THE GUIDE TO THE CODE OF ETHICS The British Franchise Association Best Practice Guide
Contents Page 1. Introduction...................................................................................................................................................3 2. Definition of Franchising...........................................................................................................................6 3. Joint Obligations – Fair Dealing...............................................................................................................8 4. Franchisor’s Guiding Principles............................................................................................................. 15 5. Franchisee’s Guiding Principles............................................................................................................. 18 6. Advertising.................................................................................................................................................. 21 7. Disclosure.................................................................................................................................................... 22 8. Pre-contract Issues and Selection of Franchisees........................................................................... 27 9. Franchise Agreements.............................................................................................................................. 29 10. Master Franchise Agreements............................................................................................................... 34 11. Resolution of Disputes............................................................................................................................ 36 Appendix .European Code of Ethics for Franchising and British Franchise Association Code of Ethical Conduct: Extension & Interpretation
© 2012 British Franchise Association Copyright: Reproduction of this publication in whole or in part by any means without written permission from the British Franchise Association is strictly forbidden.
Foreword This Guide is about “ethics” in business, in particular in franchising; it is about what is “fair” in the form and conduct of the relationship between franchisor and franchisee. Fairness in franchising cannot be set out in a handful of simple rules. It is complicated to balance the rights and obligations of franchisors and franchisees, to balance their risks and rewards, and to balance the interests of individuals with the interests of the network as a whole. This Guide is a working compendium of the collected experience of the ethical franchise community in Britain built up over more than thirty years. It deals not just with notions of fairness in the contractual arrangements in franchising, but also with the conduct of practitioners in franchising as they go about their daily business of building businesses that work. It is a guide to what good franchising looks like and is an essential read for anyone contemplating coming into the business of franchising whether as a franchisor or a franchisee. I hope too that it will serve as a reminder to everyone that franchising is now a very professional business with refined and defined operating principles and with a developed skill set that is a requirement for all those who profess to operate within our ranks, whether as practitioners, as lawyers, as consultants, as accountants and bankers, or indeed as the guardians of the good practice that is set down in this Guide. The British Franchise Association is the guardian in Britain of the standards of good practice that make up ethical franchising, that make good business. We thank all those who have lent their time and experience to the compilation of this Guide to those standards. Brian Smart Director General, bfa
Acknowledgements The first edition of this guide to the ethics of franchising was written for the Association in 1987 by Martin Mendelsohn, the leading franchise lawyer whose steadfast support for the British Franchise Association and the standards it represents, and whose work on the development of good practice in franchising in the UK, in Europe and internationally, cannot be overestimated. Martin wrote a number of the subsequent editions of the Guide and the Association wishes to record its indebtedness to Martin Mendelsohn for his contribution to its work and to franchising. 2
1. Introduction One of the main objectives of the bfa, particularly in the absence of franchise specific legislation, is to promote ethical franchising in the UK and the interests of its members. As more and more businesses in the UK adopt franchising as a business expansion technique and the value of the franchise industry in the UK continues to grow so too the role of the bfa has expanded and by necessity has had to become wider and more representative of the franchise industry as a whole. In order to ensure that the bfa maintains its rightful role as the representative body for the franchise industry and the unofficial watchdog for standards, it has recently undergone an extensive review of its quality standards for members and an in depth consultation process culminating in a set of standards and procedures which, if followed, should ensure best practice within the franchise industry as a whole. As a result, this latest edition of the Guide provides a more comprehensive explanation of what the bfa considers to be ethical behaviour and therefore best practice in a number of key areas in franchising. Although the guidance is aimed primarily at franchisors it also addresses issues which affect franchisees and professional advisors and consultants involved in the franchise industry. It is therefore invaluable reading for all those involved in franchising whether or not they aspire to become members of the bfa. It must be recognised however that this Guide and the Code of Ethics itself is not intended to form the part of any contract between franchisor and franchisee unless the parties in question have specifically agreed this. In addition the bfaâ€™s views as expressed in this Guide should not be taken as the definitive meaning of the Code of Ethics with legal standing. Whilst franchising is a proven business method that helps to eliminate many of the risks associated with a business start up there are still too many franchisees who do not conduct proper due diligence of the proposed franchise transaction despite the literature and guidance available. There are also too many businesses that try adopting franchising methods without properly investigating how this business technique might be best applied in their business, and all too often on the basis of so called professional advice, which in reality is inadequate. As a business method, franchising has its limitations and does not provide a route to automatic success. It does however provide a business framework which reduces but does not eliminate the risks which are inherent in establishing and running a business. It must also be borne in mind that franchising is used in a remarkable variety of business sectors with sizable variations in the division of responsibility and authority between franchisee and franchisor. Therefore some degree of flexibility over what is considered best practice must be retained. However where a principle of best practice appears to be inapplicable to a franchised business the reasons for this must be investigated with care to ensure that they are valid and fair. A franchisor cannot and should not be expected to guarantee success but it should be expected to have proven the business concept as a franchise proposition as far as possible. There are business risks 3
which can affect any category of business and franchising is not exempt. The business sector in which the franchise operates should be thoroughly investigated to ensure it is not a passing fad and that it is proven as a viable business with a future. This emphasises the need for careful, patient and thorough pilot testing of a business concept before rolling it out as a franchise proposition. This testing must be done at the risk and expense of the franchisor not franchisees. The most common reasons that franchisors fail are inadequate pilot testing
poorly structured system
lack of capital
poor selection of initial franchisees
the franchisor is a poor businessman and does not run his/her own business properly
The bfa publishes a comprehensive initial guide for franchisors on the use of franchising in business which is essential reading for all prospective franchisors wishing to avoid the pitfalls. No matter how good the franchise concept or the franchisor, a franchisee who is not thoroughly prepared and wholly committed to the business concept is unlikely to succeed. Conversely the franchisee who has entered the relationship with the right attitude may succeed even if the franchisor is below average. There are also those franchisees who, if they encounter trading difficulties believe that the bfa will guarantee a painless exit even if the franchisor is not a bfa member. The bfa (like any other trade association) gives no such guarantees and cannot do so. Any person wishing to become a franchisee must understand that as with all new business ventures there is a risk of failure. What the bfa seeks to achieve with its membership criteria and its ethical standards is to reduce the risk. Prospective franchisees must understand that no-one can eliminate the risks entirely. The bfa has become established as the responsible voice of franchising in the UK and is fully prepared to undertake the responsibilities inherent in the achievement of this objective. The bfa can discipline members who, on joining, submit to the disciplinary controls which are set out in detail in the bfaâ€™s Articles of Association and in rules made pursuant to its provisions. The disciplinary procedure coupled with the promotion of and publicity given to the basic standards which the bfa expects is the major influence which the bfa can bring to bear on its members and indirectly on non-members. The bfa hopes that, by the establishment and maintenance of its standards, membership of the bfa will acquire a cachet which is so powerful that no franchisor will, after it is established, find it comfortable to exist without being a member. If a franchisor does not wish to become a member, and not everyone wishes to belong to associations, the bfa hopes that it will publicly accept and comply with bfaâ€™s ethical standards and guidelines. 4
The bfa well understands the difficulties for a new franchisor seeking to become established without the benefit of bfa membership. However the bfa cannot allow a business into membership until it has demonstrated the quality of the franchise which it intends to offer. Provisional listing of the bfa is available to those who are developing a franchise and who take the proper steps carefully to structure and develop their franchise and to ensure that they are adequately financed. The bfa monitors developments in the marketplace and from time to time issues guidelines to franchisor members on how to deal with new practices from its ethical point of view. Those guidelines can be accessed on the bfa website and should be read in conjunction with this guide. The bfa will continue to keep the guidelines published in this booklet under review and will adapt and adjust them in the light of practical experience.
2. Definition of Franchising 2.1
Introduction The European Franchise Federation (EFF), a federation of national associations, has been in existence for many years. Indeed the first Code of Ethics which the EFF prepared was adopted as long ago as 1972. The EFF and its member associations produced a Code which could be adopted by all national associations. It was agreed that each national association would publish an Extension and Interpretation subject to agreement by the EFF and which would form part of the Code of Ethics applicable to the relevant country. The bfa has adopted an extension and interpretation, and the bfa Code of Ethics therefore comprises the EFF Code plus the Extension & Interpretation adopted by the bfa, and agreed by the EFF, for the application of the European Code of Ethics for Franchising by the bfa within the United Kingdom of Great Britain and Northern Ireland. This “Code” appears as an Appendix to this document.
2.2 The EFF Code defines franchising in the following way:
“Franchising is a system of marketing goods and/or services and/or technology, which is based upon a close and ongoing collaboration between legally and financially separate and independent undertakings, the franchisor and its individual franchisees, whereby the franchisor grants its individual franchisees the right, and imposes the obligation, to conduct a business in accordance with the franchisor’s concept. The right entitles and compels the individual franchisee, in exchange for a direct or indirect financial consideration, to use the franchisor’s trade name, and/or mark and/or services mark, know-how*, business and technical methods, procedural system, and other industrial and/or intellectual property rights, supported by continuing provision of commercial and technical assistance, within the framework and for the term of a written franchise agreement, concluded between parties for this purpose.
(*) “Know-how” means a body of non-patented practical information, resulting from experience and testing by the franchisor, which is secret, substantial and identified;
“secret”, means that the know-how, as a body or in the precise configuration and assembly of its components, is not generally known or easily accessible; it is not limited in the narrow sense that each individual component of the know-how should be totally unknown or unobtainable outside the franchisor’s business;
“substantial” means that the know-how includes information which is indispensable to the franchisee for the sale of goods or the provision of services to end users, and in particular for the presentation of goods for sale, the processing of goods in connection with the provision of services, methods of dealing with customers, and administration and financial management; the know-how must be useful for the franchisee by being capable, at the date of conclusion of the agreement, of improving the competitive position of the franchisee, in particular by improving the franchisee’s performance or helping it to enter a new market.
“identified” means that the know-how must be described in a sufficiently comprehensive manner so as to make it possible to verify that it fulfils the criteria of secrecy and substantiality; the description of the know-how can either be set out in the franchise agreement or in a separate document or recorded in any other appropriate form.”
The definition is important because it not only specifies what is franchising for the purpose of the Code but it also specifies elements to be found in a franchise:
it is a system of marketing goods and/or services and/or technology.
it is based upon a close and ongoing collaboration between legally and financially separate and independent undertakings.
the franchisor grants its franchisees the right and imposes the obligation (upon the franchisees) to conduct a business in accordance with the franchisor’s concept.
a financial consideration (which may be direct or indirect) must be paid by franchisee to franchisor.
the rights granted include the use of the franchisor’s trade name and/or trade mark and/ or service mark, know-how business and technical methods procedural system and other industrial and/or intellectual property rights.
the franchisor is to provide support by continuing to provide commercial and technical assistance.
the parties are to conclude a written franchise agreement. The bfa considers that a further fundamental element to any franchise is that the business model itself is workable and consequently that the franchisor must ensure that it continues to be workable for the duration of the franchise agreement.
The definition is not to be used in a restrictive way so that a technical reason may be found to avoid the application of the Code. For example failure to conclude a written franchise agreement would not mean the Code did not apply. All members of national franchise associations affiliated to the EFF will be bound to observe it under the terms of their membership. That of course includes all bfa members. The bfa’s view is that the definition itself imposes a framework to be adopted by franchisors and that failure to adopt that framework could itself be a breach of the Code. It should be understood that one is dealing with an ethical code which means that the spirit is to be observed as well as the letter of the Code. There may be technical reasons why an element in the definition may not apply because of the particular nature of the franchised business but those reasons should be inherent in its nature and not contrived. The use of the expression “end-users” in the definition of substantial is not intended to limit the Code to franchising at retail level and this expression means the end user of the goods or services the subject of the franchise at whatever level in the chain of supply it is provided. 7
3. Joint Obligations – Fair Dealing 3.1 Introduction
Paragraph 2.4 of the Code states: “Parties shall exercise fairness in all dealings with each other. A franchisor shall given written notice to its individual franchisees of any contractual breach and where appropriate grant reasonable time to remedy default”.
“Fairness” is very subjective and this chapter will deal with the application of fairness to specific contractual issues.
Note that there is an equal obligation on both the franchisor and the franchisee to be fair in their dealings with each other and the extent to which both parties abide with the Guiding Principles will be taken into account when assessing fairness.
A further complication is that a franchisor may have to be unfair to a franchisee in order to maintain the integrity of the branding, goodwill and operating system e.g. where a franchisee’s conduct may jeopardise the continuation of a national account, which would obviously be to the detriment of the rest of the network. In those circumstances a franchisor may not have to have to be scrupulously fair with that franchisee in contractual issues (see below). The bfa’s view is that the franchisor in this sort of situation will not be acting unreasonably provided it goes no further than is reasonable to protect the valid commercial interests of the network.
The fairness principle is most likely to be examined in the following areas: 3.2 Training 3.2.1 In some cases during training it may be clear that the franchisee is unsuitable which, notwithstanding anything in the franchise agreement, means the franchisor should be able to terminate that franchisee. This is particularly so if the franchisee has not behaved ethically e.g. by failing to disclose a disability. 3.2.2 The franchisor should be able to recover his direct (including recruitment) costs in getting to the point of termination. 3.3
Renewal of Contract
3.3.1 The Code does not contain any requirement that there must be a renewal of the franchise agreement. But paragraph 5.5 does say that the franchise agreement should state “the basis for any renewal of the agreement”. 3.3.2 The bfa takes the view that so long as the parties discharge their obligations the franchise relationship should be capable of continuing on a long term basis. They may have no objection to a single twenty year term provided the agreement is clear about any rights of renewal. More typical is a “5 + 5 renewal”, where the franchisee, provided he is not in breach of the conditions 8
for renewal, can be sure of a second five year term, which is ordinarily adequate time for a franchisee to build up value in the business. The bfa expects a franchisee’s right on transfer to realise the value of his business (one of the principles underpinning 5 + 5) to be passed to the incoming franchisee so that he too has the same opportunity to build and eventually realise the value he has added to the business. The bfa looks to the franchisor to make such renewal rights explicit in franchise agreements issued in respect of a resale, in order that the new franchisee will in time be able to sell the business at its going concern value. 3.3.3 The fact of renewal goes to the heart of the value of the franchise business. The bfa’s view is that “franchisees who are in compliance with the terms and conditions of their agreement shall have the right to realise the value of their business on transfer”. Thus a franchisee should have the right to re-sell towards the end of their last term and the franchisor should be prepared to grant a new five year term to the buyer, else the value of the business will be drastically diminished if, for example, the buyer can only have the balance (perhaps one year) of the outgoing franchisee’s term. 3.3.4 The terms of the renewal should be clear. It is reasonable that they can include:
A requirement that the terms should be on the then current terms of the franchisor’s standard franchise agreement. The franchisor may not introduce unattractive commercial terms as a mechanism to discourage renewal;
An obligation on the franchisee to remedy any existing breaches and to have substantially observed the terms of the existing agreement;
A right not to accept a late application for renewal if a franchisee has failed to comply with the notice provisions in the renewal clause.
3.3.5 There are some contentious areas that historically have been open to abuse:
A revamp clause requiring for example a complete re-fit to a shop. This will not be unfair if the terms would also be fair if the renewing franchisee were a new franchisee and thus able to reap the financial rewards for its expenditure.
A relocation clause which requires the franchisee to close down the present premises and move to fresh premises which the franchisor considers will offer a better trading opportunity. This will not be unfair if the motive behind the move is to enhance and promote the franchise system and for the move to be equally profitable for both franchisor and franchisee.
Changes to the system requiring new capital expenditure
3.4.1 The most common areas are the introduction of EPOS into a retailing system; or the introduction of new or updated tracking schemes for courier circumstances; or of a central booking system. Clearly if introduced properly there are advantages for all concerned. 9
3.4.2 The bfa’s view is that such an introduction will not be unfair if the franchisor is able to demonstrate a likely cost effectiveness of the introduced addition and such introduction should not cost significantly more than the franchisee might expect to pay to anyone else for the provision of similar services. 3.5
Advertising, Market and PR
3.5.1 So far as advertising, marketing and public relations contributions are concerned many franchisees take a subjective view on the way in which the contributions are spent. It is impossible for all franchisees to be satisfied particularly where some consider that not enough is spent in their area of operation and on them in particular. Most advertising, marketing and public relations contributions are to be used for the overall benefit of the network. 3.5.2 The provisions of the agreement dealing with the expenditure of advertising, marketing and public relations contributions should clearly indicate the nature of the items upon which the contributions are to be spent. The franchisor should not mislead the franchisee about how the contributions are to be spent. It is recommended that the franchisor discuss with the franchisees their advertising promotion and public relations activities and that franchisees are given the opportunity to contribute to the discussion. If a franchisor handles these activities in-house rather than by using outside services the franchisees should be informed that such is the case and if it is the case that the cost of such in-house services will be recovered from the contributions. It is important that, on request, franchisors should provide franchisees at least with annual verification from the franchisor’s accountants that the sums so received have been expended for the intended purpose. It would not be unreasonable for the cost of such verification to be charged against the contributions received. 3.6
The great majority of franchise agreements contain some sort of a product tie but very few give franchisees any protection as to the price that they will have to pay for the products. It is inherently unfair that a franchisor or its nominated supplier can charge whatever they want for products which franchisees have to acquire from the franchisor/nominated supplier.
Franchisors can undertake in the franchise agreement not to charge a mark up or to charge only a very small mark up to cover their administration and other costs but from the franchisee’s perspective it may be difficult to establish what is the cost price and whether any mark up has been retained. There are two alternative approaches. The first alternative is to put wording in the franchise agreement to the effect that the franchisor will ensure that products are supplied at competitive prices. Inevitably the concept of a “competitive price” is vague and may be difficult to enforce. The second alternative is to give franchisees the ability to find alternative sources of supply but, in the latter case, franchisors will inevitably want to approve the sources of supply to ensure that standards are maintained.
If products are supplied by nominated suppliers franchisors should agree that they will not retain discounts, rebates, commissions, etc all of which will be passed on to franchisees or, alternatively, the franchise agreement must be entirely “transparent” by clearly setting out that the franchisor will retain these “incentives”.
Fixed and Minimum Ongoing Fees
3.7.1 Some franchise systems require a set ongoing franchise fee which is payable regardless of turnover or the level of maturity of the business. This can be harsh on the franchisee in the early years, but advantageous once the business has taken off. The bfa has always viewed fixed fees as undesirable but accepts that in certain circumstances e.g. where taking a percentage of the franchisee’s sales is inappropriate such as where the franchisee operates largely a cash business, this may be acceptable subject to objective justification; 3.7.2 The bfa has also indicated a dislike of minimum (i.e. the greater of a fixed amount, or a particular percentage of the franchisee’s sales) franchise fees. Minimums may be inherently unfair if the franchisor’s actions e.g. responsibility for central marketing are a large component of the sales effort; or if catchment areas are non uniform. 3.8
Performance and Business Plan clauses
3.8.1 The franchisor must be able to drive performance forward but not at the expense of the fundamental principle of reasonableness. Thus where a franchisee enjoys an exclusive territory the franchisor must have the right to require the franchisee to perform to a certain standard, once the franchisee has been established in the network. A minimum fee which assumes the franchisee will achieve 70% of the bona fide projections of growth sales for the franchisee’s territory and location, based upon comparable network performance, is not unfair even where it may constitute a minimum performance clause as part of a requirement for a franchisee to prepare a business plan. 3.8.2 A business plan that allows a franchisor to impose a minimum performance target on a franchisee without reference to the rest of the network’s performance is unfair. 3.8.3 The balance between the basis of the calculation of the minimum level, the escalation of consequences for non achievement, and the severity of penalties available to the franchisor, should pass the test of reasonableness. 3.9
3.9.1 The moment when a franchisee wishes to sell his or her business provides an opportunity for a franchisor to be unfair. This may first occur in the selection of the incoming franchisee. The franchisor should apply the same criteria to applicants as if they were a new applicant and not just buying a re-sale. It would be unfair of the franchisor to use the right of approval to exert other leverage on the existing franchisee for example to extract further fees or to persuade a very good franchisee to stay on until a candidate of the same calibre (which might be higher 11
than the franchisor’s standard criteria) is found. The bfa accepts that this would be rare as the majority of re-sales are used to refresh the network. 3.9.2 The franchisee should not be prevented by the franchisor from selling their business at market value rather than at its net asset value. Indeed many franchisors encourage franchisees to consider at the recruitment stage how they will build value into their business as a key part of their exit route. 3.9.3 Selling at “market value” does not detract from the measure of the franchisor’s “goodwill”. There seems to be much confusion over the issue of goodwill in franchising. There are two “goodwills”: one is the traditional “goodwill”, the other is the accounting “goodwill”. The traditional goodwill is that which a trade name and reputation enjoys; this would be related to the business systems and all industrial and intellectual property rights which are associated with it. This goodwill belongs to the franchisor and will always so belong – the franchise agreement grants the franchisee the right to benefit from the goodwill – while operating within the agreement. The other “goodwill” – the accounting goodwill, is the amount by which the “going concern” value of the franchisee’s business exceeds the value of the net assets of that business. This means that when the franchisee sells his/her business the profit from the sale belongs to him/her. The bfa sees no conflict between these two descriptions. 3.9.4 Franchisors may also try and charge disproportionately high fees in connection with the resale. This would conflict with the statement at 2.3 that “franchisees... shall have the right to realise the value of their business on transfer”. This would conflict with the bfa’s stated position, expressed in the following membership rule: “Franchise agreements must contain the right for franchisees to realise the value of their investments and the ongoing concern premiums that their efforts have built into those businesses.” 3.9.5 Agreements will often provide the franchisor with the right to exercise an option to purchase when the franchisee decides to sell. The option period should not be longer than is reasonable for the franchisor to decide and certainly should not be such that the prospective purchaser will be lost. The option should not enable the franchisor to purchase the business for less than it is worth on the open market as a going concern. It is also not unreasonable for the franchisor to charge a reasonable introductory fee. 3.9.6 Another deterrent to a resale is for the franchisor to require the incoming purchaser to revamp or relocate an outlet. It would be considered unfair if the purchaser was required to make such a significant investment that there was no longer much point in buying the franchisee’s business. 3.10
Death of a Franchisee
3.10.1 An agreement which provides for termination on death of a franchisee, or a partner in the franchisee, or a director or shareholder of the franchisee, if the franchisor in its discretion 12
considers that person material to carrying on the operation, is unfair. It could effectively
deprive the deceased franchisee’s family or their partner or the other directors and shareholders of an asset, at the discretion of the franchisor. 3.10.2 It is suggested that it is fair if, as a minimum, in the event of death of the franchisee or such a partner or a director or shareholder of the franchisee, the beneficiaries of the deceased are given the opportunity to qualify as franchisees or to step into the position which the deceased formerly occupied or to sell to an approved purchaser. But where this is not practicable (where for example the beneficiaries are children) it is fair that the franchisor can reasonably force through a sale if it considers that the way the business of the deceased is being run will damage the value of the brand. It is desirable that franchisors should give serious consideration where practicable to the provision of back up and support from the franchisor certainly in the early days following death. 3.11 Termination 3.11.1 The provisions of paragraph 2.4 of the Code of Ethics expressly provide that a franchisee should be given notice of any contractual breach and, where appropriate, granted reasonable time to remedy a default. This is a proper requirement and should be emphasised. The only circumstances in which a franchisor should be entitled to terminate forthwith are
bankruptcy or liquidation
appointment of an administrator or receiver
the franchisee deliberately acting in a way that damages the brand or may have a detrimental effect on the network
an incurable breach of a material provision in the agreement. It is considered better practice if the agreement defines what is a “material provision” if that expression is used.
a failure by the franchisee to remedy a breach complained of within the specified time
abandonment of the business by a franchisee
serious criminal conviction.
3.11.2 It is difficult to lay down what are reasonable periods of time since it will often depend upon the nature of the breach how urgent it is that it should be remedied and how much time is reasonably required for the purpose. A very short period will be reasonable if there is a failure in standards which directly and adversely affect the customers or if there is a money default, a breach of the law (e.g. Health and Safety), or hygiene issues.
3.11.3 The consequences of termination have to be severe but care should be taken to avoid provisions which give the franchisor confiscatory powers. 3.11.4 Time is of the essence:
A “time of the essence” clause in a franchise agreement has the effect that if a franchisee delays in performing a contractual obligation by a specific date, the franchisor can terminate the franchise agreement. The bfa has ruled that such a blanket clause is unethical so that any bfa member whose agreement includes such a blanket provision would be in breach of the bfa Membership Rules.
This does not stop a franchisor from specifying in the agreement a specific date for the performance of a specific contractual obligation but in practice there will be few situations in which it will be ethical for a franchisor to provide that such a failure entitles them to have the right immediately to terminate the franchise agreement.
The most common provision is the right for franchisors to terminate for a franchisee’s failure to make payment by a due date. Most franchisors recognise that a judge would be reluctant to find the termination lawful if for example there are grounds for the delay (such as a failure in the banking system or it happens only rarely or the delay was, say, of a short duration). The bfa would concur with this view unless there were extenuating circumstances.
4. Franchisor’s Guiding Principles 4.1
Paragraph 2.2 of the Code states:
“The franchisor shall have operated a business concept with success, for a reasonable time and in at least one pilot unit before starting its franchise network.”
4.1.1 The business concept must have been developed and shown to be successful. This will be demonstrated if the level of profitability is sufficient (when the business is operated by a franchisee):
to enable the franchisee to obtain a reasonable return on the investment and for the work involved within a reasonable period (see Chapter 9 in relation to the duration of the franchise agreement);
to enable the franchisee to make payment to the franchisor of the fee due under the franchise agreement;
to enable the franchisor to earn sufficient from the fees received from franchisees (or other legitimate sources of income from the franchise network) to enable the franchisor to operate profitably in the medium to long term. A franchisor cannot expect in the short term to trade profitably at least until a certain number of franchisees have been established so that it becomes positive both in cash flow and profits on a cumulative basis. Its trading in the meantime must be financed by working capital, although the profits from one or more pilot operations can assist the franchisor in providing some of this working capital.
4.1.2 Success must be demonstrated for a reasonable time. What is reasonable will inevitably depend upon the circumstances and the nature of the business. Factors to be considered will include the seasonality of the business, the period of time required to build up the type of business concerned and exceptional trading conditions such as extremes of weather, recession etc. 4.1.3 The concept should be operated in at least one pilot unit. The expression “at least” is very important since one unit in a unique location will not prove that the concept is capable of being franchised elsewhere. What is needed is such number of pilot units in locations typical of those in which franchisees will operate to be able to satisfy prospective franchisees that the business concept could be successful in the location where they propose to open for business. Franchisor company-owned units may provide the basis for a pilot operation but these should be run by a “manager” on an arm’s length basis to test the systems and the supporting infrastructure. 4.2
Paragraph 2.2 of the Code also states: “The franchisor must be the owner, or have legal rights to the use, of the network’s trade name, trade mark or other distinguishing identification.” 15
It is vital that the franchisor has control over the branding to be used in the network. There may be a master franchise agreement and/or branding may be ultimately owned by someone other than the franchisor e.g. a director personally. A franchisor who is using a third party’s brand must have the right not only to use the branding itself but also to license its franchisees to use it. This must be capable of verification.
Paragraph 2.2 of the Code further states:
“The franchisor must provide the individual franchisee with initial training and continuing commercial and/or technical assistance during the entire life of the agreement.”
4.3.1 The initial training and continuing support are important elements in the establishment of the franchisee in business and in assisting in sustaining the business while the relationship continues. 4.3.2 The principle of continuing support and the division of responsibility between franchisor and franchisee of the essential tasks involved in running the network and on the provision and development of the “know-how” behind those tasks, are essential characteristics of a genuine business format franchise. The concept of continuing support does not mean that the franchisor will or should become involved in the day to day conduct of the franchisee’s business. The franchisor provides guidance - it is for the franchisee to deliver performance. It is fundamental that the business model being franchised works for the duration of the franchise agreement and consequently the franchisor should continue to develop the business model as the market requires.
It is axiomatic that the franchisor is not providing a business model that can be guaranteed to be successful on every occasion as external factors will vary; he is providing a model that has the proven potential to be successful.
4.3.3 In terms of initial training and support, depending on the nature of the business, the franchisor could well become involved in assisting franchisees in:
• premises related issues
• site selection criteria
• planning and by-law compliance
• lease negotiations
• equipment requirements
• opening inventory
• business launch
• acquisition of technology
• training and support
• Internet and intranet
• design and remodelling of premises
and if there is a mobile franchise:
• vehicle selection and sourcing
• territorial evaluation criteria
• fitting out of vehicle.
4.3.4 In terms of continuing services the franchisor will be providing some or all of the following:
• field support
• reports and financial monitoring
• research and development including market research
• advertising, marketing and promotion
• Head Office type support
• ongoing training and retraining
• software systems and support
• some accountancy services, e.g. invoicing or credit collection.
5. Franchisee’s Guiding Principles 5.1
Paragraph 2.3 of the Code sets out the obligations of the individual franchisee as follows:
“The individual franchisee shall:
devote its best endeavours to the growth of the franchise business and to the maintenance of the common identity and reputation of the franchise network;
supply the franchisor with verifiable operating data to facilitate the determination of performance and the financial statements necessary for effective management guidance, and allow the franchisor, and/or its agents, to have access to the individual franchisee’s premises and records at the franchisor’s request and at reasonable times;
not disclose to third parties the know how provided by the franchisor, neither during nor after termination of the agreement.”
Franchisees and their lawyers are often quick to point to the Code of Ethics with a view to imposing obligations and duties on franchisors but the Code also sets out obligations on individual franchisees. Clearly individual franchisees are not contractually obliged to comply with these obligations unless the franchise agreement requires them to do so. Since the Guide sets out good practice it would be “unattractive” for a franchisee to seek to criticise a franchisor’s failure to comply with the general obligations imposed on franchisors without also accepting that it has to comply with franchisee obligations.
5.3 The obligations imposed on franchisees are analysed below:
Franchisees must try to grow their franchise business.
The concept of “growing a business” is inherently vague. Does it mean undertaking marketing, advertising and business development activities, increasing turnover, customers, profitability, individual customer spend, territorial coverage or something else? It probably means a combination of all these elements.
Most franchise agreements require franchisees to use their best endeavours to grow their franchise business.
A “best endeavours” obligation does not require a franchise to “fly to the moon and back” to achieve the objective, but requires the franchisee to do everything that is commercially sensible to achieve the objective. In other words, franchisees cannot sit back and wait for their business to grow or expect the franchisor to grow their business for them – they have to take active steps.
In some franchise agreements, franchisees are obliged to use their best endeavours to increase turnover – which is different to an obligation to grow its business. Usually it is in a franchisor’s commercial interest for franchisees’ turnover to increase (because continuing fees are based on a percentage of turnover) but franchisees usually want to improve their profit margin rather than increase their turnover.
Franchisees must try to maintain the “common identity” and “reputation” of the franchise network.
This imposes an obligation on franchisees not to “step outside” the franchise system developed by the franchisor. It is an essential element of franchising that all franchisees operate their businesses and offer their goods or services in a consistent way.
The obligation to maintain the reputation of the franchise network not only requires franchisees not to “step outside” the system, and thereby do things which may not be approved or authorised by the franchisor but also not to say or do anything that could affect the reputation of the franchise network. An obvious example of a breach of this obligation would be to say negative things about the franchise system to the press or over the internet.
The reference to the “franchise network” is primarily to the businesses operated by other franchisees, but would also include the franchisor.
Franchisees must provide the franchisor with accurate information about their business.
An obligation to provide accurate information is normally specifically set out in the franchise agreement.
Franchisors generally not only require financial information to enable the franchisor to establish how well its franchisees are performing, but also to enable the franchisor to ensure that the proper level of continuing fees is being paid, particularly if those continuing fees are calculated as a percentage of the franchisee’s turnover.
The Code makes it clear that the need to provide operating data is to enable the franchisor to provide guidance to the franchisee in respect of such data. This is an important feature of franchising – franchisees really do need to receive guidance from their franchisor as to how they are doing and what they need to do to improve their performance. The obligation on a franchisee to provide information should not simply be seen as a way of checking up on the franchisee.
Franchisees must allow the franchisor to have access to their premises and records.
In terms of entering franchisees’ premises this causes no difficulty (which is not to say that it is welcomed by franchisees) when franchisees operate from commercial, industrial or retail premises. It is not thought acceptable for a franchisor to have the power to enter into a franchisee’s home if the franchisee operates from residential premises.
Most franchise agreements give the franchisor the right to make unannounced visits to enable franchisors to review records before a franchisee, who is suspected of being “dodgy”, has time either to remove or to alter the information. Making an unannounced visit if the franchisor suspects “foul play” would not breach the Code.
The reference to “reasonable times” would suggest that any such inspections or visits would have to be made during business hours.
The franchisee must not disclose know-how.
Know-how is defined as “a body of non patented practical information resulting from experience and testing by the franchisor which is secret, substantial and identified”. Essentially, this definition of know how relates to the information in the franchisor’s operations manual.
On the face of it, it would not include other information such as customer lists, prices or franchisee details. As a general rule franchisees should not disclose any aspect of their business to a third party. Usually the franchise agreement would specifically prohibit this.
The obligation not to disclose know-how applies both during the term of the franchise and thereafter.
Curiously the obligation does not relate to use of the know-how. It simply refers to “disclosure” so technically franchisees are not prevented by the terms of the Code from using the know-how for their own purposes subject, of course, to any non compete covenants or other contractual restrictions in their franchise agreements but the obligation should be read as broadly as possible and not in a narrow or restrictive way and should be read to include a prohibition on a franchisee misusing the know-how for the franchisee’s own purposes, if such purposes are outside what is required for the purposes of the franchise business.
6. Advertising 6.1
Paragraph 3.1 of the Codes states that:
“Advertising for the recruitment of individual franchisees shall be free of ambiguity and misleading statements;”
Whilst this does not impose a positive disclosure requirement it does impose a standard on what the advertisements actually say. There are two standards
the advertisements must be free from ambiguity; that is they must state the position clearly; no half truths; nothing which is incomplete.
the advertisements must not contain any misleading statements; remember a statement can be misleading by what it does not say just as much as by what it does say.
6.2 The Code therefore requires that recruitment advertisements set the tone for the subsequent disclosure. In particular, the bfa takes the view that celebrity endorsement of a franchise may be misleading unless the celebrity is a current (or very recent) active franchisee of the franchisor and/or has a material financial stake in either a franchisee operation, or the franchisor. 6.3
Paragraph 3.2 of the Codes states that:
“Any recruitment, advertising and publicity material, containing direct or indirect references to future possible results, figures or earnings to be expected by individual franchisees, shall be objective and shall not be misleading.”
This requirement is far ranging - a direct reference is relatively easy to contemplate; indirect references are not so easy to define. Any statement indicating that a franchisee can expect to make profits or achieve any level of return without any qualifying explanation would not be within the Code. The franchisor would have to state the basis, assumptions and criteria upon which such a statement is made so that there is no possibility of a reasonable person being misled.
Some franchise advertising and promotional literature holds out the promise of a guaranteed turnover, which may have the effect of attracting prospective franchisees who do not recognise that these are not profit guarantees. Some guarantees are promoted as “guaranteed earnings”, making confusion more likely.
If specific suggestions are made as to what future results, figures or earnings may be, the franchisor must present them in the same way as they would be by an independent third party without bias and without any statements or omissions which might mislead.
7. Disclosure 7.1
Paragraph 3.4 of the Code states: “in order to allow prospective individual franchisees to enter into any binding document with full knowledge that they shall be given a copy of the present Code of Ethics as well as a full and accurate written disclosure of all information material to the franchise relationship within a reasonable time prior to the execution of any binding document”.
7.2 The Code recognises that disclosure begins at the first point of contact which of course is when the franchisor starts to explain the franchise opportunity. 7.3
Note that where personal data is to be provided the provisions of the Data Protection Act must be complied with by the franchisor.
Disclosure must be in writing. The franchisor should be prepared to stand by the accuracy of the information disclosed subject only to the reservations expressly contained in the document which should be underlined or emphasised so as to draw them specifically to the franchisee’s attention. The difference between statements of fact and judgements which a franchisor may make should be clearly indicated.
There is no requirement to follow a set format but it is important that the information is presented in a clear and user-friendly way
The bfa having considered the nature and range of information to be disclosed is of the view that the following subjects should be dealt with in the information to be provided to the franchisee if the ethical requirements of Paragraph 3.4 are to be discharged:
The business and financial position of the franchisor
The people involved in the franchise company
The franchise proposition
The financial projections
NOTE: In particular that a copy of the Code of Ethics should also be provided as part of the franchisor’s disclosure.
The business and financial position of the franchisor
The franchisor should explain the business, how it has developed and over what period, so that the franchisee can assess the franchisor’s business experience and background.
The franchisor should also provide the franchisee with a set of its latest certified balance sheet and profit and loss accounts which should be dated as certified by its auditors or by a qualified accountant not more than twelve months prior to the date they are handed to the franchisee accompanied by a statement by the franchisor:
“that there has been no decline in its financial position since the date of the accounts which would result in the franchisor not having adequate resources to finance its present business requirements.”
In addition the franchisor should confirm that it has never had any action taken against it in consequence of debt save for any genuine disputes to which it was professionally advised that it had at the least an arguable case.
If the franchisor cannot provide such a certificate or confirmation the prospective franchisee must be provided with a full explanation of the position.
Franchise companies which are themselves part of large public companies or groups may not be in a position to release accounts solely relating to the franchised business where the consolidated group accounts may not provide the sort of information a franchisee would like to see.
The people involved in the franchisor business In the case of each of the directors and senior executive staff of the franchisor with authority to make decisions directly and substantially affecting franchisees, the following information should be provided:
Qualifications (if any)
Previous relevant business experience
Confirmation that he or she has never been:
bankrupt /insolvent or had action taken against him or her in consequence of debt save where he or she was professionally advised that he or she had at least an arguable case
convicted of a criminal offence (other than a minor traffic offence)
the subject of an order disqualifying him from acting as or being a director.
If such information or confirmation cannot be given, a full explanation should be provided to the franchisee.
The franchise proposition
The franchisor should describe the franchise proposition and what it offers. This will include a realistic description of the business format and the initial and the continuing services which will be made available to the franchisee.
Details should be provided, in the early stages of development of the franchise system, of the amount of pilot testing which has been carried out with details of the financial performance of the pilot operations. The larger the system the less important will be the pilot testing – the emphasis changes and what existing franchisees think about how their franchisor performs becomes more relevant.
Where products are to be supplied by the franchisor, the franchisor should indicate what will happen if the source of supplies fails. If site approval is a feature of the franchise the franchisor must explain the basis of approval and whether they intend the franchisee to rely on his/her own choice and if so to what extent.
The franchisor should disclose
how many franchisees they have;
who they are, where they trade from and when they each opened their business;
how many franchisees have terminated their franchise agreements within the previous year, and why;
how many franchise agreements were terminated by the franchisor within that year and on what grounds;
with how many franchisees or former franchisees the franchisor is then involved in litigation or arbitration and what is the nature of the disputes;
where the franchisor or any franchisee have previously traded in the territory proposed for a franchisee, the trading history of that territory over the period during which such trading has taken place for up to the previous five years should be disclosed.
7.11 The financial projections
There are different ways in which franchisors present financial projections. Whichever way is chosen the information MUST CLEARLY STATE the basis of presentation of the financial projections. Invariably they are illustrations of profit performance which can be expected if certain turnover levels are achieved. The banks require provision of detailed information and cash flow projections in business plans and recognise how important it is for franchisees to prepare these plans. The more details provided to a prospective franchisee the more they are inclined, despite warning notices, to place reliance on them. He/she believes that because of
the detail involved there must be promises of performances. In fact no franchisor can do that, since, very often the franchisee’s own involvement and skill levels will have marked effect on the results that the business achieves. No franchisor should forecast that which it cannot itself be responsible for performing.
Franchisees must therefore be WARNED that they should understand that no franchisor can warrant with accuracy any financial performance in any particular case. A prospective franchisee should take his/her own proper accountancy advice in considering the franchise proposition.
The best that a franchisor can do is:
show illustrations of what they or a franchisee have actually achieved in practice – no franchisee whose figures are used should be identified without their consent
show what sort of gross profit and net profit might be achieved if certain turnover levels are reached. The gross margin and revenue expenses shown in any such calculation should be the same as or no better than those actually achieved in practice by the franchisor in its own operation or on average by its franchisees. The franchisor should clearly state which of the alternatives it has chosen for the illustration.
The franchisor should state clearly and boldly on each page of projections depending on the circumstances one of the following statements:
“The figures set forth in this illustration represent ACTUAL performance by either the franchisor or a franchisee. There is no guarantee that you will achieve these figures and nor is it intended that you should rely on them as a warranty or guarantee”
“The figures set forth in this illustration indicate the gross profit margins and revenue expenses at stated turnover levels which have been experienced by (the franchisor in its own operations) (the franchisees on average in the last profit and loss accounts prepared and certified by auditors or by a qualified accountant which have been supplied to the franchisor). There is no guarantee that you will achieve the same results, nor is it intended that you should rely on them as a warranty or guarantee of what you will achieve.”
In presenting the illustrative figures the franchisor should clearly STATE whether or not depreciation and any salary or wages for the franchisee and the cost of servicing loans are included.
Use of Guaranteed Turnover Promises 7.12.1 The practice of guaranteeing turnover is most common in the contract cleaning industry, where franchisors provide to franchisees a guaranteed volume of contracted work. In some cases different levels of guaranteed turnover can be bought with different levels of initial fee. However, the margins at which such work can be delivered are not subject to the same level of guarantee, not surprisingly since the margin will depend on the efficiency of the franchisee as well as the nature of the work. Such schemes leave it open to an unscrupulous franchisor to get contracts for franchisees by under-pricing them and still claim to have discharged the guarantee obligation which was used to attract franchisees.
7.12.2 Guarantees of turnover or “earnings” are considered by the bfa to be a special case requiring a specific caveat in order to protect prospective franchisees. Franchisor members offering guaranteed levels of turnover (or earnings or other similar expressions) are required to display in all advertisements and material which present such a guarantee, in an easily readable format and in reasonable proximity to the guarantee, the statement “Guaranteed turnover is not a guarantee of profitability.”
7.13 The contract
The franchisor must provide the franchisee with a copy of the franchise agreement which he or she will be required to sign and should, preferably in writing, advise the franchisee to take independent and franchise experienced expert legal advice to ensure that he or she understands the contractual provisions.
No franchisor with a well thought out franchise would normally negotiate different terms with each franchisee. Franchise agreements are invariably standard documents only changing as the franchise evolves and more experience is obtained.
8. Pre-contract Issues and Selection of Franchisees 8.1 Pre-contract Issues
8.1.1 Paragraph 3.4 of the Code states:
“If a franchisor imposes a pre-contact on a candidate individual franchisee, the following principles should be respected:
prior to the signing of any pre-contract, the candidate individual franchisee should be given written information on its purpose and on any consideration he/she may be required to pay to the franchisor to cover the latter’s actual expenses, incurred during and with respect to the pre-contract phase; if the agreement is executed, the said consideration should be reimbursed by the franchisor or set off against a possible entry fee to be paid by the individual franchisee;
the pre-contract shall define its term and include a termination clause;
the franchisor can impose non-competition and/or secrecy clauses to protect its know-how and identity.”
8.1.2 The intent of the Code is that all deposits should be refunded after the deduction of quantifiable directly-related expenses. The bfa requires its members to refund deposits (whenever such deposits are paid and whether or not the deposits are paid in instalments) paid by prospective franchisees if they do not proceed, although it is acceptable to deduct directly related and verifiable expenses.
8.1.3 The bfa has determined that compliance within ethical requirements will be determined as follows:
The details of any pre-contract deposit, and of any phased payment requirements, must be given in writing to prospective franchisees, including details of what costs, if incurred, will be deducted from the deposit and under what circumstances;
Pre-contract deposits must be refunded to prospective franchisees who (regardless of reason) withdraw their application, less any direct costs as set out in writing under (a) above, and as actually incurred;
Pre-contract deposits must be set off against the published costs of the franchise for prospects joining the network;
Costs that, if related to the particular candidate, can legitimately be deducted from any refund include, but are not necessarily limited to:
Estate agents’ fees
Food and accommodation
Paid research for the particular territory
8.1.4 Costs that cannot be legitimately deducted from any refund include, but are not limited to:
“Opportunity costs”, e.g. the cost of a lost sale to an alternative applicant for the same territory
Staff costs, including the investment of staff time.
Selection of Franchisees
Paragraph 4 of the Code states:
“A franchisor should select and accept as individual franchisees only those who, upon reasonable investigation, appear to possess the basic skills, education, personal qualities and financial resources sufficient to carry on the franchised business.”
8.2.1 Increasingly franchisors are using brokers to assist in marketing and selling franchises. Bfa members who use brokers must ensure that the Code is complied with by the broker as if it were the franchisor effecting the sale and throughout the sale process.
8.2.2 The franchisor cannot rely on the judgement of others however experienced they may be in franchise recruitment. The recruitment process cannot be delegated to third parties who may have an interest in procuring a prospective franchisee on which a commission or payment is to be received by them. The franchisor’s interest is to have as large a pool as possible of quality candidates, but also to have a rigorous procedure for assessing prospective franchisees. Only the franchisor will know the qualities that it is looking for in a franchisee. Ultimately the success of a franchise network will depend on the quality of franchisees in the system. In view of the importance of this fact, franchisors cannot delegate this element. By all means make use of brokers to find suitable candidates but, under no circumstances should the franchisor delegate the ultimate selection to a third party. Further, of course, franchisors should be aware that they may well be responsible for the statements made by the third parties on their behalf. Accordingly, if third party consultants/brokers paint too rosy a picture of the franchise offering in order to encourage candidates and such consultants/brokers are the franchisor’s agents (as
they are likely to be), then the franchisor could be liable.
9. Franchise Agreements 9.1
Paragraph 5.1 of the Code states: “The agreement shall comply with National Law, European Law and the Code of Ethics and any national extensions thereto.)”
So far as the laws are concerned this paragraph states the obvious. However in requiring that the Code applies to the contract this means that in preparing a contract not only should the letter of the Code be applied but also its spirit and the bfa guidance as set out in this Guide and the bfa’s Extension & Interpretation of the Code (see Appendix).
Paragraph 5.2 of the Code states:
“The agreement shall reflect the interests of the members of the franchised network in protecting the franchisor’s industrial and intellectual property rights and in maintaining the common identity and reputation of the franchised network.”
This provision underlines the need for the franchisor to have control over the system, the name and the way in which it is used as well as the controls necessary to ensure that individual franchisees adhere to the branding requirements of the franchisor and the uniformity of operation.
Paragraph 5.2 of the Code also states: “All agreements and all contractual arrangements in connection with the franchise relationship shall be written in or translated into the language of the franchisee’s country and a signed agreement must be given to the franchisee immediately.”
This provision is the subject of a paragraph in the Extension & Interpretation of the Code (see Appendix) which clarifies that franchisors should seek to ensure that they offer to franchisees contracts in a language in which the franchisee is competent.
Paragraph 5.3 of the Code states:
“The franchise agreement shall set forth without ambiguity the respective obligations and responsibilities of the parties and all other mutual terms of the relationship.”
Contracts should be written clearly and should contain all the terms – nothing should be left to undertakings or such statements as “don’t worry about what the agreement says we will do if that happens”. If that is what will be done it must be in the agreement. There is clearly an ethical problem (as well as a legal problem) with a contract which says one thing when it is intended to mean another.
Paragraph 5.4. of the Code contains a list of the terms to be contained in a franchise agreement:
In most cases there is a broad description of a category without the specific detail of what should be included. In those cases clearly the franchisor is expected to list all items within the category which are relevant to the particular system. We shall consider each item on the list.
9.5.1 “The rights granted to the franchisor”
This clearly is a reference to a case where the franchisor does not own the system or trade marks or other industrial or intellectual property rights. An example would be the case of a master franchisee under a master franchise agreement. However there will be some rights granted to the franchisor under the agreement: rights to receive fees, rights to receive information, rights to impose and enforce controls and so on. The franchisor may use third party software in the running of the system in which case it will need a licence and that licence will have to permit sublicensing to the franchisees. These rights must also be referred to in the contractual documentation, and must be capable of verification.
9.5.2 “The rights granted to the individual franchisees”
This would normally include all the rights which a franchisee would require in order to be in a position properly to conduct the business which is being franchised. At the very least it would be expected to include the use of the branding and the franchisor’s system.
9.5.3 “The goods and/or services to be provided to the individual franchisee”
This links with the next item on the list “the obligations of the franchisor” and it is clear that the franchisor should have an obligation in the agreement to provide the necessary goods and/or services required by a franchisee to open and operate his or her franchised business.
9.5.4 “The obligations of the franchisor”
Apart from the goods and services mentioned in the previous item franchisors are expected to provide ongoing services. The definition of franchising in the Code refers to the rights granted being “supported by continuing provision of commercial and technical assistance within the framework of a written franchise agreement”. This item in the text of the Code reflects the requirement in the definition.
“The obligations of the individual franchisees”
The Code requires that all obligations of franchisees should be detailed in the franchise agreement. Nothing should be left out. It is quite usual for such obligations to be set out in detail in franchise agreements. This reference to “obligation” is to substantive legal obligations and it does not affect the common practice of having a separate operating manual which provides the details of the franchisor’s system and the way in which it is to be operated. The position of the operating manual is one which often causes confusion – the operating manual is concerned with identifying the “know-how”. The operating manual therefore contains the details of the way in which the franchisor’s system is to be operated in order to discharge the obligations in this respect contained in the agreement. The operating manual should not be used to impose substantive obligations which the franchisor would then seek unilaterally to vary as a subterfuge on the basis that it is only a variation manual to the manual.
9.5.6 “The terms of payment by the individual franchisees”
The agreement should enable the franchisee to calculate what he or she is expected to pay and how his/her liability for payment should arise. As a general rule no franchisor should have secret sources of income from the operation of the system by its franchisees e.g. hidden commission or kickbacks. These are in essence payments by franchisees, since they do not result in the passing on to franchisees of the cost benefits of memberships, of the bulk purchasing power of the network etc. and can indeed increase the costs to the franchisees.
9.5.7 “The duration of the agreement which should be long enough to allow the individual franchisee to amortise their initial investment specific to the franchise”
This requirement is subject to two provisions in the Extension & Interpretation (see Appendix) recognising that different franchisees may have different objectives and that there may be laws which have an effect on what is otherwise a desirable objective.
The requirement is one of the more difficult to apply, since it appears to place a limit, equal to or less than the term of the agreement, on the speed of amortisation. The investment which has to be amortised is “the initial investment specific to the franchise”. The use of the word “specific” limits the amount of the investment to what is needed to be done directly to establish the franchise. It would not for example include the cost of the acquisition of a freehold property nor so it appears does it include any investment made after the initial set up costs have been incurred.
9.5.8 “The basis for and renewal of the agreement”
This requirement does not mean that there must be a renewal provision in the agreement, but that if there is, the basis of such renewal must be set out in the agreement. The grant of a right of renewal should be fair and the franchisor should not seek by imposing unreasonable conditions to create barriers which may make renewal less attractive than it fairly should be. The bfa discourages the charging of renewal fees if used as a method unfairly of imposing a financial burden at a time when the franchisee may be in a vulnerable position. The Extension & Interpretation (see Appendix) provides further guidance on this issue.
9.5.9 “The terms upon which the individual franchisee may sell or transfer the franchised business and the franchisor’s possible pre-emption rights in this respect”
The Code requires that the franchisee should be in a position to sell the franchised business. The terms and conditions on which this may be done must be set out in the agreement.
In many cases franchisors wish to have the right to purchase the business when the franchisee intends to sell. The terms upon which the franchisor may do this should be set out in the agreement. The bfa believes that ethically the price to be paid should be the proper market value or the price offered by a bona fide arm’s length prospective purchaser and the franchisor should not incorporate terms in the agreement which provide for the franchisor to be able to purchase the franchisee’s business on a voluntary sale by the franchisee below its market value.
Many agreements provide for payments to be made to a franchisor on a sale of the business by a franchisee. There are two types of fee both of which (if charged) should be fixed at reasonable levels. The first type is a form of transfer fee to compensate the franchisor for dealing with application for approval of the prospective purchaser, for evaluating and training them and for dealing with all the practical issues which arise in dealing with the transfer and the completion of new agreements. The second type is a “brokers” fee for introducing a purchaser when the franchisee has indicated their wish to sell.
9.5.10 “Provisions relevant to the use by the individual franchisee of the franchisor’s distinctive systems, trade name, trade mark, service mark, store sign, logo or other distinguishing identification”
No franchisor would wish to omit these provisions since it would weaken the protection of its property rights. The provisions which the agreement will contain will depend upon legal advice about the correct treatment of the individual items of the franchisor’s industrial and intellectual property rights.
9.5.11 “The franchisor’s right to adapt the franchise system to new or changed methods”
It is an essential feature of franchising that the franchisor’s system must be capable of being varied to deal with market developments and to keep it competitive. This is often achieved by amendment to the operating manual. Basically, the agreement sets out what the franchisor and franchisee must do. The operating manual sets out how the franchisee must run the business.
9.5.12 “Provisions for termination of the agreement”
The termination provisions in the agreement should reflect the requirement under Paragraph 2.4 of the Code that “the franchisor shall give written notice to its individual franchisees of any contractual breach and, where appropriate, grant reasonable time to remedy default”. The period of time will possibly vary according to the nature of the default. For example a default which amounts in a fast food operation to a breach of health and hygiene laws and regulations must be put right within a very short timeframe, whereas a default relating to an operational procedure may need 15-30 days to be remedied if the requirement is to be considered reasonable.
The franchise agreement must set out the position without ambiguity. Nowhere is the need for no ambiguity greater than in the clause relating to termination of the agreement.
9.5.13 “Provisions for surrendering promptly upon termination of the franchise agreement any tangible and intangible property belonging to the franchisor or other owner thereof ”
Since the franchisee’s rights to use the franchisor’s tangible and intangible property depend upon the franchise agreement, it is clear that upon termination of the agreement those rights must also come to an end. The reference to the “other owner” of such property is to allow for circumstances where the franchisor is given the right to deal in such property by a third party e.g., where there is a master franchise agreement.
10. Master Franchise Agreements 10.1
Paragraph 6 of the Code states:
“This Code of Ethics shall apply to the relationship between the franchisor and its individual franchisees and equally between the master franchisee and its individual franchisees. It shall not apply to the relationship between the franchisor and its master franchisees.” 10.2
It therefore excludes from its application the relationship between a franchisor and a master franchisee. It does apply to the relationship between franchisor and franchisee, and master franchisee and franchisee (sub franchisee). Why this should be the case is not clear although a number of the specific paragraphs in the Code would clearly, on the face of it, not be applicable.
Perhaps the European Franchise Federation felt that master franchisees, in practice, were unlikely to be individuals without extensive commercial experience and, therefore, the need to set out the terms of their relationship would not be necessary because it would be dealt with in the detailed master franchise agreement. Master franchise agreements, unlike sub franchise agreements, are almost invariably negotiated documents where a franchisor does not adopt a “take it or leave it” approach to the master franchise agreement. Even though the Code does not apply to master franchise agreements, many of its principles would be applicable - these include paragraphs 2.1, 2.2, 2.3, 2.4, 3.2, 5.1, 5.3 and 5.4 save that all references to the franchise agreement would, in the case of paragraph 5 be to the master franchise agreement.
In terms of the master franchisee and its sub franchisees the Code applies as if references to the franchisor are to the master franchisee who, of course, to all intents and purposes, is the franchisor as far as sub franchisees are concerned. Are there any provisions of the Code which could give rise to difficulty for master franchisees in their relationship with their sub franchisees? The following paragraphs of this chapter will analyse those provisions:
10.4.1 Paragraph 2.1 - clearly the master franchisee is not the initiator of a franchise network in the sense of having developed the concept itself although, undoubtedly, a master franchisee would be able to argue that by reviewing the system and market conditions in its own territory, it is the initiator of changes to the system that may be required. Most franchise agreements do envisage that the master franchisee has the ability (and usually the obligation) to review the manual containing the operating system and adapt it (subject to the franchisor’s consent) for the market conditions under which it will operate. Almost all franchise systems have to be adapted to market conditions in the master franchisee’s territory.
10.4.2 Paragraph 2.2 (first and second indent) – The master franchisee may not have operated a business concept with success for a reasonable time or “at least” one pilot unit before starting to sub franchise. Increasingly franchisors are requiring their master franchisee to do precisely that in order to enable the master franchisee to obtain hands on commercial experience which a master franchisee would not have by simply acquiring master franchise rights. A major issue for franchisors using the master franchise concept is that their master franchisee may know little or nothing about franchising and, indeed, may know little about the particular industry which it is required to franchise. This is clearly not advisable but the extent to which the Code specifically requires a master franchisee (and not simply the franchisor) to have operated a pilot operation as required by the first two indents of paragraph 2.2 of the Code is unclear.
10.4.3 Paragraph 2.2 (third indent) - The master franchisee will not be the owner of the trade name, trade mark or other distinguishing identification, but will have contractual rights in respect of their use and, importantly in a master franchise relationship, to sub licence those rights to sub franchisees. The master franchise agreement will set those rights out. Occasionally franchisors grant rights directly to sub franchisees but this, in practice, is unusual. Sub franchisees are entitled to verify the legal rights granted to the master franchisee in relation to the use of trade marks, trade names, etc.
10.4.4 Paragraph 2.2 (fourth indent) - Master franchisees do, often, provide training to sub franchisees although, in some cases, training is required by the franchisor to be provided at the franchisor’s head quarters at least in the early days until the master franchisee has established its own training capabilities and facilities. The obligation on sub franchisees to be trained in the franchisor’s home country is becoming less common.
10.4.5 Paragraph 4 - Master franchisees are required to select and accept as individual franchisees only those that have certain attributes. You would expect the master franchise agreement to set out similar provisions and perhaps to set out what those attributes might be.
11. Resolution of Disputes 11.1
Paragraph 2.4. of the Code states: â€œParties should resolve complaints, grievances and disputes with good faith and goodwill through fair and reasonable direct communication and negotiationâ€?
This imposes the obligation on both parties to talk to each other in a genuine attempt to settle their differences. This can present many difficulties. Very few franchisors would be prepared to debate the system, its standards and whether or not they have been complied with or indeed whether the system should be changed as some franchisees suggest when questioned about compliance. There can be many areas within which differences arise frequently from misunderstanding and poor communication. It is an ethical requirement that both parties should try to get to the root of the problems and find a solution.
The bfa recognises that this will not always be easy and it has introduced two distinctly different approaches. One is a system for mediation and conciliation â€“ the other is arbitration.
The difference between the two is that arbitration is private litigation where, although there is arbitration law, the parties can lay down their own procedures and can appoint the arbitrator with, if appropriate, experience relevant to the subject matter of the dispute.
The bfa mediation and arbitration rules and application for mediation and arbitration can be accessed through the bfa website.
APPENDIX Code of Ethical Conduct This Code of Ethical Conduct in franchising takes as its foundation the Code developed by the European Franchise Federation. In adopting the Code, the Federation recognised that national requirements may necessitate certain other clauses or provisions and delegated responsibility for the presentation and implementation of the Code in their own country to individual member National Franchise Associations. The Extension and Interpretation, which follows the European Code, has been adopted by the British Franchise Association, and agreed by the European Franchise Federation, for the application of the European Code of Ethics for Franchising by the British Franchise Association within the United Kingdom of Great Britain and Northern Ireland.
EUROPEAN CODE OF ETHICS FOR FRANCHISING Part I - Introduction (I-III) II. THE EFF REPRESENTS EUROPEAN FRANCHISING
The European Franchise Federation is an international non-profit Association, constituted in 1972. Its members are national Franchise Associations or Federations established in Europe.
The European Franchise Federation also accepts Associate members who are non European Franchise Associations or Federations
THE AIMS OF THE EFF
The promotion of Franchising in Europe
Protecting the Franchise Industry by promoting the European Code of Ethics
Influencing and encouraging the development of Franchising in Europe
Representing the interests of the Franchise industry to international organisations such as the European Commission and the European Parliament.
The promotion and representation of the European Franchise industry and its members world-wide.
The exchange of information and documentation between national Associations or Federations in Europe and in the world.
Serving the Member Associations.
CONDITIONS FOR MEMBERSHIP
All representative national Associations or Federations established in Europe can apply for membership of the Federation. MEMBERS are subject to the following conditions:
members of the national Associations or Federations must be Franchise networks comprising franchisors and their franchisees, their governing body primarily composed of franchisors elected by accredited franchisor members. Furthermore, the Chairman of the Association or Federation must be a franchisor and national Board member.
acceptance without reservation of the Articles of the FEDERATION and the rules and regulations drawn up in accordance with the Articles.
In particular, member Associations or Federations must require their member franchisors to accept and comply with the European Code of Ethics on Franchising.
each member Association or Federation must operate an accreditation scheme with positive checks to ensure that its voting franchisor members comply with the European Code of Ethics on Franchising.
acceptance by the Board of Directors of the FEDERATION.
payment of the dues fixed by the Board of Directors of the FEDERATION. The Federation will also admit to Associate membership on terms to be agreed by the Board of Directors, national Franchise Associations who, whilst they do not meet the above conditions, commit to and are demonstrably working towards meeting those conditions.
Part II - The Text of the Code (IV) (Last Amended On December 5th, 2003) V.
EUROPEAN CODE OF ETHICS FOR FRANCHISING This European Code of Ethics is the up-to-date version of the Code first elaborated in 1972 by the European Franchise Federation (EFF).
Each National Association or Federation member of the EFF has participated in its writing and will ensure its promotions, interpretation and adaptation in its own country.
Proposed adaptations by Member Associations may come as complements to the basic Code, without altering it, and must be approved by the EFF’s governing bodies before being implemented.
This Code of Ethics is meant to be a practical ensemble of essential provisions of fair behaviour for Franchise practitioners in Europe. 1. DEFINITION OF FRANCHISING
Franchising is a system of marketing goods and/or services and/or technology, which is based upon a close and ongoing collaboration between legally and financially separate and independent undertakings, the franchisor and its individual franchisees, whereby the franchisor grants its Individual franchisee the right, and imposes the obligation, to conduct a business in accordance with the franchisor’s concept.
The right entitles and compels the Individual franchisee, in exchange for a direct or indirect financial consideration, to use the franchisor’s trade name, and/or trade mark and/or service mark, know-how, business and technical methods, procedural system, and other industrial and /or intellectual property rights, supported by continuing provision of commercial and technical assistance, within the framework and for the term of a written franchise agreement, concluded between parties for this purpose.
“know-how” means a body of non-patented practical information, resulting from experience and testing by the franchisor, which is secret, substantial and identified;
“secret” means that the know-how, as a body or in the precise configuration and assembly of its components, is not generally known or easily accessible; it is not limited in the narrow sense that each individual component of the know-how should be totally unknown or unobtainable outside the franchisor’s business;
“substantial” means that the know-how includes information which is indispensable to the franchisee for the use, sale or resale of the contract goods or services , in particular for the presentation of goods for sale, the processing of goods in connection with the provision of services, methods of dealing with customers, and administration and financial management; the know-how must be useful for the franchisee by being capable, at the date of conclusion of the agreement, of improving the competitive position of the franchisee, in particular by improving the franchisee’s performance or helping it to enter a new market.
“identified” means that the know-how must be described in a sufficiently comprehensive manner so as to make it possible to verify that it fulfils the criteria of secrecy and substantiality; the description of the know-how can either be set out in the franchise agreement or in a separate document or recorded in any other appropriate form.”
2.1 The franchisor is the initiator of a franchise network, composed of itself and its Individual franchisees, of which the franchisor is the long-term guardian.
2.2 The obligations of the franchisor: The franchisor shall
have operated a business concept with success,
for a reasonable time and in at least one pilot unit before starting its franchise network,
be the owner, or have legal rights to the use, of its network’s trade name, trade mark or other distinguishing identification,
provide the Individual franchisee with initial training and continuing commercial and/or technical assistance during the entire life of the agreement.
2.3 The obligations of the Individual franchisee: The Individual franchisee shall: •
devote its best endeavours to the growth of the franchise business and to the maintenance of the common identity and reputation of the franchise network,
supply the franchisor with verifiable operating data to facilitate the determination of performance and the financial statements necessary for effective management guidance, and allow the franchisor, and/or its agents, to have access to the individual franchisee’s premises and records at the franchisor’s request and at reasonable times,
not disclose to third parties the know-how provided by the franchisor, neither during nor after termination of the agreement.
The ongoing obligations of both parties: •
Parties shall exercise fairness in their dealings with each other. The franchisor shall give written notice to its individual franchisees of any contractual breach and, where appropriate, grant reasonable time to remedy default;
Parties should resolve complaints, grievances and disputes with good faith and goodwill through fair and reasonable direct communication and negotiation.
RECRUITMENT, ADVERTISING AND DISCLOSURE
3.1 Advertising for the recruitment of Individual franchisees shall be free- of ambiguity and misleading statements;
3.2 Any recruitment, advertising and publicity material, containing direct or indirect references to future possible results, figures or earnings to be expected by individual franchisees, shall be objective and shall not be misleading.
3.3 In order to allow prospective Individual franchisees to enter into any binding document with full knowledge, they shall be given a copy of the present Code of Ethics as well as full and accurate written disclosure of all information material to the franchise relationship, within a reasonable time prior to the execution of these binding documents.
3.4 If a franchisor imposes a pre-contract on a candidate Individual franchisee, the following principles should be respected :
prior to the signing of any pre-contract, the candidate individual franchisee should be given written information on its purpose and on any consideration he/she may be required to pay to the franchisor to cover the latter’s actual expenses, incurred during and with respect to the pre-contract phase; if the agreement is executed, the said consideration should be reimbursed by the franchisor or;
set off against a possible entry fee to be paid by the Individual franchisee;
the pre-contract shall define its term and include a termination clause;
the franchisor can impose non-competition and/or secrecy clauses to protect its know-how and identity.
SELECTION OF INDIVIDUAL FRANCHISEES A franchisor should select and accept as Individual franchisees only those who, upon reasonable investigation, appear to possess the basic skills, education, personal qualities and financial resources sufficient to carry on the franchised business.
THE FRANCHISE AGREEMENT
5.1 The franchise agreement shall comply with the National law, European community law and this Code of Ethics and any national Extensions thereto.
5.2 The agreement shall reflect the interests of the members of the franchised network in protecting the franchisor’s industrial and intellectual property rights and in maintaining the common identity and reputation of the franchised network. All agreements and all contractual arrangements in connection with the franchise relationship shall be written in or translated by a sworn translator into the official language of the country the Individual franchisee is established in, and signed agreements shall be given immediately to the individual franchisee.
5.3 The Franchise agreement shall set forth without ambiguity, the respective obligations and responsibilities of the parties and all other material terms of the relationship.
5.4 The essential minimum terms of the agreement shall be the following:
the rights granted to the franchisor;
the rights granted to the Individual franchisee;
the goods and/or services to be provided to the Individual franchisee;
the obligations of the franchisor;
the obligations of the Individual franchisee;
the terms of payment by the Individual franchisee;
the duration of the agreement which should be long enough to allow Individual franchisees to amortise their initial investments specific to the franchise;
the basis for any renewal of the agreement;
the terms upon which the Individual Franchisee may sell or transfer the franchised business and the franchisor’s possible pre-emption rights in this respect;
provisions relevant to the use by the Individual franchisee of the franchisor’s distinctive signs, trade name, trademark, service mark, store sign, logo or other distinguishing identification;
the franchisor’s right to adapt the franchise system to new or changed methods;
provisions for termination of the agreement;
provisions for surrendering promptly upon termination of the franchise agreement any tangible and intangible property belonging to the franchisor or other owner thereof.
THE CODE OF ETHICS AND THE MASTER-FRANCHISE SYSTEM
This Code of Ethics shall apply to the relationship between the franchisor and its Individual franchisees and equally between the Master Franchisee and its Individual franchisees. It shall not apply to the relationship between the franchisor and its Master-franchisees. 42
BRITISH FRANCHISE ASSOCIATION CODE OF ETHICAL CONDUCT: EXTENSION AND INTERPRETATION This Extension and Interpretation forms an integral part of the Code of Ethical Conduct adopted by the British Franchise Association and to which its members adhere. APPLICATION 1. This Code of Ethical Conduct forms part of the membership agreement between the British Franchise Association and its member companies. It does not form any part of the contractual agreement between franchisor and franchisee unless expressly stated to do so by the franchisor. Neither should anything in this Code be construed as limiting a franchisor’s right to sell or assign its interest in a franchised business. DISCLOSURE 2. The objectivity of recruitment literature (Clause 3.2) refers specifically to publicly available material. It is recognised that in discussing individual business projections with franchisees, franchisors are invariable involved in making assumptions which can only be tested by the passage of time. CONFIDENTIALITY 3. For the generality of this Code of Ethical Conduct, ‘know-how’ is taken as being as defined in the European Block Exemption to Article 85 of the Treaty of Rome. However, for the purposes of Article 3.4 of the European Code of Ethics it is accepted that franchisors may impose non-competition and secrecy clauses to protect other information and systems where they may be reasonably regarded as material to the operation of the franchise. CONTRACT LANGUAGE 4. Franchisors should seek to ensure that they offer to franchisees contracts in a language in which the franchisee is competent. CONTRACT TERM 5. In suggesting in Article 5.4 of the European Code of Ethics that the minimum term for a franchise contract should be the period necessary to amortize those of a franchisee’s initial investment which are specific to the franchise, it is recognised: (a) that for a minority of the largest franchise opportunities amortizing initial investments may not be a primary objective for the franchisee. In such cases the objective should be to adopt a contract period which reasonably balances the interests of the parties to the contract. (b) that this section could be subject to national laws concerning the restraint of trade and may need to be met through renewal clauses. 43
CONTRACT RENEWAL 6. The basis for contract renewal should take into account the length of the original term, the extent to which the contract empowers the franchisor to require investments from the franchisee for refurbishment or renovation, and the extent to which the franchisor may vary the terms of a contract on renewal. The overriding objective is to ensure that the franchisee has the opportunity to recover their franchise specific initial and subsequent investments and to exploit the franchised business for as long as the contract persists. ADOPTION 7. This Code of Ethical Conduct comprising this Extension and Interpretation and the European Code of Ethics for Franchising was adopted by the British Franchise Association, replacing its previous Code of Ethics on 30th August 1990, subject to a transitional period for full compliance ending 31st December 1991. During the transitional period members of the Association are nonetheless required to comply at least with the Code of Ethics previously in force. In October 1991 the Association agreed with the European Franchise Federation some amendments to the Code agreed in August 1990 and at the same time extended the transitional period to full compliance to 31st December 1992.
Index A administrator 13 advertising 10, 17, 18, 21, 41 arbitration 24, 36 B bankruptcy 13 best practice 3 brand, branding 13, 16 breach, breaches 7, 8, 13, 14, 19, 20, 33, 41 brokers 28, 32 business plan 11 C capital 4, 9, 15 Code, Code of Ethics 2, 1, 3, 6, 7, 8, 13, 15, 16, 18, 19, 20, 21, 22, 27, 28, 29, 30, 31, 32, 33, 34, 35, 36, 37, 38, 39, 41, 42, 43, 44 contract 1, 3, 22, 26, 27, 29, 40, 41, 43, 44 D death 12, 13 deposit, deposits 27 disclosure 20, 21, 22, 41 disputes 23, 24, 36, 41 E EFF 6, 7, 38, 39
F fairness 2, 8, 41 financial projections 22, 24 fixed fees 11 franchise agreement 6, 7, 8, 9, 10, 11, 12, 14, 15, 16, 18, 19, 20, 26, 29, 30, 31, 33, 34, 35, 39, 40, 41, 42 franchise fee 11 G goodwill 8, 12, 36, 41 guaranteed earnings, guaranteed turnover 21, 26 I insolvency 13 intellectual property rights 6, 7, 12, 29, 30, 32, 42 K know-how 6, 7, 16, 20, 27, 31, 39, 40, 41, 43 L liquidation 13 M marketing 6, 7, 10, 11, 17, 18, 28, 39 market value 12, 32 master franchise agreement 16, 30, 33, 34, 35 master franchisee 30, 34, 35 material provision 13 mediation 36 minimum fee 11 minimum performance 11 N national account 8 O obligations 2, 8, 18, 29, 30, 31, 40, 41, 42 operating manual 31, 33
P performance 6, 11, 14, 16, 18, 19, 24, 25, 40 pilot, pilot operation, pilot unit 4, 15, 24, 35, 40 pilot testing 4, 24 pre-contract 27, 41 product tie 10 profit, profits 12, 19, 21, 23, 24, 25, 38 projections 11, 22, 24, 25, 43 public relations 10 R rebates 11 receiver 13 recruitment 8, 12, 21, 28, 41, 43 relocation 9 renewal 8, 9, 32, 42, 43, 44 resale, re-sales 9, 12, 40 revamp 9, 12 S sub franchise, sub franchisees 34, 35 support 2, 7, 13, 16, 17 T term 6, 8, 9, 15, 20, 27, 31, 39, 40, 41, 43, 44 termination 8, 12, 14, 18, 27, 33, 40, 41, 42 trade mark, trade name 7, 15, 32, 35, 39, 40 training 8, 12, 16, 17, 32, 35, 40 transfer 9, 12, 32, 42 V value 3, 9, 12, 13, 32
British Franchise Association, Centurion Court, 85f Milton Park, Abingdon, OX14 4RY Tel 01235 820 470 Fax 01235 832 158 Email firstname.lastname@example.org Web www.thebfa.org