International Franchising Vis-à-Vis Technology Transfer: Legal Challenges in India
It is undisputable that the systematic knowledge that one possesses with regard to manufacturing, applying or processing things should be diffused through human activity. One of the most preferred methods for such transfer is franchising. This article aims to provide a brief idea about franchising and the elements specified in a codified legislation belonging to a developed economy i.e. US. It also highlights certain disclosure requirements, mandated by the US Federal Law for the purpose of full-fledged transfer of technology through franchising. The next part aims to establish that international franchising is one of the efficient means to transfer technologies to developed and least developed economies. That being said, it is important to analyse the legal barriers that can potentially retard the entry of international franchisors in a developed economy like India. To that extent, this article makes a critical analysis on the legal challenges existing in India, in the absence of a specific legislation, which fails to promote technology transfer in the country through international franchising.
Technology may be regarded as the systematic study of techniques for making and doing things.It can also be defined as the application of the arts, science, processes, ideas, tools and machines to solve human problems. The UNCTAD draft International Code on the Transfer of Technology, in its definition of “technology transfer”, describes “technology” as “systematic knowledge for the manufacture of a product, for the application of a process or for the rendering of a service". Technology is considered as an important base for economic growth and development, and thus, the importation of technology is actively encouraged by the governments of many states. Technology is transferred from one country or firm to others and this might involve transfer of new products, processes, working methods or the use of specialized know-how. The term technology transfer refers to the process by which science and technology are diffused throughout human activity. It is said that the important factor in defining technology transfer is that the recipient acquires the capability to manufacture itself a product whose quality is comparable to that manufactured by the technology supplier. Franchising is regarded one of the preferred methods for transferring technology. It is demonstrated that the know-how contained in a typical franchise license could legitimately be regarded as a “technology transfer” to developed economies. To that extent, as a developing economy, it is important to analyse the legal challenges to the franchise schemes in India that serve as hindrances to the transfer of technology.
A franchise is probably best defined as comprising a contractual relationship between a franchisee (usually taking the form of a small business) and a franchisor (usually a larger business) in which the former agrees to produce or market a product or service in accordance with an overall 'blueprint' devised by the franchisor. Hence, the franchisee starts manufacturing and selling the goods according to the franchisor's specification. The franchisors may, by way of franchise agreement, authorise the franchisees to use the franchisee’s business format, distribute the franchisee’s products, manufacture and market the franchisee’s products etc. The parties may label the transaction or agreement as license, joint venture, consulting and supply agreement, dealership etc. Notwithstanding such labels, if an arrangement has all of the elements of a franchise, it is a franchise. There are three main elements used for determining a franchise. Firstly, the business must be substantially associated with the franchisor's trademark or other commercial symbol for the business to be a franchise. This usually takes the form of a license to use the franchisor's name. Secondly, the franchisee must make payment of fee to the franchisor. A payment by a franchisee does not have to be labelled a franchise fee to satisfy this element of the definition. Ongoing royalty payments or payments characterized otherwise, such as consulting fees, training fees, or site assistance fees, are sufficient, as long as they are for the right to operate the business. Thirdly, the franchisor must exert substantial control or community of interest over the franchisee’s business. Such control can be through financial interest, offering operation guide and technical assistance etc. The FTC uses yet another standard: whether or not the licensor can exert significant control over the putative franchisee's method of operating the business, or whether significant assistance is offered in the method of operation.
Disclosure Requirements under US Federal Law
In 1979, the Federal Trade Commission promulgated “Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures,” commonly called the “FTC Rule.”As the name implies, the FTC Rule laid out requirements for pre-sale disclosures about which the FTC concluded franchise buyers should be informed. The FTC Rule was accompanied by final interpretive guides and a lengthy, detailed statement of basis and purpose that were to be consulted in determining the Rule's meaning. The requirements are being amended on a regular basis so as to prevent the abuse of treatment to the franchisees. The franchisees are required to make the disclosure by using the form included in the UFDD Guidelines (“UFDD Form”).
The following is the list of what is required to be disclosed:
(1) The name of the franchisor and any parents, predecessors, and affiliates. (2) The identity and business experience of persons affiliated with the franchisor. (3) Litigation. (4) Bankruptcy. (5) The franchisee's initial franchise fee or other initial payments. (6) Other fees. (7) The franchisee's estimated initial investment. (8) The restrictions on the franchisee's sources of products and services. (9) The franchisee's obligations. (10) Financing arrangements. (11) Obligations of the franchisor to assist the franchisee and other supervision, assistance, or services provide by the franchisor. (12) Territory. (13) Trademarks. (14) Patents, copyrights, and proprietary information. (15) The obligation of the franchisee to participate in the actual operation of the franchise business. (16) Restrictions on goods and services offered by the franchisee. (17) Renewal, termination, and transfer of the Franchise Agreement and dispute resolution. (18) Arrangements with public figures. (19) Financial performance representations. (20) List of outlets and information regarding existing franchises and company-owned units of the franchisor. (21) Financial statements of the franchisor. (22) A list of the contracts to be signed by the franchisee.
Thus, a franchisor would be required to state, if such were the case, that it does not provide any form of territorial protection to the franchisees, or that it does not solicit or accept rebates from its suppliers. For purposes of clarification, each disclosure item must be preceded by a prescribed heading.Such disclosure requirements will further the transfer of technology as the franchisees would be provided with much information about the operations, and furthermore, it helps them to carry out hassle-free business. These requirements are similar to the ex- ante disclosure requirements in the case of Standard Essential Patents as both seek to promote technology transfer.Nevertheless, the disclosure requirements in franchises can be found in the developed economies like United States, and not in developing economies like Philippines, India etc.
International Franchising- Means of Technology Transfer to Developing Economies
The transfer of franchise know-how across national boundaries can be viewed as a process providing local franchisees with access to value-added businesses as well as the marketing techniques and managerial support implicit to firms developed in industrialized economies. Here, the strength of the franchisor's home base plays an important role in conferring competitive advantages to the franchisee and economic development opportunities to the satellite country. An implicit feature of a franchise system is the concept of technological transfer and the 'learning organization', where technology refers to skills and know-how rather than just machinery and hardware. This broader process relates to methods of organization and operation, quality control, and various other manufacturing procedures. Developing economies with increasing urbanization, rising disposable incomes and expanding consumer markets provide conditions favorable to the growth of franchising.
Such transfer of technology in the form of franchises can be possible with the help of ‘International Franchising’. It induces a franchisor, originating from one country, to grant a franchisee (located in a different country) the right to sell a product under the franchisor’s business model with the franchisor charging a royalty to the franchisee. For example, the world’s leading franchisor McDonalds gets 55 percent of its sales outside the US. While McDonald’s, “with its presence in over 100 countries”, offers a classic example of franchising and is often “used as a benchmark for developing franchise companies" within and across borders, a wide range of companies engage in such arrangements that extend their global reach.
A recent survey, conducted in 2013 by the International Franchise Association (IFA), revealed that 61 percent of the respondents currently franchise in international locations, and 16 percent generate between 25 percent and 30 percent of revenue from international franchising. The importance of international franchising is summarized by American writer Eroglu:
"...from a balance-of-payments perspective, international franchising is considered (in the U.S.) as a safe and speedy means of obtaining foreign currency with a relatively small financial investment abroad. It is notable in that it neither replaces (American) exports nor exports (American) jobs, all these reasons making this business arrangement one of the most preferred and government-supported forms of international involvement."
There are different ways through which an international franchise can be made.
According to U.S. Department of Commerce international franchising can be arranged by “franchising directly to individuals, company-owned operations, joint ventures or master franchisors. Many franchisors use more than one method in conducting foreign operations but the most popular, cheapest and fastest method is the master license technique".The master franchise agreements involve a franchisor from one country establishing a partnership with a foreign firm (master franchisee) who then distributes the rights to sell, the franchisor’s product, to other firms (sub-franchisees) within a specific geographic area of the country (host) in which the master franchisee is located.
So long as the technology transfer is concerned, it is identified that there are three levels of technology transfer that could be aligned to the context of franchising.
First: the operating capability. It is the capability required to operate a technology, for example, to run and maintain a business unit.
Second: the investment capability– It is the capability that is required to create new productive capacity.
Third: the innovative capability. It is the ability to modify and improve methods and products. It is within the franchisor's home base that the infrastructure, such as bank support suppliers and main customers, are most sophisticated and contribute to the rate of diffusion of a particular technology. Lower educational standards within LDCs may have a detrimental effect on attracting international franchises not only due to cost considerations but because the ability to attain critical mass within such countries may be slower than within developed economies. Some franchise organizations have become increasingly sophisticated in their strategies for developing franchisees' operating ability through the combined use of class-room and hands-on techniques. As business format franchising focuses upon the transfer of know-how, at least the operating capability, rather than simple product distribution, it is most likely to have a direct effect on the economic progress of developing countries. The innovative capability of the technology transfer process is the most difficult to achieve since it requires some alteration to the marketing mix of the franchise in order to adapt to local conditions. It is argued that one of the reasons for franchisor concentration upon industrialized nations is the lower costs of technological transfer resulting from higher educational standards as well as higher savings ratios - indicating the potential presence of finance available for investment in franchising. Nevertheless, whatever posture governments of developing economies decide to adopt on franchising, one thing appears fairly certain and that is that franchising as a business concept cannot be indefinitely ignored.
Legal Challenges for International Franchising Activities in India
By appointing franchisees in a foreign country, a franchisor may become liable for and subject to the laws of the country in which its foreign franchisee operates. It is observed that the local laws have significant impact on the entry of international franchisors in the developing countries. Many foreign entities interested in investing in India are discouraged due to the intricacies in the local laws of the country. Though there is no specific law pertaining to franchising in India, franchising as a business touches upon various business laws and industry specific laws within the country. It would be important to understand how these different laws can affect a franchising business in India and issues that can potentially arise thereunder.
a. Contractual Relationship
The franchising agreement constitutes a contractual relationship, and thus, it is governed by the Indian Contract Act, 1872. For a franchising agreement to be valid in India, it should fulfil the requirements specified under the Act viz., an agreement, lawful consideration, lawful object and purpose, free consent of the parties, and the capacity of the parties to enter into an agreement.
Another issue is with regard to the constitution of agency. While normally franchisors and franchisees intend to create an independent contractor relationship, sometimes, depending upon the nature of the contract, the relationship between the franchisor and the franchisee could be considered to be an agency.If the parties decide to enter into an independent contractor relationship, the franchisor would not be liable for the franchisee's actions. However, if they opt for an agency relationship, then the franchisor, being the principal, would be liable for the franchisee's actions, i.e., the franchisee's actions that fall within the scope of the contract.
b. Non competition covenants
Another issue that could arise is of competing with the franchisor’s business during the term of the franchising relationship. In the landmark case ofGujarat Bottling Co. Ltd. v. Coca Cola Co., the Coca Cola Co. had imposed a restriction on Gujarat Bottling Co. Ltd from entering into an agreement with any other beverage manufacturing company during the term of their contract. The Court therefore held that a negative agreement restraining the franchisee from manufacturing, bottling, selling, dealing or otherwise being concerned with the products or beverages of any other brands or trademarks/trade names during the subsistence of a franchise agreement including the period of the period of one years' notice, is not violative of Section 27 of the Contract Act. However, the Court did not address the issue of a negative covenant post-termination of the agreement. This is an issue that the parties must bear in mind while formulating the contract.
c. Protection of IPRs
Since the intellectual property licence lies at the core of a franchise, the laws governing licensing of intellectual property constitute the heart and arteries of franchise laws.A major concern for a franchisor is whether its intellectual property would be adequately protected in the franchisee's country. Since India is a signatory to the Agreement on Trade Related Aspects of Intellectual Property Rights (TRIPs), most of its intellectual property laws are in compliance with TRIPs and afford adequate protection to intellectual property rights. The franchisor will be liable, in the absence of due diligence on his part, if any case of intentional misbranding done by the franchisee in the target country. Another important issue is regarding the enforceability of a negative covenant restricting the use of IPRs post-term. Such covenants can be helpful in preventing the franchisee from using the trademark pendent lite, or even after the termination for reference purposes or as part of a corporate name. It would also be useful in cases where the confidential information is continuously used by the franchisee after the termination of franchise agreement.
d. Competition issues
In franchising arrangements, the products and services acquired by the franchisee and the prices and circumstances under which they are sold are invariably under the control of the franchisor to some degree. This creates a risk of the franchising arrangement falling foul of the domestic competition laws. The Competition Act, 2002 prohibits anti-competitive agreements and abuse of dominant position and seeks to regulate combinations (also known as “merger control” in other jurisdictions). In US, At one time, the battle between franchisors and franchisees was waged primarily in the antitrust arena. Following the decision in Siegel v. Chicken Delight, which found a required purchase of restaurant equipment to be an unlawful tie, such issues were commonly litigated in franchising. This argument was firmly rejected in Queen City Pizza, Inc. v. Domino's, Inc., where the court held that Domino's could eliminate other authorized suppliers and designate itself as the sole authorized supplier of pizza ingredients without creating an unlawful tie. The difference in approaches taken by different jurisdiction causes legal issues to the franchisors as the control on supplies, manufacture, distribution etc. may be regarded as anti-competitive in Indian courts.
e. Tortious liability
A tort is a civil wrong independent of contract for which the appropriate remedy is an action for unliquidated damages. Tortious liability could arise in a franchise relationship in the following situations:
(a) Negligence: Negligence is a breach of duty caused by an act or omission, which results in damage. In a franchising arrangement, the breach of any duty by the franchisor or franchisee, which causes a loss or damage to the franchisee or franchisor, respectively or to any third party, could lead to a civil action for negligence.
(b) Vicarious Liability: In the event there is a principal-agent relationship, or an employer-employee relationship between the franchisor and the franchisee, the franchisor could be held liable for any torts committed by the franchisee during the course of the business. However, if the franchisee has acted outside his capacity or contrary to the instructions of the franchisor, the franchisor may be able to recover any damages from the franchisee. If the franchisee is an independent contractor, the franchisor may not be liable for the tortious acts of the franchisee.
Furthermore, the franchise will be governed by as set of laws such as tax laws, e-commerce laws, property laws, consumer protection laws, labour laws, environmental laws, exchange control laws, insolvency laws and e-commerce laws. In addition to these laws, there are industry-specific legislations, depending upon the sector to which the franchising agreement is related. There are unsettled issues in the said respective areas, and such issues will continue to plague the franchise system in the absence of a specific legislation.
Observations and Conclusions
In US, in the 40 years since the first franchise law was enacted, the law of franchising has burgeoned into a complex international web of statutes, regulations, and cases. But, as far as India is concerned, it is not equipped with adequate jurisprudence to solve the legal issue pertaining to international franchising. Quality controls and protection of proprietary information are a major concern in international franchise agreements. The former is an issue that has to be considered from the business perspective. For governments of developing countries who wish to tap the potential of franchising and concentrate on promoting local businesses, whilst resisting the downside factors of imported franchise retail know-how, the 'wholesaler-retailer' franchise model has sometimes proved effective. This has sometimes also served the purpose of promoting ethnic majority businesses in their attempts to compete with those of powerful ethnic minority groups, e.g., Chinese, Indian, Lebanese, etc. Here, retailers can form a wholesaling co-operative capable of yielding economies of scale in purchasing typically beyond the scope of small traders. Furthermore, in so far as legal disabilities are concerned, India is lagging behind in enforcing disclosure requirements on the franchisor since there is law requiring it. This position does not hold good in promoting the transfer of technology because of obvious reasons. The absence of specific technology transfer laws in India fails the purpose that international franchising seeks to serve in furthering technology transfer. It is high time that we should discuss and deliberate the idea of enacting asui gener is legislation that regulates franchising.
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# Supranote 53
# Supranote 45
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