Case Analysis: Legal Risks in Franchise Business

(By Yu Zhiyuan) I recently represented a client who was finally the winning party to a typical franchise dispute case, from which we can learn most legal risks possibly facing franchisors and franchisees during their performance of franchise business as well as operational standards and risk control measures for businesses in the brand chain industry.

  1. Case Facts  

In this case, the franchiser, owner of a well-known early childhood education brand, entered into a franchise agreement with each franchisee to perform franchise activities as a chain store dealing in the franchiser’s brand. As mutually agreed, in addition to one-off franchise fees and deposits, each franchisee should pay royalty fees in advance before each royalty year begins, and if there is any overdue payment of royalty fees, penalties.

Later as disputes arose from the franchiser’s failure to provide continuous guiding support under the franchise agreement, a number of franchisees refused to pay royalty fees. Then the franchiser filed a lawsuit, for which the franchisees appointed me to represent them together.

  1. Lawyer’s opinions

The facts of this case seem simple, but indicate a lot of useful information. First up, the dispute arose from the franchiser’s failure to render “continuous guiding services” under the franchise agreement. Apart from licensing the use of their brands, the franchiser is obligated to ensure effective operation of the franchise system and offer continuous guiding services. This franchiser obligation represents an important characteristic of franchise activities. Second, most of the franchisees alleged that the franchiser’s company had some problems in its internal systems that adversely affect the overall brand image. What the franchisees alleged is frequently encountered by long-term franchise businesses. The stability of the franchisers plays an important role in the chain system. Third, the two sides failed to agree on how to calculate the royalty fees. For details, please refer to the following.

    a. Continuous guiding services

It is usually agreed in franchise agreements that besides licensing important brands, franchisers should offer franchisees follow-up services. The State Council provided in the Franchise Rules that franchisers should offer necessary continuous guiding services. By analyzing and comparing evidence submitted by both sides, I found out the franchiser failed to offer continuous guiding services under the franchise agreement and therefore might have breached the franchise agreement.

    b. Brand damage

As expressly specified by the franchise agreement, the franchiser’s brand was established based on the teaching methodologies created by its founder. The fact that the founder separated from the franchiser to found a new company in the same industry right before the dispute arose fully substantiated the franchiser’s failure to fulfill its obligation to maintain the brand reputation.

    c. Due payments in dispute

Before the proceedings commenced, the franchiser sent a notice to each franchisee, informing that if the franchisees settled the overdue payments prior to a specific date, they would be entitled to a 50% discount on their due payments, or if otherwise, the franchiser would file a legal action. Before the court, I claimed that the notice legally entitled the franchisees to enjoy a 50% discount on their due payments, while the franchiser argued that the 50% discount policy mentioned in the notice was only applicable to the franchisees who made full payments prior to the specified date, which meant the franchisees who failed to make payments prior to the specified date were not eligible to enjoy the 50% discount.

The reasons for my claims are as follows. The payments in arrears were debts owned by the debtors to the franchiser. The reduction of the overdue payments should be deemed an unconditional release of a part of debts owed by the debtors. The specified date above mentioned is the deadline of payment, not a condition for the actual release of debts. Furthermore, according to the evidence I presented, months after the specified date, the franchisor and some franchisees were still able to implement the 50% discount policy under the notice.

  1. The Ruling

After hearing the case for a number of times and going through the complicated argument and debate processes, the court basically accepted my claims, finding that the franchiser defaulted on its obligations under the franchise agreement, the 50% discount notice should be deemed valid and the franchisee I represented should be given a further discount on the half payments. The results indicated that the key arguments and main reasons on our part held water.

  1. Risks

Based on the foregoing, I recommend that

  1. Franchisers should
  2. Give emphasis on continuous guiding services, especially service record filing and classification management. If services are provided by email, all the emails with attachments (if any) should be retained in their entirety. Prompt reply from franchisers or automatic reply to each email is necessary.
  3. Check regularly (at least once a year) if franchiser obligations specified in franchise agreements are fulfilled. For example, franchisers should check whether they have provided franchisees with onsite services for times each year and kept written records as provided by franchise agreements.

iii. Ask counsels whether or not internal equity structure change or any other change occurring to franchisers affects matters with respect to franchise agreements, and if yes, ask franchisees’ opinions or take other actions to dispel their worries.

  1. Franchisees should
  2. Keep on file exclusively letters, faxes, emails, etc. from franchisors. If anything required or notified by franchisors is outside the scope of franchisee obligations, franchisees should let franchisors know promptly.
  3. Check terms of payment carefully. If disputes arise from advance payment as required by franchise agreements, franchisees should notify franchisors of their breaches of the agreements and try to resolve the disputes by consultation or filing legal actions in order to avoid payment of partial penalties for prior breaches of the agreements.

iii. Take seriously early agreement termination provisions. If franchisors fail to provide services at franchisees’ satisfaction, it is very likely that the franchisees terminate franchise agreements before they expire. If possible, before executing franchise agreements, franchisees should ask legal counsels for advice and ensure clauses governing early agreement termination are included therein. If franchisors insist on excluding such clauses therefrom, franchisees had better take the initiative to commence legal actions against franchisors for their breaches of the franchise agreements, if any. There is a specialized issue that laws governing franchise transactions are more inclined to protect the franchisee right of “voluntary participation”, which will not be further analyzed herein.

Lawyer Contacts

You Yunting86-21-52134918

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