Legal Enforcement of International Franchise Relationships: What Makes Sense for the Business
March 2008 Franchising World
In the international arena there is no substitute for good prior planning and judgment.
By Roger Schmidt and Joyce Mazero
U.S. franchisors tend to structure domestic franchise arrangements by contemplating almost every undesirable eventuality. Most franchisors structure domestic franchise arrangements to provide remedies for every “worst case” scenario. For franchisors, fighting a domestic dispute in an adversarial proceeding is not unusual, while often disregarding the possible desirable outcome of attempted resolution efforts.
When U.S. franchisors structure international franchise arrangements, they too often take the domestic approach that they are accustomed to, only to later realize that the rules change and that engaging in disputes in foreign adversarial proceedings can be substantially more difficult, expensive and time consuming than the domestic judicial battles to which they are accustomed. Many franchisors find that a domestic kitchen-sink approach to drafting international franchise agreements is frequently a “turn off” to prospective international franchisees. In many cases, broad inclusion of standard domestic requirements appropriate for a domestic arrangement could be characterized as a knee-jerk response, wholly inappropriate for an international transaction setting the arrangement up for immediate confrontation or failure, simply due to lack of forethought. For example, provisions governing events of default that subject the franchisee to automatic termination without notice, mandatory contributions to advertising funds, mandatory accounting reviews, certain concepts of equity and even jury trials are not always appropriate for inclusion in international franchise agreements. Such forced inclusions by the franchisor are often an initial recipe for disaster.
While all lawyers approach tasks differently, it should be incumbent upon them to approach litigation in the international arena with a different view than in the United States. This is especially true at the onset of a franchise arrangement in a country or jurisdiction that is completely unfamiliar to the franchise system and probably to the lawyer. This is where choice of law and forum can be the most effective enforcement tools even though there are no pending disputes and the relationship is in its infancy. Be keenly aware of countries that impose limitations on litigation, damages and jurisdiction, and be careful if the brand intends to agree on a “third party neutral” country as its choice of dispute resolution. The choice of law and jurisdiction can be very complex and time well spent on these aspects will have ultimate positive rewards. Choose the law and forum wisely.
Deterrents to Litigation
While some boilerplate franchise agreement provisions may not be appropriate for international transactions, there are other contract provisions that can act as effective deterrents to litigation, provide the franchisor with greater leverage in compelling compliance by the franchisee, and in some cases, provide a road map for the resolution of disputes. Happily, these are largely provisions that can be fairly explained and reasonably defended in negotiations with a potential franchisee. This is important. Litigating or arbitrating a dispute with U.S. franchisees can be a very uncomfortable experience, but a cross-border lawsuit is almost always a significant drain on money, time and morale. The laws of other countries often make the playing field uneven. The logistics and personnel investment can be wearisome and even a win in a proceeding does not mean a win in reality. Recognition and enforcement of foreign court judgments and arbitration awards, finding assets on which to execute a judgment and maintaining a market that is still receptive to the franchisor’s concept post-litigation is tricky. In addition, in many cases, the litigation experience is simply not good for business.
In October 2005, Professor Arthur Kalnins compiled a study of 142 master franchise ventures of 53 U.S. food franchisors in 37 countries. He found that of the 142 ventures in the sample, only 55 (39 percent) survived until the end of the development commitment periods, typically five years. Interestingly, he also found that among the 87 failed ventures studied, only five were accompanied by news of lawsuits regarding the non-fulfillment of the development commitments. Thus, while 60 percent of master franchise ventures failed, only a tenth of those failures resulted in litigation. This result runs counter to what might otherwise be expected, but supports the premise that litigation or arbitration are remedies of last resort. Franchisors need to, or by default are required to, rely on other more cost-and time-efficient deterrents or quasi-remedies to press for compliance with the franchise agreement when dealing with international franchise relationships.
The following are examples of types of provisions that offer either a deterrent effect or a middle ground for the resolution of commonly-occurring problems:
• Failure to meet development schedule: Provide alternative consequences for the developer’s or master franchisee’s failure to timely develop units, such as the developer’s ability to purchase a pre-determined number of extensions; provide for the franchisor’s right to reduce the geographic scope of rights granted under the development agreement; structure an increase in fees; reduce the time for development and the number of units to be developed; or eliminate exclusivity in the market.
• Taxes and currency exchange: Allocate responsibility to the franchisee for paying the withholding or other taxes due on payments made to the franchisor; and allocate liability to the franchisee for currency exchange risk.
• Guaranteeing payment: In lieu of a personal or corporate guaranty which can be rendered worthless without continuing vigilance by the franchisor over the quality of the assets supporting the guaranty, use a letter of credit or a bank guaranty (non-U.S. only) in sufficient replenishing amounts during the term of the franchise agreement that may be drawn against by the franchisor in the event of non-payment or other defaults. Some are dissuaded from use of a letter of credit or bank guaranty because of the expense to the franchisee or possible negative effect on credit. However, either serves as a strong deterrent to noncompliance and can save significant money for both sides when compared to litigation or arbitration costs. Additionally, one approach for the developer would be to offer the franchisor a letter of credit in a flat amount as the sole remedy for settling all monetary damages.
• Liquidated damages: Provide for liquidated damages in the event of certain defaults by the franchisee, such as those relating to confidentiality (but not noncompetition covenants), compliance with transfer restrictions and some post-termination obligations. The liquidated damages should be in amounts that the franchisor can defend as reasonable and attributable to defaults for which the franchisor does not plan to also ask for injunctive relief because they will likely be viewed as an election of remedies.
• Subfranchise agreements: Maintain a range of alternatives for dealing with subfranchise agreements if a master franchisee is terminated, such as a franchisor’s right to terminate, step into, amend or assign the subfranchise agreements.
• Language requirements: Control the language of translations and law to govern the franchise agreement. This can be a key part of dealing with other countries’ protective agency laws. In particular, in Middle Eastern countries such as the United Arab Emirates, it is important to ensure that no translations are made (save perhaps, a dual translation of a guaranty, if used) and no filings are made with the government that would permit the franchisee to gain the status of an “agent” under the country’s protective agency laws. Franchisee protection under the agency laws may make termination of the franchise agreement substantially more difficult, can create market exclusivity where none was provided, and or prevent the exporting of goods into the country. Other approaches to reducing the risk of agency laws include a choice of law provision other than the target country’s law, a letter of credit or bank guaranty to subsidize any compensation payment, and a right to execute on a security interest in the franchisee’s ownership, including voting rights or a right to exercise an option to obtain control of the franchisee’s assets.
• Dispute resolution: Mediation is particularly well suited to international commercial disputes because parties do not have to submit to the authority of another jurisdiction. Mediation can be customized to the parties’ needs and can be particularly helpful for resolving disputes where cultural differences exist. In addition, mediation is more flexible and can provide cost-efficiency where arbitration or litigation is substantially less flexible and cost-efficient. With mediation, the parties may arrive at a settlement, choose to proceed with litigation or arbitration, or do nothing. The specific types of interim remedies available to a franchisor will vary in part based on the nature of the franchise system, but in many cases, interim remedies facilitate the parties’ ability to consider the best business deal to be struck in the face of a weakening relationship.
Litigation and Arbitration
A franchisor may consider incorporating the above provisions into any international franchise agreement to settle disputes before they result in litigation. If pre-litigation attempts to resolve a dispute are not viable, litigating or arbitrating the dispute may be the only remaining viable option. However, if the franchise system is not merely seeking money damages but rather equitable remedies such as injunctive relief, a court, arbitration or administrative proceeding is the only option. A great number of ventures by franchisors into international legal waters target relief, stopping a franchisee from an act that is in violation of the franchise agreement such as post-termination infringement of the trademark.
International franchise disputes can sometimes be resolved favorably through traditional litigation, but keep in mind international litigation is commonly criticized for its considerable cost, consumption of time and lack of predictability. The obvious advantage of litigation is that it provides greater procedural certainty and definitive outcomes for all parties. However, litigation usually generates negative publicity which can damage a franchise brand. Again, be careful of litigation, as the forum laws of the franchisee may successfully resist enforcement of the contractual choice of law and may unfairly benefit the franchisee, and, the franchisors may find it difficult to enforce court orders as enforcement is normally determined on a country-by-country basis, as opposed to a multi-country supported convention like the New York Convention.
A franchisor that seeks to stop a franchisee from committing violations of the franchise agreement should also note that while arbitration is not advisable for every dispute, it is normally the international resolution mechanism of choice. International arbitration associations offer impartial, neutral procedures for resolving international franchise disputes. International arbitration treaties make arbitration decisions easier to enforce. The United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards, commonly known as the 1958 New York Convention, provides that “the court of each signatory will abide by, recognize and enforce foreign arbitral awards.” Arbitration also preserves confidentiality over the proceedings, a result which cannot be ensured by litigating in a trial court. Franchisors also often insist on arbitration clauses that restrict the availability of class actions, limit the type of damages recoverable, pre-select the favorable forum or prevent access to jury trials. The drawbacks of arbitration are most notably, the lack of appeal process and a considerable cost that is often similar to the cost of litigation.
The following are examples of contractual provisions that can enhance the value of international arbitration as an enforcement remedy:
• Integrated arbitration provision: Use an integrated arbitration provision so that any discussion contemplated in the franchise agreement about types, election or exclusivity of remedies is contained in the arbitration provision. This should help eliminate confusion for the arbitrators or arbitration authority on the intended use of arbitration.
• Criteria for international arbitrators: If specifying the criteria, such as qualifications or experience for arbitrators, make sure the criteria is not too narrow and that arbitrators realistically can be found that meet such criteria, unless the franchise company purposefully wants to delay the arbitration.
• Interim-measures clause: An interim-measures clause should expressly authorize the arbitrators to issue interim equitable relief. If reserving the right to commence a court action for equitable relief or other purpose, be sure to clarify the role of the arbitral panel in such event or such provision could be read as a waiver of arbitration.
• Multi-party arbitration provision: Since there are other potential parties to most franchise agreements other than the franchisor and franchisee, consider a multi-party arbitration provision giving express recognition of third-party beneficiaries or multiple principals who may be involved in a dispute. In that case, a franchisor may lose the ability to appoint its arbitrator in a multi-party arbitration and may want to add an express provision permitting such appointment.
• Cost allocation: Consider adding a provision clearly allocating costs to any party that fails to comply with any arbitration award or court order. If translations will be needed in the arbitration action, ensure the franchise has allocated responsibility for approval of the translation and the costs.
• Conflict of terms: Where there are several different forms of franchise agreements with a franchisee over the years, include a statement providing that in the event of a conflict in terms, the terms under the latest or most current form of dispute resolution provision shall control and have it initialed when executed.
Of course, one of the greatest advantages of writing arbitration into an international agreement is that the franchise system has great discretion in establishing its own procedural rules and forum selection, rather than subjecting the agreement to interpretation of the rules and procedures of an organization such as the International Chamber of Commerce, American Arbitration Association or the London Court of International Arbitration, all of which may be unacceptable to the parties should a dispute arise. As to an arbitration forum, several developed countries have laws that prevent their courts from intervening or interfering in the arbitration process and subsequent awards, and those countries offer very plausible forum choices.
Enforcement of a U.S. franchise in the international waters must be approached with trepidation coupled with good legal and business counsel to ensure compliance with the laws of each country and the needs of the franchisor. Whether drafting the agreement, litigating, mediating or arbitrating in the international waters, do your homework prudently and comprehensively on all fronts. In the international arena there is no substitute for good prior planning and judgment.
Roger Schmidt is chief general counsel of Curves International, Inc. and Joyce Mazero is a partner with the law firm Haynes and Boone, LLP. He can be reached at firstname.lastname@example.org or 254-399-9285 and she can be reached at 214-651-5336 or email@example.com.
Sources of information referenced in this article include:
Arthur Kalnins, Biting Off More Than They Can Chew: Unfulfilled Development Commitments in International Master Franchising Ventures, 5.12 CHR Reports 1, 8 (2005); Carl Zwisler, How to Enforce Franchise Agreements and Resolve Disputes in International Franchise Relationships, International Franchise Expo, Washington D.C. (2007); Jenifer Dolman, Robert Lauer, Larry Weinberg, Structuring International Master Franchising Relationships for Success, And Responding When Things Go Awry, ABA Forum on Franchising, October 12-14, 2007.
In some countries, including those in the European Community and the Middle East, franchise agreements are often categorized as agency agreements. If this occurs, a grant of exclusivity can be read into the agreement and the choice of foreign law may be unenforceable. Pursuant to local law, upon termination or non-renewal of a franchise agreement, the franchisor may have to pay compensation to a franchisee unless termination or nonrenewal occurs for one of the statutory “good” causes for termination.
Franchisors should note the Ninth Circuit’s decision in Nagrampa v. MailCoups, Inc., 401. F.3d 1024 (9th Cir. 2005), discussing the lack of enforcement of arbitration clauses with venue outside of California. This decision could affect California franchisors who want to use a non-California venue for international deals.