New York Franchise Law Blog : Franchise Lawyer & Attorney Charles N. Internicola, Providing National Representation of Franchisees and Franchisors

(Part two of a two part series)

Franchise agreements drafted for common law countries tend to be longer and more comprehensive than franchise agreements used in civil law countries. Franchisors based in the United States often use their common law agreements in civil law countries without localization, reasoning that a more comprehensive agreement is all that is needed to protect them in a civil law system. However, when considering this approach, franchisors and their counsel need to be aware that a more comprehensive franchise agreement alone may not be enough to protect them in a civil law system. Recently, when discussing this issue with Kenneth A. Goss, Esq., in house counsel to a franchisor experienced in franchising in countries under common law, civil law and Islamic law systems, Mr. Goss explained some general principles common to many civil law systems from the perspective of a common law practitioner. The following is the second of Mr. Goss' two part guest post on this important topic:

Common Law Franchise Agreements in Civil Law Systems

As discussed in Part I of this series, courts in civil law systems are not bound by precedent, may look only to statutes as the source of law applicable to a franchise relationship and may go beyond the plain meaning of the terms of a franchise agreement to ascertain the parties' intent. As a practical matter, this means that franchisors should expect courts in a civil law system to apply certain mandatory rules regardless of whether the parties have negotiated and agreed to different terms in their common law franchise agreement. Additionally, courts may apply by analogy rules the legislature intended to govern contracts other than franchise agreements if the legislature is silent on an issue or the court otherwise deems it appropriate. In each case, courts in civil law systems typically will not recognize that a common law franchise agreement contains the complete agreement between the parties and may look beyond the four corners of a franchise agreement to ascertain the parties' intent.
Mandatory Rules

Civil codes typically delineate general rules of contract construction that are applicable to all contracts including franchise agreements. Examples of terms that are often mandatory in civil law systems relate to the definition of a contract, whether or not parties have the capacity to enter into a contract, the object of the contract, the formalities for creating the contract, the evidence a court will use to determine the parties' intent and the legal effect of the contract. Such are analogous to the boilerplate terms found in contracts in the United States. However, unlike boilerplate, parties cannot agree to opt out of mandatory terms provided by civil codes. In other words, courts in civil law countries will simply substitute mandatory terms for conflicting provisions of a franchise agreement, even when to do so is contrary to the express intent of the parties. Therefore, franchisors should be prepared to accept the mandatory terms of a civil code of the target country as part of their franchise agreement.

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Inherent to every franchise system is the license of intellectual property rights that, for good reason, has been (and should remain) focused on the trademarks and trade dress associated with the franchise system. While trademarks, logos, and trade dress are critically important intellectual property ("IP") assets, an additional (and possibly overlooked) IP asset may exist in the form of "design patents" issued by the United States Patent and Trademark Office. Design patents relate to the "novelty" and "ornamental appearance" of a product and may add a supplemental layer of IP protection for franchisors. When evaluating your IP portfolio and whether or not you are maximizing the legal protection of your IP assets, consider the following:

• Design patents relate to the protection of the "ornamental design" of a product and may include the "surface" design and appearance of products and equipment.

• "Utility patents" protects the way a product is used and works, while "design patents" protects the way a product looks;

• The elements of a "design patent" must be limited to the "ornamental appearance" of a product (i.e., how the product looks) and not thef unctional aspects of the product (i.e., how the product works); and

• Examples of design patents include, the layout of buttons on the "Google" search page, the original Coca-Cola bottle, the exterior surface design of custard vending machines and the ornamental appearance of numerous other products and equipment - many of which may appear quite ordinary.

When managing the legal protections to be afforded to your intellectual property, it is critical to recognize that design patents could very well play an important role in your IP strategy. By branding and acquiring design patents in the ornamental designs associated with the equipment, displays and products offered by your franchise system, you will be adding a valuable layer of IP protection. One valuable strategy to consider is to evaluate the overall trade dress associated with your franchise system and determine whether or not design patents maybe applied to certain products, equipment and designs associated with your system. Dont overlook this IP asset.

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Many times, "start-up" franchisors (and, too often, some established franchisors) overlook the necessity of maintaining a thorough operations manual that is both "current and relevant" to the particular franchise system. That is, many times operations manuals are viewed as an "afterthought" or a"generic" obligation to be sourced out to third party vendors.

Much more than a "generic resource", your operations manual must be drafted, updated and maintained as an integrated extension of your franchise agreement and FDD disclosures. Recognizing the critical importance of a properly prepared and integrated operations manual, startup and established franchisors should consider the following:

• Franchise agreements are typically drafted and structured to integrate and obligate franchisees to abide by both current "and future" operational requirements set forth in the operations manual. If the franchise agreement is drafted properly, the operations manual should create "contractual flexability", allowing the franchisor to modify elements of the franchise system through amendments and supplements to the operations manual.

• Your operations manual must serve as a thorough blueprint to provide franchisees with detailed "how to" information respecting each and every administrative and operational element of the franchise system.  

Examples of "administrative obligations" include (a) the franchisees royalty and financial reporting obligations, (b) franchisees financial record retention obligations, and (c) system requirements for point of sale systems. 

Examples of "operational obligations" include (a) franchisees obligations respecting the management of the franchise business, (b) requirements for management and control of inventory and supplies, (c) building and construction plans and specifications, (d) training programs and obligations, and (e) operational elements respecting the day-today management and operation of the franchised business.

• The preparation of your operations manual cannot be a task that you simply "outsource". While it is prudent to obtain the advice and input of a qualified consultant (including your franchise attorney), the operations manual must directly reflect and embody "your" direct understanding and knowledge about the franchised business. "You" must be the primary contributor and driving force behind the preparation and development of your operations manual.

• Your operations manual must be consistent with your franchise agreement and FDD. Review with your franchise lawyer the content of your operations manual to ensure that there is consistency with your franchise agreement. Ensure that your training programs are extensively identified in the operations manual and properly disclosed.

• Your operations manual should be constantly updated, refined and clarified to reflect the constant and continuous evolution and growth of your franchise system. 

Your operations manual is critically important to the long-term success of your franchise - treat it as such.
 

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 Franchise agreements drafted for common law countries tend to be longer and more comprehensive than franchise agreements used in civil law countries. Franchisors based in the United States often use their common law agreements in civil law countries without localization, reasoning that a more comprehensive agreement is all that is needed to protect them in a civil law system. However, when considering this approach, franchisors and their counsel need to be aware that a more comprehensive franchise agreement alone may not be enough to protect them in a civil law system. Recently, when discussing this issue with Kenneth A. Goss, Esq., in house counsel to a franchisor experienced in franchising in countries under common law, civil law and Islamic law systems, Mr. Goss explained shared some general principles common to many civil law systems from the perspective of a common law practitioner. The following is the first of Mr. Goss' two part guest post on this important topic:

Common Law verses Civil Law.

There are two dominant legal systems in the world today - the common law and the civil law. In addition to the specific franchise disclosure, relationship and other laws applicable to franchising in any specific country, franchisors in the United States should carefully consider the different approach each system takes to contract law before using a common law franchise agreement in a civil law country. This series looks at some characteristics typical of most civil law systems. Part I of this series compares common law and civil law systems generally and Part II takes a closer look at what affect a civil law system will have on a common law franchise agreement.

Common law and civil law systems are similar in principle but differ considerably in the methodical approach each takes with respect to statutes and interpretation. Both common law and civil law systems are rooted in liberal philosophy, which has the purpose of protecting and advancing individual rights. In this regard, common law and civil systems are more akin than, for example, Islamic law, which is based on religious teachings and is regarded as the word of God. However, a major difference between common law and civil law systems is the priority given to sources of law. Specifically, the common law gives priority to jurisprudence over legislation and the civil law gives priority to legislation over jurisprudence. As a result, there are considerable differences between common law and civil law systems in style, terminology, interpretation, conception and emphasis on certain elements over others, all of which are relevant for a franchisor that is thinking about operating between the two systems.

Common Law Systems

Most U.S. based franchisors are familiar with operating in a common law system. The common law is the Anglo-American legal tradition based on unwritten usage and custom that derives its authority from the legal opinions of judges. The common law was adopted by each of the United States, except Louisiana, and has spread to India, Australia, most of Canada and other countries formerly part of the British commonwealth.

In common law systems, the judiciary has the power to make law and each court is bound to apply precedent to cases with similar fact patterns as they arise. This means that the judiciary in a common law system has the power to create new rules for cases with novel fact patterns where the legislature has not enacted a statute addressing the specific issue. The power of a court to make law in a common law system is typically constrained by precedent and is a function reserved to the highest courts of appeal. 

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For the start-up and established franchisor alike, as your franchise system evolves continuous consideration must be given to your franchise agreement and "the legal rights that you reserve for your franchise system".  That is, basic to every franchise agreement are the "reservation clauses" identifying and  establishing alternative channels of distribution and legal rights  that are not granted, conveyed or licensed to your franchisees.  These reserved rights typically address alternative channels of  distribution and markets that are expressly reserved to the  franchisor.  Examples include internet sales, mail order sales, captive market accounts and licensed products sold through alternative sales channels.

Chances are that your "existing franchise agreement" contains reservation clauses.  However, have you recently reviewed these legal provisions?  Are the reservation clauses contained in your franchise agreement generic, or do they account for your future plans for expansion? When evaluating your franchise agreements and future plans for expansion, discuss with your franchise attorney and staff:

• Potential distribution and sale of private label products;
• Potential expansion and development of alternative franchise systems;
• Licensed distribution and sale of signature products and services through non-franchised outlets; and
• Your current and future plans for internet and/or mail order based sales.

There are other points but they are all based on the fundamental fact that you must be constantly evaluating your franchise agreement to ensure that it matches where your franchise is today and where it may be ten years from now.  Avoid the generic.

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Has the United States economy changed?  Are we in a "new economy"?

Yes, undoubtedly yes.   In fact there are so many new facets to our economy - some good, some questionable and some bad - that you don't need me to tell you that the economy has changed.  Ultimately, where our economy "ends up" is still undecided and, in large measure, will be decided by political and economic factors yet to be determined. But, no matter where we end up, one thing is clear: our economy has been and will remain fundamentally altered. 

So, what are some of the characteristics of this evolving "new economy" and what do franchisors need to know?

• Opportunity Still Exists - Although there are elements of economic turmoil - opportunities still exist.  For the start-up franchisor the current  level of economic instability may indeed constitute a competitive advantage and opportunity to level the playing field and compete with the "big players".   More than ever, technology is abundant and relatively cheap. Competitive tools such as the internet, automated database systems, point of sale systems and social networking have created the opportunity for small competitors to compete at the highest levels and take on much larger competitors who may be distracted by franchisee defaults, litigation and over leveraged balance sheets.

• A Renewed Focus on Franchisee Profitability is Critical.  Prior to the current economic cycle (and the 10 years prior to that) capital was abundant with consumers and prospective franchisees being afforded access to easy credit.  In many instances, franchise system sales and franchisee investments were, in large measure, fueled (or at least inflated) by consumers and franchisees who simply spent more than they could afford.  System growth was focused on the incremental "gross sales and royalties" generated by franchisee expansion.  Insufficient resources were placed on franchisee profitability (compared to gross sales) and, in the current economic cycle, franchisee default rates are increasing at a substantial rate. A renewed focus on franchisee profitability (even if it comes at the expense of gross sales) is more critical than ever as consumers and capital markets remain in retreat. 

• Other Factors. As you are well aware, there are many other facets to this "new economy", including the impact of the declining credit markets on franchisee financing.  In our future and continuing posts about franchising and the new economy we will discuss franchisee financing and other issues that franchisors are confronting.   

This story is evolving rapidly...

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There are many reasons why, for many, the purchase of a franchise makes sense. However, buying a franchise may not be right for you. I was, again, reminded of this "obvious and basic fact" during a conference call today with a client considering a substantial investment in a multi-unit franchise. The investment was sizable and, quite frankly, there was plenty of opportunity in the deal.  After a substantial legal review (where everything looked good and substantial negotiating points were achieved) he decided that "becoming a franchisee was not right for him" -  so he walked away from the deal. 

I think the right decision was made.  Not for any particular legal reason, but, because sometimes, becoming a franchisee is just not right.  When your "gut" tells you its not right - then walk away. The reverse, however, should not be applied.  That is,  if, your "gut" tells you that a potential franchise opportunity "is right for you", then your next step is not to just sign a franchise agreement but, rather, to engage in a thorough "due diligence" evaluation to ensure that you are acting on solid information.

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In a comment to a recent post - "5 Things to Know before Buying a Franchise" - the Franchise King, Joel Libava, raises the critical issue of maintaining "uniformity" in franchise agreements.  That is, the insightful Mr. Libava, challenges the propriety of promoting negotiated modifications to franchise agreements.  The point raised by Mr. Libava is a legitimate and genuine issue that must be evaluated by both franchisors and prospective franchisees.  

From a franchisors perspective uniformity is a critical factor that must underly the franchisors  legal relationship with its franchisees.  Similar to the uniform standards and procedures inherent in franchise systems, franchise agreements must also maintain consistent levels of uniformity.  Such uniformity will, at a minimum, serve to reduce litigation exposure and foster a consistent platform for the management and growth of the overall franchise system.  

From a franchisee's perspective, uniformity in franchise agreements may be a positive factor (i.e., a franchisor committed to its franchise agreement and systems) if the proposed franchise agreement is "balanced" and the franchisor possesses a substantive track record.  So how do you determine if the franchise agreement is "balanced" ?  You do your research, review the franchise agreement and FDD with a qualified franchise lawyer, speak to qualified franchise consultants and conduct the necessary due diligence.  Chances are that there will be "imbalances" in your proposed franchise agreement - there always will - but you must honestly evaluate the impact of this relationship.

So how do I put all this together, i.e., "franchisors perspective", "franchisees perspective", "balance", "imbalance"? Here are my thoughts:

1.  If you are a franchisor, focus on the development of a balanced franchise agreement that fosters the maintenance, protection and growth of, both, your franchise system and business interests of your franchisees.  Once this is achieved - really achieved - then stick to your franchise agreement and be prepared to "walk-away" from potential franchise sales;

2. If you are a prospective franchisee and you have viable questions or concerns about a potential franchise investment (after you have conducted the necessary due-diligence and evaluated the legal implications of the franchise agreement) then be prepared to "walk away" . 

The real issue comes down to a "third scenario" involving  a "franchisor not prepared to walk-away" or a "franchisee not prepared to walk away".  These are the situations where negotiations and targeted franchise agreement modifications come in.  For that prospective franchisee I would much rather obtain targeted franchise agreement modifications that I know will have a substantive impact on the prospective franchisees rights.   I think that Mr. Libava's position would be that  there should not be a third scenario?

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From a franchisors perspective litigation is a critical "cost factor" that must be contained and mitigated.  When consulting with franchisors (both start-up and established) one issue that provides good reason for concern is the ability of "franchisee associations" to sue you directly.  Traditionally, the issue of "standing" - that is the right to sue another individual or company - requires that, in commercial transactions, the parties possess a direct relationship and "privity" with one another.  When dealing with certain associations (including franchisee associations) the courts have expanded the concept of "privity" and have afforded certain associations the right to sue even where a direct relationship may not exist.  That is, although you may have no dealings or contractual relationship with a "franchisee association", the "association may nevertheless possess the legal right to sue your company.  Considering the significance of this issue and to better address the question of - why? - that franchisors rightfully ask, the following is a brief review and summary of some of the case law involving a franchisee association's right to sue (My comment follows at the end):

[Guest Post: Kenneth A. Goss, Esq.] 

Franchisors that have experienced litigation from franchisee associations may wonder how a franchisee association has a right to bring a lawsuit against a franchisor. Here is the brief answer.

First, a little background and let's assume we are only talking about federal court, where many franchise cases are brought. Under Article III of the United States Constitution and applicable federal law, a franchisee association must have standing to bring a lawsuit against the franchisor. Standing simply means that the franchise association has the right to file a lawsuit under the particular facts of the case. In the franchise relationship, franchisees themselves may have standing to sue a franchisor because of privity of contract. Privity of contract simply means that a franchisee can enforce its franchise agreement by a lawsuit against the franchisor and vice versa. However, a franchisee association may be a separate entity, not a party to a franchise agreement with the franchisor and, therefore, not in privity of contract with the franchisor. How then can a franchisee association bring suit against a franchisor?

The simple answer is that courts have said they can. Courts have held that an association, which otherwise itself would lack standing to sue, nevertheless has standing to bring suit on behalf of its members when (1) its members would otherwise have standing to sue in their own right; (2) the interests it seeks to protect in the lawsuit are germane to the association's purpose; and (3) neither the claim asserted nor the relief requested requires the participation of the individuals in the lawsuit. See, for example, Clark v. McDonald's Corporation, 213 F.R.D. 198 (2003). If a franchisee association meets this test, then it can bring suit against a franchisor on behalf of its members.

[My take on this issue:  When evaluating the factors as to a franchisee association's "standing to sue", one serious point of attack in challenging the association's "right to sue" or, at least, limiting the relief sought by the association exists in the third factor - point (3), above. That is, although franchisee association's possess a "right to sue" this right is limited to claims and relief "that do not require the individual participation of your individual franchisees".  If the franchisee association's claims extend to "monetary damages" - a claim that "requires the participation of individual franchisees - then the association may have exceeded its legal standing.  Claims that fall within the association's standing typically involve claims where the association seeks "declaratory judgment and injunctive relief.  When faced with association litigation, franchisors must challenge standing at every reasonable opportunity.]

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