The Bi Feng Tang case: What do franchise fees really mean?

By Harry He, AllBright Law Offices
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In a franchise business, a franchisor licenses a franchisee to use its registered trademark, corporate logo, patents, proprietary technology and other business resources. The franchisee carries on business according to the standard business model of the franchisor and pays a franchise fee in accordance with a franchise contract.

In practice, however, the parties to a franchise contract often do not fully understand the initial fees, royalties and deposits that are provided for in the contract they have signed. This may trigger disputes.

By analysing a case of this nature, this article attempts to discern the true legal meaning of franchise fees, with a view to facilitating the prevention and settlement of franchise contract disputes.

The Bi Feng Tang case

In 2003, Bi Feng Tang Company entered into a franchise contract with a Mr Wang, pursuant to which the company would grant franchise rights to its Bi Feng Tang Teahouse business to Mr Wang for a period of five years. Mr Wang would pay an initial fee of RMB150,000 (US$22,000) which was non-refundable under any circumstances, as well as monthly royalties.

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Harry He
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The contract also provided for the payment of a deposit and liquidated damages in the event of a default.

Upon signing the contract, Mr Wang paid the initial fee of RMB150,000 and a deposit of RMB30,000. However, Mr Wang subsequently failed to pay royalties for a long period of time despite Bi Feng Tang’s efforts to urge him to pay.

Bi Feng Tang eventually brought the case to court, demanding that the contract be terminated, royalties totalling RMB52,800 be paid, and Mr Wang and his Hai Tong Restaurant Company be held jointly and severally liable.

Mr Wang claimed that as he had paid a large initial fee to Bi Feng Tang, it was not right for him also to pay royalties. “If they insist that they want to cancel the contract, they should return the deposit to me in full, and the balance of the initial fee after deducting an appropriate portion of the fee for the term during which the contract was performed,” Mr Wang claimed.

In this dispute, the points at issue were:

  1. If a franchise contract is terminated prior to its expiry, should the initial fee be partially returned?
  2. After the franchisee has paid the initial fee, should he still be required to pay royalties to the franchisor? and
  3. Should the deposit be refunded?

Types of franchise fee and their implications

To analyse the points at issue, it is necessary to define the precise meaning of initial fees, royalties and deposits.

An initial fee is a one-off fee paid by a franchisee to a franchisor for the purpose of acquiring a franchise right. The acquisition of this right implies that the franchisee obtains a licence, and can thereby receive intellectual property rights; rights to standardized marketing and training programmes; and an effective business model and management methods. This should minimize the funds needed for, and the risks associated with, the start-up of a new business.

An initial fee is, in essence, remuneration paid by a franchisee for the use of the intangible property of a franchisor, and is a partial return on the investment made by the franchisor during the initial stage of building its brand. Accordingly, in international practice, initial fees are treated as entry fees and are chargeable on a one-off basis. They are non-refundable.

Royalties are paid by a franchisee to a franchisor on a regular basis during the course of a franchise, primarily to cover the cost of promotions, advertising and materials. While initial fees are paid on a one-off and non-refundable basis for the purpose of acquiring a franchise right as described above, royalties are paid to franchisors as remuneration, for the purchase by the franchisees of raw materials from the franchisors, and for the enjoyment of benefits deriving from the advertising and promotion of the franchise business by the franchisors on a continuing basis.

A deposit is paid by a franchisee to a franchisor under a franchise contract as a form of security to ensure that the franchisee will discharge its obligations in strict compliance with the contract. For instance, if the franchisee fails to pay royalties as agreed or is in breach of other obligations under the contract, it will be required to pay liquidated damages or a fine. The franchisor will have the right to deduct the liquidated damages or the fine from the deposit, and thereafter the franchisee will be required to make up the amount of the deposit accordingly.

After the franchisee has performed all of its obligations under the franchise contract, the franchisor should return the deposit upon termination of the contract.

Case analysis

The above analysis suggests that an initial fee is a form of one-off remuneration and is not refundable for any reason in the event of the early termination of a franchise contract.

In the dispute outlined above, after Mr Wang acquired the franchise right, his non-compliance resulted in early cancellation of the contract by Bi Feng Tang, and therefore Bi Feng Tang was not required to return the initial fee to Mr Wang.

Royalties differ from initial fees in nature. The obligation to pay royalties is not met by virtue of the payment of an initial fee. Therefore, it appears that Mr Wang should be obliged to pay royalties to Bi Feng Tang.

Bi Feng Tang received the deposit in order to hold Mr Wang to his obligations under the contract. Mr Wang’s failure to pay the royalties as agreed constituted a breach of contract, and therefore it appears that Bi Feng Tang had the right to deduct the outstanding royalties from the deposit.

Based on the above analysis, Mr Wang should still be required to pay Bi Feng Tang royalties amounting to RMB52,800 – RMB30,000 = RMB22,800.

Harry He is a partner of AllBright Law Offices. His main practice areas are foreign direct investment, M&A and labour disputes.

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