Franchise Agreement

This article has been written by Priyal Bhandari pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution course from LawSikho.

 This article has been edited and published by Shashwat Kaushik.

Introduction 

In the business world, entrepreneurs and investors are given countless opportunities but one approach that is proven to be cost-effective and popular is franchising. Franchising is an instrument that allows individuals to strengthen their success by promoting recognised and renowned brands and reducing the risks involved in starting a new business from scratch. However, it is important to understand the foundation of this contractual relationship, i.e., the franchise agreement.

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This article will provide the basis of the franchise agreement, important clauses in the agreement, the rights and obligations of the parties, the nature and scope of the franchise agreement and how one can protect their IP and confidential information.

What is a franchise agreement

A franchise agreement governs the contractual relationship between the franchisor and franchisee, under which the franchisor allows the franchisee to sell the products or services under his established business’s goodwill. Under a franchise agreement, the franchisor sells or licences his intellectual property rights (IPR) to the franchisee, generally to expand his business or to outreach people. The franchisor owns the established business and its trademark, while the franchisee operates the business at a different location using the franchisor’s intellectual property. This method of distributing products or services through retail outlets is called franchising. Hence, it is executed through this agreement, which sets out the principles that govern both parties. This document defines the rights and obligations of both the franchisor and the franchisee. 

What is the scope of franchise agreements

A franchise agreement outlines specific terms and conditions, operation of the business, responsibilities of the parties and their rights, business strategies, liabilities of the parties, compliance and regulation, etc. It helps bring consistency and integrity to the franchise business. The scope of a franchise agreement is essential to ensuring the smooth functioning of the business.

Laws that govern franchise agreements

The Indian Contract Act of 1872

The general principles of the Indian Contract Act of 1872, such as offer and acceptance, consideration, terms and conditions, obligations, termination and dispute resolution instruments, apply to these types of agreements. The statute describes free consent, which protects the parties from any undue influence, fraud, or misrepresentation and provides for remedies of compensation or damages to the aggrieved party.

Offer and acceptance: In the context of franchise agreements, an offer is made by the franchisor, outlining the terms and conditions of the franchise, including the rights and responsibilities of both parties. The franchisee, upon reviewing the offer, communicates their acceptance, thereby forming a legally binding contract.

Consideration: Consideration is a vital element in contract law, and it applies equally to franchise agreements. Consideration refers to the exchange of something of value between the parties involved. In franchise agreements, this is typically represented by the payment of a franchise fee or royalty by the franchisee to the franchisor in exchange for the rights and resources provided under the agreement.

Terms and conditions: Franchise agreements often encompass a wide range of terms and conditions that govern the relationship between the franchisor and franchisee. These may include provisions related to the use of trademarks, marketing strategies, training and support, territory rights, and termination procedures. Clear and well-defined terms and conditions help ensure a mutually beneficial and sustainable partnership.

Obligations: Both parties in a franchise agreement have specific obligations to fulfil. The franchisor is generally responsible for providing training, marketing support, and ongoing assistance to the franchisee. The franchisee, on the other hand, is typically obligated to maintain the quality and standards of the franchise brand, adhere to operational procedures, and make timely payments as stipulated in the agreement.

Termination and dispute resolution: Franchise agreements often include provisions addressing termination and dispute resolution mechanisms. Termination may occur due to various reasons, such as breach of contract, insolvency, or mutual agreement. Well-crafted termination clauses outline the process and any associated penalties or obligations. Dispute resolution instruments, such as arbitration or mediation, are commonly included to facilitate the resolution of conflicts and disputes that may arise during the term of the agreement.

By adhering to the principles outlined in the Indian Contract Act of 1872, franchise agreements can be structured to ensure fairness, transparency, and mutual benefit for both the franchisor and franchisee. These principles provide a solid foundation for building successful and enduring franchise partnerships.

Intellectual Property Laws

Franchise agreements typically involve the utilisation of trademarks, trade secrets, and the know-how encompassed within the franchisor’s intellectual property (IP). The legal framework governing IP in India comprises several key statutes:

The Patents Act of 1970: This Act provides protection for inventions, including products, processes, and designs, that are novel, non-obvious, and have industrial application. It grants exclusive rights to the patent holder to make, use, sell, and import the patented invention for a period of 20 years from the date of filing.

The Copyright Act of 1957: The Copyright Act safeguards the rights of authors and other creators of literary, dramatic, musical, and artistic works. It provides exclusive rights to the copyright holder, including the right to reproduce, distribute, perform, and display the copyrighted work. The duration of copyright protection generally lasts for the author’s lifetime plus an additional 60 years.

The Trademarks Act of 1999: The Trademarks Act regulates the registration and protection of trademarks, which are distinctive signs used to identify goods or services. It grants exclusive rights to the trademark owner to use the mark and prevents others from using identical or confusingly similar marks. Trademark protection can last indefinitely as long as the mark is in use and the necessary renewal fees are paid.

The Designs Act of 2000: The Designs Act protects the aesthetic appearance of products, such as their shape, configuration, pattern, or ornament. It grants exclusive rights to the design owner to make, use, sell, and import products embodying the registered design for a period of 10 years, which can be extended for an additional 5 years.

These IP laws are essential in safeguarding the rights of franchisors and ensuring that their valuable intellectual property is protected from unauthorised use or infringement. By complying with these laws, franchisors can maintain the integrity of their brand, foster innovation, and secure a competitive advantage in the marketplace.

The Consumer Protection Act, 2019

The Consumer Protection Act of 2019 safeguards the rights of consumers who buy products from franchise companies and provides a platform for resolving disputes between the parties. The aggrieved consumers can seek compensation or other remedies under this law against unfair or defective practices. The Act mandates  a smooth negotiation process for dispute resolution between the parties.

Key features of the Consumer Protection Act of 2019:

Consumer rights protection: The Act recognises and protects the fundamental rights of consumers, including the right to be informed about the quality, quantity, price, and other relevant aspects of products or services offered by franchise companies. It also ensures that consumers are protected from unfair trade practices, such as misleading advertisements, false representations, and defective products.

Dispute resolution mechanism: The Act establishes a streamlined and efficient dispute resolution mechanism for addressing consumer grievances against franchise companies. Consumers who have suffered losses or damages due to unfair or defective practices can seek compensation or other appropriate remedies through this mechanism.

Mandatory negotiation process: The Act mandates a mandatory negotiation process between the parties involved in a consumer dispute before approaching the consumer courts. This negotiation process aims to facilitate an amicable resolution of the dispute outside the formal court system, saving time and resources for both parties.

Penalties and compensation: The Act empowers consumer courts to impose penalties on franchise companies found guilty of violating consumer rights. Additionally, consumers can be awarded compensation for the losses suffered due to such violations, including the cost of the product or service, consequential damages, and mental agony.

The Companies Act, 2013

The Companies Act of 2013 generally governs the various aspects of a company, such as its formation, registration, management and operation. However, this Act provides for registration and other requirements for companies that enter the franchise business. It is important for a company to comply with the rules and regulations of this Act to gain benefits such as goodwill, reduced legal risks and financial stability.

Key provisions of the Companies Act of 2013 pertaining to franchise businesses include:

  • Registration of franchise agreements: The Act mandates that all franchise agreements must be registered with the Registrar of Companies (ROC) within 30 days of their execution. This registration process provides transparency and ensures that the terms and conditions of the franchise agreement are legally binding.
  • Disclosure requirements: Companies engaged in franchising are required to provide prospective franchisees with a comprehensive disclosure document containing all material information related to the franchise business. This document includes details about the franchisor’s business history, financial position, litigation history, and other relevant information. The disclosure document helps prospective franchisees make informed decisions and assess the potential risks and rewards associated with the franchise opportunity.
  • Franchisee protection: The Act includes provisions to protect the rights and interests of franchisees. It prohibits franchisors from engaging in unfair trade practices, such as misrepresentation, coercion, or tying arrangements. Franchisees are also provided with certain rights, including the right to terminate the franchise agreement under specific circumstances.
  • Regulation of franchise fees and royalties: The Act empowers the Central Government to regulate the fees and royalties charged by franchisors. This provision aims to prevent excessive or unreasonable charges that may disadvantage franchisees.
  • Cooling-off period: The Act provides a cooling-off period during which prospective franchisees can review and consider the franchise agreement before making a final decision. This period allows franchisees to seek legal or professional advice and make an informed choice about entering into the franchise relationship.

By incorporating these provisions, the Companies Act of 2013 seeks to establish a balanced and fair regulatory framework for the franchise industry in India. It ensures that franchisors and franchisees operate in an ethical and transparent manner, fostering the growth and success of the franchise business model while safeguarding the interests of all stakeholders involved.

Tax laws

The Indian tax laws, such as the Central Goods and Services Tax Act of 2017 (GST Act) and the Income Tax Act of 1961, apply to franchising companies. Companies that conduct business in more than one state are usually subject to franchise tax under the GST Act of the state in which they are registered. As the franchisors receive royalties or franchise fees, they are liable to pay tax under the Income Tax Act.

The GST Act, introduced in 2017, is a comprehensive tax reform that applies to the supply of goods and services in India. It mandates that franchising companies registered in multiple states must comply with the franchise tax provisions of the GST Act in each respective state. This is because the GST is a destination-based tax, which means that the tax liability arises in the state where the goods or services are consumed. Consequently, franchising companies with operations spanning multiple states need to register under the GST Act in each state and adhere to the relevant tax obligations, such as filing returns and paying taxes.

Additionally, the Income Tax Act of 1961 governs the taxation of income earned by franchising companies. This law outlines the various provisions and rules for calculating taxable income, determining tax rates, and filing tax returns. Franchisors and franchisees must comply with the Income Tax Act to ensure accurate reporting and payment of taxes on their income and profits.

It’s important for franchising companies to understand and comply with these tax laws to avoid potential legal and financial consequences. Proper tax planning and consultation with tax professionals can assist franchising companies in navigating the complexities of the Indian tax system and ensuring compliance.

Nature of relationship between a franchisor and franchisee

Although the nature of the relationship under this agreement appears to be that of an agent and principal, in which they collaborate to achieve common goals. However, the relationship that a franchisor and a franchisee share is an independent contractual relationship, as it provides flexibility and allows the parties to work together more efficiently. 

What are the most important operative clauses in a franchise agreement

Every agreement has certain important clauses that are to be negotiated and discussed by the parties. It is important to consider these clauses before entering into an agreement. The parties should exchange views relating to the ingredients of such clauses to bring clarity and avoid any kind of dispute arising in the future. Now, let’s discuss these important clauses in detail.

Intellectual property rights clause

The IPR clause is essential in a franchise agreement to protect the rights of the franchisor’s trademark, copyright or patent, trade secrets and know-how. It specifies ownership of the franchisor’s IP, and it shouldn’t be licenced or assigned to any third party by the franchisee (maybe with the prior consent of the franchisor).  It is crucial that the parties entering into the agreement negotiate the terms of these clauses. While negotiating this clause, the franchisor must describe the IP for which the licence is granted, the manner in which the franchisee should use such IP, and the limitations for using it.

Confidentiality clause

The confidentiality clause is an important clause to protect sensitive information about the company. The clause states the obligations of the franchisee to avoid any unauthorised disclosure, preserve the confidential information and use it only for the purpose for which it is shared. Confidential information can include any vital information, such as ideas, inventions, product plans, processes, designs, market information, etc. However, there are certain exceptions, such as the disclosure of such information that is already known to the public, if any competent court requires to produce such information, or if the franchisee takes prior permission from the franchisor. In such situations, the disclosure shall not be considered a breach of confidentiality.

Rights and obligations clause

A franchise agreement should spell out the responsibilities of the parties, which shall be followed by them during the term. It should not create any ambiguity that could cause a dispute in the future. The franchisor may be required to provide training and information to the franchisee’s employees according to the standards of the company. He may be required to provide an operation manual, give specifications regarding any product or service, assist the franchisee in setting up the business, advertise and promote the franchise, etc. On the other hand, the franchisee may be required to make capital investments, maintain the standards of the franchise business, exercise and protect all the rights, trademarks and intellectual property given under the agreement, etc. 

Consideration clause

The franchisee, in return for exercising the franchisor’s IP rights, pays a certain amount as consideration, which should be incorporated into this clause. There are various modes available to make payments; the franchisor should clearly specify the mode in which he wants the payment to be made and the manner of such payments (partly, wholly or otherwise). This clause may cover certain other fees which are payable by the franchisee, such as service fee, management fees, marketing fees, insurance fees, legal costs, etc.

Term and termination clause 

A term and termination clause provides the duration for which the agreement will be enforceable and the circumstances that will bring the agreement to an end. For example, the agreement will be terminated if any obligation is breached by the franchisee or if the term expires. The term of the agreement can always be extended and renewed with the consent of both parties.

This clause is essential for both the franchisor and the franchisee, as it provides certainty and predictability regarding the length of their relationship.

Duration of the agreement:

The term of the agreement specifies the period during which the franchisee is granted the right to operate the franchise. This term can be for a fixed period (e.g., 10 years) or indefinite. In the case of a fixed term, the agreement will automatically terminate at the end of the term unless both parties agree to extend it. If the term is indefinite, either party may terminate the agreement by providing the other party with written notice.

Termination for breach:

The term and termination clause will also typically specify the circumstances under which either party may terminate the agreement for breach of its terms. Common grounds for termination include:

  • Material breach: A material breach is a significant violation of the agreement by one party that undermines the foundation of the franchise relationship. Examples of material breaches include failing to pay royalties, operating outside of the authorised territory, or engaging in conduct that damages the franchisor’s brand.
  • Default: A default occurs when a party fails to perform a material obligation under the agreement, such as failing to pay rent or maintain the franchise premises in accordance with the franchisor’s standards.
  • Bankruptcy: If either party files for bankruptcy, the other party may have the right to terminate the agreement.

Extension and renewal:

The term and termination clause may also include provisions for extending or renewing the agreement. Extensions typically involve adding additional time to the original term, while renewals involve creating a new agreement for a subsequent term.

In either case, both parties must consent to the extension or renewal. It is important to note that if the parties continue to operate under the agreement after the initial term has expired without executing a new agreement, this may be considered a “holdover” tenancy, which is subject to different legal rules and obligations.

By carefully considering the term and termination provisions of a franchise agreement, both franchisors and franchisees can protect their interests and ensure a smooth and successful business relationship.

How to protect IP rights and confidential information after the termination of a contract

In today’s business environment, protecting intellectual property and confidential information is very crucial. Once the contract is terminated, the parties are freed from the obligations of the contract. An agreement or contract, therefore, plays an important role in safeguarding such rights even after the relationship has ended. To protect the IP and confidential information after termination, a survival clause should be inserted. A survival clause makes certain clauses binding even after the termination provided. The term for such survival should be mentioned. When a survival clause is mentioned in the agreement, the clauses become enforceable and the rights are preserved for a certain period after termination.

Conclusion

A franchise agreement should be well-drafted and precise as to the context of the agreement. The agreement should clearly specify the rights and obligations of the parties to avoid any future disputes. Also, both parties need to review and understand the terms of the agreement carefully before entering into this business relationship. The parties should comply with such terms, which is essential for maintaining the brand’s image and delivering a satisfying experience to the consumer. 

A franchise agreement provides the franchisee with brand recognition and support, while the franchisor gets to expand his business. In conclusion, a well-structured agreement plays an important role in building a successful franchise business.

References

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