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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 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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Can you expand your business in the State of New Jersey through a "license agreement" without triggering New Jersey's franchise relationship laws?  (This is not a simple question and, unfortunately, the answer involves an evaluation of both "objective" and "subjective" factors.)

Short Answer:  

Yes, however you must discuss and evaluate the substance of  your license agreement, including your degree of control over your "licensees" operations and your economic influence over your "licensees" business.  

Long Answer :

The New Jersey Franchise Practices Act contains extensive prohibitions and restrictions governing (and in many cases modifying) the contractual relationship between franchisors and franchisees within the state.  Under New Jersey law the following criteria give rise to a franchise relationship and the potential imposition of franchise regulation:

1. The existence of a written agreement for a definite or indefinite period;
2. Providing for a license to use a trade name, trademark, service mark or related characteristic is granted; and
3. The existence of a community of interest in the marketing of goods or services at wholesale, retail, by lease, agreement, or otherwise.

With New Jersey's definition of a "franchise" heavily dependent on the existence of a "trademark license", your contemplated "license agreement" may have the unintended consequence of creating a regulated "franchise relationship".  To determine if your (1) written (2) trademark license agreement "crosses the line into franchise territory" you must evaluate the (3) community of interest criteria and determine whether or not your written license agreement "creates a community of interest [between you and your licensee] in the marketing of goods or services..."

This "community of interest" criteria is not defined by the New Jersey statute, involves a subjective determination and has been expansively evaluated by New Jersey courts in favor of finding a franchise relationship. To make this determination the courts look to the relationship between the parties and, among other things, the extent to which the licensee (franchisee) is economically dependent on the licensor (franchisor).  That is, where a licensee invests in a business that is largely dependent on a licensor's trademarks, products and/or services and where the licensor possesses significant influence over the licensees business, a "community of interest" (and thereby a franchise relationship) may exist.  Some of the factors that the courts have found to be relevant, include:

• The extent and nature of the licensees /franchisees business investment;
• The bargaining power between the parties;
• The licensees/franchisees economic dependence on the licensor's/franchisor's goods or services;
• The licensor's/franchisor's control over the goods and services offered by the licensee/franchisee; and 
• The licensees/franchisees ability to procure and/or offer goods supplied by a third-party.

Ultimately, any determination as to whether or not your New Jersey license agreement "crosses the line" into franchise territory will require a detailed evaluation of your written agreement and the economic relationship and legal rights that you create.  If your "license agreement" gives rise to a "franchise relationship", your licensee (and now franchisee) will be granted substantial protections and rights granted by the New Jersey Franchise Practices Act.    The key is to be aware of this "unintended consequence" when structuring and planning your "license" agreements and business relationships

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In certain "franchise sales settings" franchisees are sometimes led to believe that modifications cannot be legally made to their franchise agreement.  That is, to induce a franchisee to sign the franchise agreement - without the benefit of any negotiations or review by a franchise attorney - the franchisee is led to believe that the franchise agreement is a "standard agreement" (signed by everyone) and that legally the franchisor is not allowed to make any changes.  The implication: you might as well just sign the agreement and not waste time or money since "we can't change the franchise agreement even if we wanted to".  

Sadly this misstatement / "myth" leads to a false sense of security and sometimes some big mistakes by prospective franchisees.  To be clear:

• Franchise agreements are negotiable;
• It is not illegal for a franchisor to modify its franchise agreement; and
• It is extremely common for franchisees to negotiate certain aspects of the franchise agreement.

Understanding these facts keep in mind that the extent to which a franchisor may be willing to negotiate the terms of its agreement varies depending on the negotiating power of the parties - one major factor includes the financial resources of the franchisee.  Also, certain core provisions of a franchise agreement - such as the royalty rate, methods of operation and use of proprietary products - usually are not and should not be subject to change.  

Some of the critically important franchise agreement terms that you should be evaluating and potentially negotiating, include:

• Scope of your protected territory;
• Grace periods regarding the commencement of royalty obligations;
• Liquidated damages and liability for early termination;
• Renewal rights;
• Transfer rights; 
• Cure periods for alleged defaults; and
• Potential "rights of first refusal".

Depending on your circumstances and concerns there are many other issues that, as a prospective franchisee, you should be considering.  However, it is critical that, as a prospective franchisee, you recognize that you have the "right" to negotiate the terms of your franchise agreement.  This "right" must be taken seriously.

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Although the State of New Jersey is not a Franchise Registration State, over the years, the New Jersey State legislature has implemented laws pertaining to and affecting the legal rights between franchisors and franchisees.  The New Jersey Franchise Practices Act (NJSA 56:10-1)("NJFPA") adopts an extremely "paternalistic" approach to the franchisee / franchisor relationship and implements a number of legislated rights designed to benefit franchisees.

Both franchisors and franchisees with operations in the state of New Jersey should be aware of the NJFPA and its legislated rights, including NJFPA's  extremely vague "prohibition" against "unreasonable standards of performance".

Franchisor Standards of Performance must be "Reasonable".  Under the NJFPA franchisors are prohibited from imposing "unreasonable standards of performance on franchisees". This extremely vague "prohibition" is open to a broad range of interpretation and is designed, among other things, to prevent the termination of franchisee rights under the pre-text of "non-compliance".  

Relevance to Franchisees: This provision of the NJFPA, essentially, imposes a "reasonableness" standard when evaluating a franchisors attempted termination of a franchise relationship.  Under the NJFPA lawyers for the "terminated franchisee" are afforded the legal right to challenge, question and have the court evaluate the "reasonableness" of the franchisor's standards.

Relevance to Franchisors: Even if your system standards are well thought out, balanced and fair (as is typically the case with "successful" franchisors) when dealing with New Jersey franchisees, franchisors and their legal counsel must recognize that your system standards may be subject to interpretation and evaluation in a judicial proceeding.  To avoid unnecessary litigation costs and expenses, before terminating a franchise relationship take extra caution to document and communicate your performance standards and issues of non-compliance. 

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