Franchise Agreements And Transfer Opportunities
Franchising as a concept originated in 1851 when Isaac Singer invented the sewing machine; he did not have the capital to produce or customers - due to a lack of knowledge on how to use the machine. Thus, he formed agreements with sellers to solve these problems. Singer gave territorial franchises to sellers and formed the capital to produce the machine with the fee collected from those sellers. The sellers began teaching customers the principles of the machine, and accordingly Singer was able to reach more customers. Franchising later became a widespread practice in the 1960's. Franchising allows the franchisor to break into new markets and the franchisor's trademark becomes introduced to a greater market providing the finances for further production, sales and marketing. It is also advantageous for the franchisee as the franchisee buys into a system which is already tried and worked, and therefore eliminates the risks of starting a new business.
This article will try to shed light on the defining structures of franchise agreements, the applicable provisions in Turkish law, and types of franchise agreements as well as transfer of franchise agreements to third parties with a final focus on the American perspective regarding transfers of franchises.
Definition and Interpretation of Franchise Agreements
The franchise agreement is defined as a contractual relationship between two independent parties providing a long-term and continuous business relationship arising from the promise given by the first party to the second party to carry out the business subject to the concession right, by providing information and support regarding the management and organization of the business within a certain period of time, conditions and limitations.1 Franchise agreements are innominate contracts that are not regulated under Turkish local law. Under Turkish Law the Franchise Agreement is a contract which contains elements of other contracts such as but not limited to; sales, license, agency, rental, service, retainer, know-how and exclusive distributorship agreements. In case of a dispute, the agreement entered into by the parties is taken to be the primary source of rights and obligations between the parties. In case where the franchise contract provisions cannot be applied, the general provisions and the provisions regarding nominate agreements apply comparatively to the extent that the franchise agreement falls within the scope of them.
Elements of Franchise Agreements
- The franchisee must be independent. Independency means trading with its own name and account.
- There must be a franchising system. The marketing concept, incorporeal property such as a brand and know-how and the franchising organization is included in this system.
- There is a vertical cooperation between the franchisor and the franchisee.
- The franchisee must pay a fee. Parties may agree on the payment of a lumpsum-fee or a certain amount of endorsement (royalty fee). Additionally parties may agree on the payment of franchisee fees in cash at the beginning.
- The contractual relationship must be continuous.
Types of Franchise Agreement
Product Franchise: Franchisee undertakes to sell the products by using franchisor's intellectual property rights. Franchisor is under the obligation to deliver the products to franchisee regularly. In this respect, product franchise is similar to exclusive distributorship agreement. In this type franchisor does not provide a system.
Business Franchise: In this type of franchise, there is a more intense and strict cooperation in the whole process from the establishment to the management of the business. The relationship of franchisor with franchisee is not limited merely with the product, the service and the brand. It includes supportive activities such as the development of marketing strategies, planning, education, quality, and control in a business system as a whole.2
Master Franchise: In this type, franchisee is authorized to sell the franchise in a specific territory. The franchisee concludes sub-franchise agreements as the master franchisee.
Obligations of the Parties in Franchise Agreements
Franchise agreement is a multilateral contract. Franchisor is the party who has the legal rights of a qualified and successful brand regarding to a specific product and service, and gives the right to sell, distribute and operate in exchange for a fee (royalty).It provides a system containing the operation of a service or a product regarding to a qualified brand. Franchisor undertakes to give the permission to use the intellectual property rights in the production, operation and marketing system. Intellectual property rights contain trademark, patent, commercial name and company name, introductory elements and know-how. Franchisor must meet the legal requirements to keep its legal rights. Franchisor is under the obligation of disclosure. Within the scope of this, franchisor must inform franchisee about the operation of the system, the amount of capital to be invested, the investments to be made and the employment of staff.3 Franchisor must protect and support the franchisee. It must provide services such as financial advisory, technical support, training of the staff in order for the franchisee to be integrated to the system and benefit from it in the most productive way. If agreed, franchisor is obliged to regularly deliver the products in product franchise and the required materials to serve in service franchise. Franchisee may have the exclusive rights in a territory if the parties agree upon. In this case, franchisor cannot sell franchise to third parties or operate in the territory itself.
In general except its obligation to pay, franchisee is obliged to sell the products, disclose related information to franchisor, obey the marketing principles and instructions of franchisor, participate in training programs and run the business in this respect.4 Franchisee is obliged to take the products and materials from the franchisor. However if the products are the same quality and it is possible to serve them in conformity with the system franchisee can buy them from a third party.
Transfer of Franchise Agreements to Third Parties
In franchise agreements, the duty of loyalty between the parties is key due to the requirement of strict cooperation inherent in these types of agreements. Since the franchisor authorizes the franchisee to use its intellectual property rights and the system and organization created for the operation of the service or products constitutes a trade secret and this is provided to the franchisee, it is also very important that the franchisee has the power to fulfill its obligations, as the franchisor's brand and prestige may be damaged if the franchisor fails to provide the standard quality of the products or service. In this respect the qualifications of the franchisee becomes important. Therefore, pursuant to the Turkish Law of Obligations Article 83, the franchisee is obliged to perform personally. In the event of a transfer of the franchise agreement to a third party that the franchisor has not agreed to, the prestige of the franchisor may be damaged and some of the customers may be lost if the transferee fails to perform or performs insufficiently.
In practice, franchise agreements most of the time include transfer prohibitions stating that the agreement cannot be transferred without the franchisor's permission. A change of control in the franchisee company is also usually included in these clauses. These restrictive clauses are mostly upheld by courts as valid limitations. In its 2019/579 numbered decision, The Turkish Supreme Court stated that the provision in the given franchise agreement regulating the change of the franchisee's shareholding structure is subject to the franchisors' permission, does not contradict Article 27 of the Turkish Law of Obligations and Article 2 of the Turkish Civil Code. Since the franchisee has trust and loyalty-based obligations towards the franchisor, such as protecting its interests, keeping secrets and giving account when necessary, these types of limitations are generally upheld by courts.
As aforementioned, the franchise agreement is mix of different types of contracts, to the extent that it falls within the scope of nominate contracts, relevant legal provisions can be applied comparatively. Pursuant to Article 506/1 of the Turkish Law of Obligations, the franchisee must perform personally. If the franchisee transfers the contract even when the transfer prohibition is explicitly stipulated in the contract and the franchisor does not give consent, the franchisee will be liable for the actions of the transferee (Article 507/1).
The franchisee can transfer the agreement if it is explicitly stipulated in the contract and the franchisor gives prior or subsequent consent. This situation is especially common in master franchises. Within this scope, the franchisee has the duty of care in selecting and instructing the party receiving the sub-franchise.
Lastly, it is also important to determine to which extent the transfer prohibitions will be implemented. In our opinion, transfer prohibitions should be subject to an objective criteria. The franchisor should consent to a transfer if the person or the company the franchisee wants to transfer to have equal or better qualifications than the franchisee in terms of commercial reputation, financial strength, work experience etc. and if the franchisor's interest will not be effected. Accordingly, if the franchisor does not consent to the transfer without objective reasons, this act would constitute bad faith and an abuse of the right defined under Article 2 of Turkish Civil Code.
To provide a comparative perspective for those interested in foreign franchise practices, or those who are interested in becoming a franchisee of a foreign brand, the United States example could be informative.
In the US, the Franchise procedure is governed by the Federal Franchise Rule, an overarching federal law that governs the offer and sale of franchises throughout the United States. The Federal Franchise Rule (the FTC) is issued by the Federal Trade Commission and governs franchise transactions in all 50 states and US territories. Some states have also enacted Franchise Relationship Laws that supplement the federal rule. Some state laws especially protect franchisees' rights to transfer their businesses. As already mentioned, franchise agreements usually contain the relationships' governing terms and most of the time these terms include provisions that restrict the franchisee's right to transfer.5
There are certain types of transfer restrictions that do frequently come up in franchise agreements. The most frequently used restrictive clause is one in which the franchisor reserves the right to approve the financial terms of the transfer/sale agreement (called a buyer qualification). This is used as a tool to ensure that the buyer will have the financial ability to sustain the business and keep paying the royalty fees. The franchisor may also exercise a right of first refusal in case of a franchisee's sale, where the franchisor will have the right to purchase the franchisee on the same terms. The buyer (new franchisee) may also be asked to sign the main franchise agreement rather than merely assuming its terms. Another less restrictive provision in the main agreement could be the requirement for the franchisee to sign a general release agreement, agreeing that the current franchisee will be releasing the franchisor of all known and unknown claims or to simply pay a transfer fee to the franchisor.
We believe that it is always preferable to address the issue of a possible transfer in the Franchise Agreement as when the issue comes up later in the relationship, the consequences could be more risky.
A close and continuous relationship is established between the parties when they enter into a franchise agreement. The franchisor authorizes the franchisee to exercise its intellectual property rights and provides its know-how developed as a result of intensive work experience. Even though franchisee does trade in its own name and account, it invests in the franchisor's trademark and improves its prestige and ensures that it enters into new markets.
In conclusion, the parties grow together. The transfer of the franchise contract to third parties may be inconvenient for the franchisor because it is a type of contract where the qualifications of the parties are at the forefront. Accordingly, the parties should always try to address the issue of a possible transfer in the franchise agreement in order to minimize future risks. Transfer restriction clauses are valid, however, the franchisor should act in good faith pursuant to Article 2 of the Turkish Civil Code. Otherwise the franchisor might be liable from the consequences of an unjust termination of the relationship based on the violation of a transfer prohibition clause.
1 Turkish High Court Decision (Yargıtay, 19. Hukuk Dairesi 25.06.2011, 2001/819 E. 2001/4917 K.)
2 AYATA, Yeşim, Franchise Sözleşmesinde Tarafların Borçları, İstanbul, 2015, s.21
3 VARLI, s.146
4 Kırca, Çiğdem: Franchise Sözleşmesi, Ankara, 1997, s. 19-20
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