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27 June 2017
Protecting franchisor by establishing franchisee's indemnification obligations
Protecting franchisor by securing franchisee's financial obligations
Options in franchise agreements
In recent years, the commercial titles of the Civil Code have been aligned more closely with international commercial practices and the Russian courts have been enforcing these new standards. These improvements are noticeable in the area of franchise law.
Previously, franchise agreements took effect only once they had been successfully registered with the Federal Service for Intellectual Property (Rospatent). The registration process required that the prospective franchise agreement be submitted to Rospatent for substantive review and approval, which generally took months. The slightest substantive deficiency could result in rejection. All amendments to franchise agreements had to follow a similar registration process. Further, since franchise agreements often contain commercially sensitive information, it was common practice to prepare an abridged version of the agreement for filing.
Fortunately, franchise agreements no longer need to be registered. Only the grant of IP rights to the franchisee needs to be registered, which no longer involves a months-long substantive review. Instead, the process takes about 45 working days and only a notification about the granted IP rights, and not the franchise agreement, must be submitted.
While unregistered agreements were previously void, the courts now consider an unregistered franchise agreement to be valid if the parties have relied on it and started to fulfil their obligations under it. In such a situation, either party may enforce the underlying agreement. The franchisor must register the grant of rights – an obligation that the franchisee may enforce through specific performance.
Existing Russian law does not require that specific types of information be disclosed to prospective franchisees (unlike, for example, the US franchise disclosure document). However, a good-faith requirement exists and failure to act in good faith can result in liability for any consequential damages. A party lacks good faith if it provides insufficient or untrue information or fails to disclose material facts. As a practical matter, this means that franchisors are well advised to provide more detailed business information to future franchisees than under previous laws.
It is good practice to enter into a so-called 'agreement regarding discussions' with each potential franchisee, which:
Damages for breaching such an agreement may be limited, other than damages for actions or omissions made in bad faith.
A lack of good faith also occurs if a party:
Where a party has misused confidential information, the resulting damages have no specified limit. Otherwise, the remedy for a breach of good faith is limited to:
Until recently, a party that had been misled into entering into a franchise relationship was limited to rescission and restitutionary damages. However, these remedies were available only if the rescission was due to a material mistake caused by misrepresentation or fraud. If the misled party continued with the franchise agreement, it was not possible to claim damages. Now, a party that is misled into entering into a franchise relationship can claim consequential damages (which can be liquidated) while still retaining the franchise agreement. Alternatively, if the party no longer wishes to retain the franchise relationship, it can terminate the agreement and still claim consequential damages. Such a party has the right to be restored to the same position it would have been in had the representation on which it had relied been correct. A condition for such liability is that the party that misled knew or reasonably should have known that the other party would rely on its misrepresentation. A commercial entity can be held liable even without proof that it knew of the misrepresentation, unless the parties contractually agree otherwise. Even if the franchise agreement is rescinded due to fraud or a material mistake arising out of a misrepresentation, full consequential damages are still available to the party that relied on the misrepresentation if it can prove that the other party caused such misrepresentation.
Franchisors in Russia are exposed to somewhat different potential liabilities than in other countries. As a result, franchise agreements in Russia contain franchisor-protective provisions specifically tailored to national law. One such potential liability concerns product and service liability claims. For years, a Russian statute has provided that a franchisor and franchisee are jointly and severally liable for third-party claims with respect to products manufactured by the franchisee. The franchisor is also secondarily liable for claims made against a franchisee with respect to products provided or services rendered by a franchisee under a franchise agreement. While the purpose of this statutory imposition of liability is to ensure that franchisors monitor their franchisees to ensure quality, such liability is an issue for non-Russian franchisors. To address this issue, franchise agreements typically oblige the franchisee to indemnify the franchisor for any such liabilities.
Thus, franchise agreements typically include indemnification provisions for breach-of-contract claims. Russian law now also allows contractual provisions applicable to losses unrelated to breach of contract, such as:
The indemnification amount must be liquidated or the contract may specify a means for determining the amount (which may be capped). Since this type of indemnity does not arise out of a breach, but is essentially a type of insurance, a court may not reduce the indemnification amount even if it is disproportional to the losses incurred. The amount may be reduced only if the indemnified party deliberately contributed to the loss. If an indemnified loss results from the unlawful action of a third party, the indemnitor has a statutory right of recoupment from the third party. An indemnity clause automatically survives invalidation of a contract unless the parties specify otherwise.
To be meaningful, a franchisee's financial obligations (including an indemnification obligation), must be backed up with some form of security. Russian law now permits a variety of means for doing so. The simplest is to post financial collateral, which may consist of money, bonds or other securities or tangible assets.
If a suretyship is used, the limits on the surety's liability must be specified in the suretyship agreement. However, the agreement need not describe the secured obligations in detail; it is sufficient to refer to the main agreement containing the franchisee's financial obligations. The main drawback to using a surety is that it may raise the same defences that the debtor can raise and may even suspend payment until the creditor has offset its claim against any obligation it may have toward the debtor.
Another method of securing a franchisee's financial obligation is a guarantee. In the past, guarantors could be only banks, insurers and other credit institutions. Other companies or private individuals were not permitted to provide corporate or personal guarantees. Now, any commercial entity can serve as guarantor. The limit of the guarantor's liability must be specified, although the parties may agree that the guarantee limit may be determined as of the date on which the guarantor must pay. From the franchisor's perspective, a guarantee has the distinct advantage that a guarantor, unlike a surety, may not raise defences arising out of the guaranteed obligations. Further, the guarantor is not entitled to offset its obligations against any claim it may have against the beneficiary unless otherwise provided in the guarantee or agreed between the guarantor and the beneficiary. The invalidity of the guaranteed obligations constitutes a ground for suspension of payment for seven days, but not for refusal to pay. In this case, the franchisor must compensate the guarantor, or the franchisee, for having paid the non-existent debt. It is also possible for a franchisor to delegate the franchisee's payment obligations toward the franchisor to a third party such that the third party becomes legally responsible for paying them as they become due. On such delegation, both the delegee and the franchisee remain jointly and severally liable to the franchisor or creditor, unless the delegation agreement specifically states otherwise. The delegee can raise the same defences that the franchisee could raise, but is not entitled to offset any claim that the franchisee may have against the franchisor.
Finally, the franchisee or a third party can provide a pledge to secure the franchisee's financial obligations. A pledge involving titled intangible property must be registered with the State Register of Real Estate Rights and Transactions. A pledge of tangible property must be recorded in the official register maintained by the uniform system of notaries. Recently enacted Russian law protects bona fide purchasers of pledged properties. As a result, if a registrable or recordable pledge is not registered or recorded and the pledged assets are acquired by a purchaser in good faith without knowledge of the existing pledge, the pledge automatically terminates.
Two types of interest charge may be imposed in Russia: statutory and contractual interest. Statutory interest is usually imposed when a payment is overdue and is thus considered to be a penalty for delayed payment, whereas contractual interest is generally considered to be a fee for the use of money. Statutory interest will apply only if the agreement in question does not specify a separate late payment penalty (although the agreement may provide for both a late payment penalty and statutory interest on the unpaid balance). Both the statutory interest rate and the contractual interest rate are equal to the Central Bank key rate in effect during the period in question, unless the parties have agreed a different rate. If a default interest rate specified in the contract is clearly disproportionate to the consequences of the breach, it may be reduced by a court on application by the debtor, but in any event will not be lower than the statutory rate.
Many franchise agreements contain rights that the franchisee may choose to exercise at a later date, such as the right to:
Russian law categorises such arrangements as conditional rights. Previously, such arrangements risked being unenforceable. As the obligations of one party were subject to the satisfaction of conditions under the other party's exclusive control, some Russian courts viewed such arrangements as invalid. Now, such arrangements are valid and the exercise, amendment and termination of contractual rights may be dependent on actions taken or not taken by any one party or the occurrence of events which may be within only one party's control.
Franchise agreements often grant the franchisor an option to purchase the franchisee's business assets at the end of the franchise relationship. Under new Russian law, the parties may enter into an option agreement under which the franchisee makes an irrevocable offer to sell and the franchisor has the option to purchase the assets pursuant to the terms of the option. Option rights may be freely bought, sold or transferred, unless the agreement provides otherwise. The main statutory restriction is that the option must include the essential terms of the future agreement and must describe the assets with sufficient detail so that they can be identified when the option is exercised. If that is impossible, the parties may enter into a preliminary purchase agreement, which – under existing Russian law – will be binding if the parties include the subject matter of the main agreement plus the terms which one of the parties want to include. The preliminary purchase agreement should contain a deadline for finalising the main agreement – otherwise, the standard deadline of one year applies. If the parties fail to meet their own deadline, either party has six months to petition a court for specific performance, which, if granted, will mean that the main agreement will be legally binding as of the date of (or specified in) the court order. If the parties disagree about the contractual terms, the court will decide the main agreement's terms.
Because these statutory provisions are new, judicial guidelines on their practical implication are not yet well developed. Thus, franchisors should check the latest court decisions for additional guidance before structuring transactions based thereon.
For further information on this topic please contact Natalya Babenkova at Noerr by telephone (+7 495 799 56 96) or email (firstname.lastname@example.org). The Noerr website can be accessed at www.noerr.com.
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