Requirements, validity of franchise contracts: A case study

By Song Ruyi and Li Tingwei, SHIAC

Party A, a Chinese company, and party B, a Samoan company, entered into an agreement called the City Agency Authorisation Covenant, in which party B agreed to license party A to use the trademark, system, technical information and know-how in a food brand owned by party B. The term for the licence was from 1 August 2015 to 31 July 2019.

The licence fees for the whole term were RMB3,150,000 (US$487,000). In return, party B agreed to provide party A with a trademark licence, educational training, equipment, tools, decoration, advertising, sales planning, supply of products and operation protocols, etc. After the covenant was signed, party A transferred to party B RMB3,150,000.

However, in the application for arbitration to Shanghai International Arbitration Centre (SHIAC), party A alleged that party B did not possess the qualification or condition for providing commercial franchise, and had been using an immature business model to illegally conduct commercial franchise. Party A also alleged that party B had failed to fulfill its legal obligations, which resulted in successive shutdowns of individual shops owned by party A, thus depriving party A of the possibility of realising the contractual purpose.

As such, party A sought a declarative relief on the termination of the covenant, as well as the return of the licence fees, compensation for the losses in decoration incurred by party A, and the liquidated damages, etc.

In its defence, party B alleged that the covenant was concluded on a real and voluntary basis, and had been actually performed by the parties. Thus, party B contended that party A’s argument on being deprived of the possibility to realise the contractual purpose was groundless. Therefore, party B requested that the arbitral tribunal reject all of party A’s claims.

The issues

Issue 1: If the licensor fails to satisfy the requirements set out in article 7.2 of the Commercial Franchise Management Regulation, does such failure constitute the ground for terminating the covenant?

Party A argued that party B lacked the qualification for conducting commercial franchise in mainland China, violating the Commercial Franchise Management Regulation, thus party A was entitled to terminate the covenant. Party B defended that it had opened several shops outside mainland China, therefore, in a substantial sense, party B had met the qualification of “two shops, one year” set out in article 7.2 of the Commercial Franchise Management Regulation.

Party B also contended that, due to the governmental agency’s limitation of “two shops, one year” to those operating in mainland China, it was unable to fulfill the record-filing requirement. Therefore, party B argued that party A’s claim for terminating the covenant was groundless.

Issue 2: Did the closure of party A’s shops result from party B’s breach of the covenant?

Party A argued that during the performance of the covenant, party B had: Rejected party’s A proposal on the choice of shop’s location; failed to provide training to party A as agreed; failed to make advertisement or sale planning for party A; failed to provide guidance on business norms or product manufacturing to party A; and failed to send an updated version of the product sheet in written form. These breaches of the covenant by party B had resulted in successive closure of the shops owned by party A, and deprived party A of the possibility to realise its contractual purpose.

On the other hand, party B defended that it had fulfilled the obligations under the covenant, including but not limited to guiding the choice of the shop’s location and party A’s business operation. Party B contended that the facts could prove it had performed the contractual obligations, thus party B did not breach the covenant.

Opinions of the tribunal

On issue 1, the arbitral tribunal’s analysis was that although party B plainly did not meet the requirements set out in the Commercial Franchise Management Regulation, the requirements were managerially mandatory in its scope of application, rather than regulating the issue of the validity of the contracts. Therefore, the question of whether or not party B met the requirements did not have a substantial impact on the validity of the covenant, nor did it constitute a ground for terminating the covenant. As such, the claim for declarative relief sought by party A was groundless, and should not be supported by the arbitral tribunal.

On issue 2, the arbitral tribunal concluded that although the covenant provided for educational training, equipment, tools, decoration, advertisement, business planning, supply of products, payments and business protocols, etc., these agreements lacked the details needed for them to be executed. The covenant also did not provide for product quality standards or measures of assurance.

The arbitral tribunal also found that party A failed to provide sufficient evidence to show that party B had breached the covenant, or to show the causality between the alleged breach of the covenant and the closure of shops. On the other hand, party B had provided some evidence, and shown that it had performed its contractual obligations.

Based on the submitted evidence, the arbitral tribunal was unable to quantify party B’s breach. In the end, the arbitral tribunal rejected the claims of party A. However, the arbitral tribunal did award damages in the amount of RMB2 million to party A, after considering the fact that party B lacked qualifications under the Commercial Franchise Management Regulation.

Typical case

This case is a typical foreign-related franchise dispute. The arbitral tribunal found that party B did not formally comply with the requirements set out in the Commercial Franchise Management Regulations, but party B objectively did have registered trademarks, corporate logos, patents and other business resources. Thus, the arbitral tribunal found that the violation of the requirements did not constitute a ground for party A to terminate the fundamental contract.

It can be found from this case that unless the provisions of laws and administrative regulations are mandatory in nature, they do not necessarily affect the validity of the contract, or the realisation of the contractual purpose of the parties, nor does the violation of those provisions constitute a legal cause for the disputing party to terminate the contract.

In addition, in the determination of the appropriateness of the contractual performance, when the contract does not make clear and quantifiable obligations to be performed by the franchisee, the arbitral tribunal is in a difficult position to determine whether the franchisee’s behaviour violates the contract or not, and will eventually make a conclusion unfavourable to the franchisee. This risk deserves the attention of parties in similar contracts.

Franchise contract disputes are more professional and complex than other types of contract disputes. Usually, the franchisee’s and franchisor’s familiarity and understanding of the relevant field are largely unequal. Thus, the franchisee is often at a disadvantage in the course of concluding or performing the franchise contract. In this case, the franchisee’s claim was not supported due to the lack of clarity in the covenant.

Therefore, when entering into the relevant franchise contracts, the parties should make clear and explicit agreement on the contractual obligations that the franchisor should perform, instead of just using vague wording, and should co-operate to quantify the franchised resources and services that the franchisor agrees to provide. Otherwise, the franchisee may find itself in a disadvantageous position when a dispute arises.

Song Ruyi is the head of case management department No. 1, and Li Tingwei is a senior case manager at Shanghai International Arbitration Centre (SHIAC)