franchising agreement must contain conditions for determining and paying remuneration to the Franchisor. Article 1030 of the Civil Code provides for the following forms of such remuneration: fixed one-time and/or periodic payments, royalties from revenue, a markup on the wholesale price of goods transferred by the right holder (Franchisor) for resale, or another form. A combination of these methods, consisting of a lump-sum payment and periodic payments of part of the profit, may be used.

It must be considered that the user must pay remuneration to the right holder even if it does not use the complex of exclusive rights, as a commercial concession agreement grants specifically the right of their use. [14]

If remuneration is established in the form of payments that vary depending on the user's sales, it is in the right holder's interest to include in the agreement an obligation for the user to provide reports and to provide for the involvement of independent auditors to verify their accuracy.

The term for which the right holder permits the use of the complex of exclusive rights is not an essential term. If the term is not specified, the agreement's duration will generally be limited to five years (Article 1235, Article 1027 of the Civil Code).

The agreement should describe the rights and obligations of the parties in detail. For example:

• The provision of technical and advisory assistance by the Franchisor, conducting training for the Franchisee's employees (Article 1031 of the Civil Code), the frequency and form in which the Franchisor conducts consultations, and which issues it helps to resolve;
• Quality control of goods, work, and services, frequency of inspections, scheduled and unscheduled audits, and analysis of reports;
• The Franchisee's obligation to ensure the confidentiality of information received from the Franchisor;
• Informing clients that the Franchisee is using a complex of exclusive rights under a commercial concession (franchising) agreement (Article 1032 of the Civil Code).

In international franchising agreements, the issue of applicable law is also significant, which we will discuss next.

Which Law Applies to an International Franchise Agreement (Commercial Concession Agreement)?

Russian law adopts the following approach for determining the law: if the parties to an international franchising agreement have not chosen the law applicable to it (Article 1210 of the Civil Code), then the law of the country with which the agreement is most closely connected applies.

Thus, Article 1211(6) of the Civil Code establishes that regarding a commercial concession agreement, the law of the country in which the user is permitted to use the complex of exclusive rights belonging to the right holder applies; or, if such use is permitted in the territories of several countries simultaneously, the law of the country where the right holder's place of residence or main place of activity is located applies.

As the Supreme Court of the Russian Federation points out, in resolving disputes from such agreements, it should be borne in mind that the content and limitations of exclusive rights to results of intellectual activity and means of individualization, their term of validity, permissible methods of disposal, and the necessity of state registration of agreements or the alienation, pledge, transfer, restriction, or termination of an exclusive right, and the granting of the right of use are in any case determined based on the law of the relevant countries in whose territory the legal protection of such a result of intellectual activity or means of individualization applies.[15]

It should also be borne in mind that the court may not apply the conflict-of-law rules from Article 1211(6) of the Civil Code "if it clearly follows from the law, conditions, or essence of the agreement or the set of circumstances of the case that the agreement is more closely connected with the law of another country (Article 1211(9) of the Civil Code). In doing so, the court must state the reasons why it considers the agreement to be clearly more closely connected with the law of another country. [16]

In light of the conflict-of-law regulation of franchising agreements, the question of the scope of mandatory (overriding mandatory) norms of the state in which the user operates while performing its contractual obligations requires resolution. In particular, foreign law chosen by the parties as the law applicable to the franchising agreement may contain provisions that contradict Russian norms prohibiting the restriction of competition. In a Russian court or arbitration, the question may be raised regarding the possibility of applying Russian law norms as overriding mandatory norms to a franchising agreement governed by foreign law (Article 1192 of the Civil Code). Such are, in particular, the provisions of Article 1033(2) of the Civil Code on the nullity of franchising agreement terms providing for an obligation of the user to sell goods, perform work, or provide services exclusively to buyers (customers) located or residing in the territory specified by the agreement. If a franchising agreement based on foreign law contains corresponding provisions, they must obviously be recognized as void by virtue of the above-mentioned overriding mandatory norm of Russian law. [17] The resolution of these and other issues of conflict-of-law regulation of franchising agreements has, unfortunately, not yet been adequately reflected in judicial practice.

Regarding the choice of jurisdiction, the parties are entitled to choose the national court of one of the parties to the agreement or an international arbitration institution as the place for resolving disputes. Some international arbitration institutions also provide specifically designated panels of arbitrators specializing in intellectual property disputes.

For example, the Panel of Arbitrators of the Hong Kong International Arbitration Centre (HKIAC) or the Panel of Arbitrators of the Singapore International Arbitration Centre (SIAC) for intellectual property disputes. The World Intellectual Property Organization (WIPO) also offers specialized procedures at the WIPO Arbitration and Mediation Center, focused on technology and intellectual property disputes.

How to Protect the Interests of a Party to an International Franchise?

There is a practice where unscrupulous Franchisees decide to terminate a franchising agreement but continue to conduct business using the Franchisor's intellectual property: its production or service delivery algorithms, marketing practices, recipes, etc. In such a case, the Franchisor incurs both reputational and financial losses, the risks of which can be prevented or minimized by correctly formulating the agreement terms.

A Franchisor can safeguard itself from such a scenario by including a clause in the agreement that prohibits the franchise acquirer from engaging in competing activities. Thus, in Case No. A71-13420/2020, a Russian franchise network of hair removal studios and hardware cosmetology clinics filed a claim to recover a fine of 1 million rubles from a former Franchisee for conducting competing activities. The Supreme Court of the Russian Federation, sending the case for a new trial, pointed out that termination of the agreement does not prevent the realization of the right holder's right to recover a fine from the user for carrying out competing activities, since the corresponding condition is contained in the agreement and does not contradict the provisions of Article 1033 of the Civil Code and the principle of freedom of contract. [18]

Upon re-examination of the case, the court of cassation, leaving the judicial acts on recovering the fine in force, gave an explanation according to which "termination of an agreement, as a general rule, leads to the release of the parties from further performance of the obligations assumed. However, in some cases, the parties remain bound by the obligations they have agreed upon. An agreement may contain such terms that remain valid by their nature even after its termination and are intended by their character to operate even after the termination of the agreement. The obligation not to conduct competing activity is not the subject of the agreement and does not terminate along with the termination of the agreement; its performance is also assumed after the termination of the agreement."[19]

Another important risk for the Franchisor is that the Franchisee may try to challenge the uniqueness and commercial value of its know-how and demand through court that the Franchisor return the lump-sum fee and royalties. Know-how can be called the core value of a franchise; its transfer is provided for by most franchising agreements. It is composed of described business processes, instructions, and other information about organizing a specific type of business, as well as information in the Franchisor company's knowledge base.[20]

The essence of the considered Case No. A67-10499/2021 was that the plaintiff — a Franchisee — demanded that the franchising agreement with a franchise network be recognized as not formed and the lump-sum fee be returned. The entrepreneur claimed that the Franchisor's know-how had no commercial value. During the legal proceedings, an expert review was conducted, during which experts determined that the franchising know-how package contained a legal block, a marketing block, information on business organization, and information on the technical means used in business activity, methods of their application, and others. The court concluded that the transferred information allowed the Franchisee to ensure a quick business start, which confirms the commercial value of such information; therefore, the claim was denied. [21]

It is important to note that within the framework of the dispute, the court outlined how the structure of know-how is formed. Four criteria can be highlighted in the court's conclusions:

• Information on know-how is a result of intellectual activity because it has been analyzed and structured by a person. The information explains how to conduct business and lists the stages from choosing the legal form to assessing results;
• The information contained in the know-how has actual commercial value. The Franchisor transfers to the Franchisee a list of goods whose effectiveness has already been confirmed, which will help them move to practice faster, open a franchise business, and reduce costs;
• Individual components of know-how, including documents, may not possess all the signs of know-how. The array of information is assessed, not the components. At the same time, know-how may contain data from open sources—this does not mean that the entire volume of information contained in the know-how does not comply with Article 1465 of the Civil Code;
• The commercial value of know-how is an advantage over third parties that the Franchisee receives. The information should help them enter the market in a new niche with minimum investment. Information that relates to a specific business and determines commercial value can be varied. [22]

In the eyes of consumers, a franchising network represents a single entity. When visiting any of the network's establishments, the consumer expects a certain level of service and quality products. Thus, maintaining a high brand reputation is only possible through the collective efforts of all Franchisees to comply with the right holder's terms and requirements when using the complex of rights provided to them.

One should not limit the agreement to formal citations of legislative norms; it is better to provide for an entire mechanism for verifying compliance with the right holder's requirements, criteria for such verification, and, necessarily, sanctions for identified violations.

Within Case No. A40-190221/2022, a violation by the defendant of the agreement terms regarding compliance with work standards was identified. The courts established that the plaintiff "conducted an on-site inspection of the defendant's enterprise, during which many violations of work standards, gross violations of SanPiN norms, and food preparation technology were revealed."[23] The courts concluded that the defendant violated contractual obligations and also justified the amount of the fine to be recovered in favor of the plaintiff.

In Case No. A40-298871/2019, the reasons for closing a franchise restaurant by the Franchisor also included violations, including critical ones: dirty refrigerators and other equipment, as well as the sign, facade, mats, and floors; absence of Banaderm on the sinks for handwashing, meaning the staff did not treat their hands with antiseptic; absence of thermometers at all stations; and expired products found in the warehouse.[24]

An example of protecting the Franchisee's interests is the rule in Article 1034 of the Civil Code regarding the subsidiary liability of the right holder for claims brought against the user regarding the non-compliance of the quality of goods (work, services) sold (performed, provided) by the user under a commercial concession agreement, as well as its joint and several liability for claims brought against the user as a manufacturer of the right holder's products (goods). However, this issue has also not yet been reflected in judicial practice.

Thus, despite a certain complexity, franchising, with proper reflection of the considered controversial issues, can serve as an effective way to both promote one's business and acquire skills for effective business management for beginning entrepreneurs using a franchise as an example. At the same time, the choice of franchise partners and the formulation of the terms for providing it require a careful approach and qualified legal expertise.

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References

[1] Strigunova D.P. International Franchising Agreement. Modern Law Journal, 2014, No. 12.

[2] Analysis of the Indian Service Market in the Sphere of Intellectual Property (Franchising and R&D) of the All-Russian Academy of Foreign Trade. My Export website.

[3] Yushchenko N.A., Gaifutdinova R.Z., Khasimova L.N. Legal Regulation of Franchising in China. Bulletin of Economics, Law and Sociology, 2021, No. 1.

[4] Ibid.

[5] Ivanova E.Yu., Romanovskiy E.A. International Legal Regulation of Franchising Relations: Problems and Prospects. Humanities, Socio-Economic and Social Sciences Journal, 2014.

[6] Bursulaya T. Franchising. Commercial Concession Agreement in Russian Legislation. Financial Newspaper, 2019, No. 16.

[7] Ibid.

[8] Strigunova D.P. International Franchising Agreement. Modern Law Journal, 2014, No. 12.

[9] Ibid.

[10] Decree of the Government of Russia No. 1416 dated December 24, 2015, On State Registration of the Disposal of the Exclusive Right to an Invention, Utility Model, Industrial Design, Trademark, Service Mark, Registered Topology of an Integrated Circuit, Computer Program, or Database Under a Contract and the Transfer of the Exclusive Right to the Said Results of Intellectual Activity Without a Contract.

[11] Bulgakova D.A. Legal Regulation of Franchising in the Legislation of Foreign Countries. Bulletin of Master's Studies Journal, 2017, No. 12-4.

[12] Klimova S.V. Franchising Agreement: Analysis of Main Elements. Jurist Journal, 2009, No. 12.

[13] Ruling of the Supreme Court of the Russian Federation dated March 16, 2017, in Case No. A68-11597/2015; Rospatent Order No. 186 dated December 29, 2009, On Approval of Recommendations on Issues of Verifying Agreements on the Disposal of the Exclusive Right to Results of Intellectual Activity or Means of Individualization.

[14] Ruling of the Supreme Court of the Russian Federation No. 78-KG16-38 dated October 18, 2016; Resolution of the Plenum of the Supreme Court of the Russian Federation No. 10 dated April 23, 2019, On the Application of Part Four of the Civil Code of the Russian Federation.

[15] Resolution of the Plenum of the Supreme Court of the Russian Federation No. 24 dated July 9, 2019, On the Application of Private International Law Norms by the Courts of the Russian Federation.

[16] Ibid.

[17] Kondratyeva E.M. Legal Nature and Regime of Franchising in National and International Turnover in Light of Private International Law. Bulletin of the Nizhny Novgorod University named after N.I. Lobachevsky, 2021, No. 4.

[18] Ruling of the Supreme Court of the Russian Federation dated June 9, 2022, in Case No. A71-13420/2020.

[19] Resolution of the Intellectual Property Court dated March 29, 2023, in Case No. A71-13420/2020.

[20] Franchise Launch: How a Correct Agreement Helps Reduce Risks. January 22, 2025. Kontur.Journal website.

[21] Controversial Issues of Determining the Status of Know-How and Its Commercial Value. May 21, 2024. Pravo Ru website.

[22] Ibid.

[23] Resolution of the Intellectual Property Court dated May 3, 2023, in Case No. A40-190221/2022.

[24] Resolution of the Ninth Arbitration Court of Appeal dated November 2, 2020, in Case No. A40-298871/2019.