John H. Pratt outlines the considerations in preparing a master franchise agreement
Master franchising has traditionally been the most commonly used franchise business model for international expansion, largely because it allows for rapid expansion without substantial ongoing commitment of human and financial resources by franchisors which would otherwise be needed if other franchise structures were used.
In a master franchise arrangement the primary responsibility for developing the system in the proposed territory is transferred from a franchisor to a master franchisee.
As a result, fewer resources and significantly less capital investment is required from a franchisor. An additional advantage is that the local master franchisee will be more familiar with its own market than the franchisor.
Notwithstanding these benefits the use of master franchising seems to have declined, partly because in the era of increased globalisation direct franchising has become less challenging, but also because the disadvantages of master franchising have become more apparent.
The major issue with master franchising is that the quality and consistency of products or services through a multi-tiered master franchise network cannot be guaranteed and that is particularly true in complex franchises such as restaurant franchises.
MASTER FRANCHISE STRUCTURE
Master franchising involves a three-tier structure whereby a franchisor grants to a master franchisee the right to develop its brand within a specified territory (usually, an entire country or several countries) by entering into franchise agreements with subfranchisees.
This means that there are generally, at least, two agreements. First, a cross-border agreement between the franchisor and the local master franchisee (called the ‘master franchise agreement’) and secondly, a domestic franchise agreement between the local master franchisee and each of the local sub-franchisees (called the ‘subfranchise agreement’).
This structure, does not envisage any contract between the franchisor and the subfranchisees – therein lies the problem, because a franchisor cannot enforce at the interface with customers, system standards and requirements.
There are a number of contractual and non-contractual techniques that can be used to mitigate the challenges caused by franchisors’ lack of a contractual link with subfranchisees.
First, franchisors should require their master franchisees to recruit and maintain a certain level of appropriately qualified staff whose role is to ensure that brand standards are maintained. Alternatively, or in addition, franchisors could require a certain number of field visits to be undertaken with reports from those field visits made available to the franchisor.
Secondly, the master franchise agreements should require master franchisees to obtain the franchisor’s prior written consent in relation to important matters arising from the master franchisee’s dealings with subfranchisees, such as the recruiting of subfranchisees, the terms of the subfranchise agreements, including their modification, transfer, and termination. Thirdly, franchisors may insert certain rights to enforce some provisions of the subfranchise agreements directly against subfranchisees.
However, making all the relevant decisions for the master franchisee, and having the ability directly to enforce obligations against the subfranchisees runs counter to the purpose of a master franchising arrangement. Indeed, most franchisors do not have the resources, or the ability to pay for such resources, information and expertise to make these decisions for the master franchisees.
In order to overcome the issues highlighted above, franchisor’s lawyers have come up with a number of techniques which are analysed below.
Third Party Beneficiary Rights
Subfranchise agreements can be drafted to provide that the franchisor is a named ‘third party beneficiary’ of the master franchisee’s rights under the subfranchise agreement. Such third party beneficiary clauses often provide that a franchisor has the right to enforce the terms of the subfranchise agreement as if the franchisor were a party to the subfranchise agreement but such clauses have varying degrees of effectiveness depending on the jurisdiction in which enforcement is sought.
They are likely to be less successful in civil law or religious law jurisdictions and so, local legal input would be required before using this approach.
Some franchisors require a tri-partite subfranchise agreement to be entered into with the franchisor, master franchisee and subfranchisee. The difficulty is that having the franchisor be a party to the subfranchise agreements also reduces the key benefit of using a master franchise structure because, as a result, the franchisor may incur direct liability to the subfranchisee.
Another approach used by franchisors is to require that subfranchisees sign a separate written acknowledgement addressed to the franchisor acknowledging the franchisor’s rights under the subfranchise agreement or master franchise agreement and acknowledging that the subfranchise agreement will terminate upon a termination of the master franchise agreement.
Finally, in some structures, the franchisor will require subfranchisees to sign a short and simple trademark licence agreement with the franchisor. That agreement will give the franchisor the right to withdraw or limit the right to use the franchisor’s brands if certain serious breaches occur.
The benefit of this approach is to give the franchisor direct rights to enforce its intellectual property rights and enforce standards without being a party to the subfranchise agreement.
Having said that, some master franchisees may be reluctant to allow franchisors to have any direct contractual relationship with subfranchisees which would enable a franchisor to take direct action and thereby bypass the master franchisee. Further, from the franchisor’s perspective, there may be a fear that entering into a direct contractual relationship with subfranchiees in a foreign country increases the likelihood of the franchisor incurring liability for the acts of the master franchisee.
If very tight control of subfranchisee standards is required, then master franchising may not be the best method to expand internationally because the legal “structures” set out in the previous section all have disadvantages.
There may, however, be practical steps that franchisors can take to maintain subfranchisee standards but that will be the subject of a subsequent article!
ABOUT THE AUTHOR
John H Pratt is the senior partner of Hamilton Pratt, Europe’s largest specialist franchise law firm. He is the immediate past Legal Advisor to the British Franchise Association and a past Chair of the International Bar Association’s International Franchise Committee and Director of the American Bar Association’s International Franchising Division. For the last two years Who’s Who Legal has rated John as Europe’s leading franchise thought leader.