Does Your Agency Or Distributorship Agreement Inadvertently Create A Franchise Relationship Or Conversely, Does Your Franchise Agreement Create An Agency Or Distributorship Relationship

Certainly, no supplier-distributor or principal-agent expects to end up defending franchise law violation allegations. Yet, these situations arise with considerable frequency both in the United States and other regions of the world. Manufacturers, suppliers, and trademark owners often overlook a possible franchise connection when they enter into relationships with independent third parties to sell their products or services.

Given the prevalence of franchising and the interstate, national, and even international scope of so many franchise networks today, attorneys need to know about potentially applicable federal, state, and foreign franchise laws. Franchise sales in the United States are subject to dual regulation at the federal and state level, depending on where the parties reside or do business. The federal franchise sales law, originally adopted in 1978 and overhauled in 2007 regulates franchise sales in all 50 states, including wholly intrastate transactions, per the 2007 version of 16 C.F.R. § 436 (Amended FTC Rule).

Why then, is a discussion of commercial agency and distributorship laws relevant? The first thought when dealing with international franchising may be, why should I be concerned? After all, agency and distribution models are likely not what the franchisor has established in its home market; it has chosen a franchise model over those other models. In fact, it is quite likely that the boilerplate provisions in the domestic franchise agreement specifically states that the agreement does not create a principal-agent relationship.

However, it has been our experience that when expanding internationally, franchisors may not wish to strictly adhere to the American-style franchise model. For example, the franchise legislation in the desired new market may be considered overly burdensome, or there may be business reasons for why the franchisor does not believe its domestic franchise model will work in the new market and it is therefore looking for alternative models. In those cases, the franchisor should carefully consider commercial agency and distributorship laws in the markets it is looking to enter. But the franchisor who wants to continue using its franchise model internationally should not ignore these laws either.

The definitions of a franchise, agency, and a distributorship arrangement differ from country-to-country (or state-to-state, or province-to province). And even when the franchisor does not wish to establish an agency relationship or grant a distributorship, even when this type of relationship is denied by the express wording of the franchise agreement, an agency or distributorship may still be the unwitting result. Simply speaking, the laws of each country vary and a relationship that is not deemed to be an agency or distributorship in the franchisor’s home country may qualify as such in the new market.

It is not all that surprising that there may be overlap between franchise laws and agency and distributorship laws, as the underlying relationships share many characteristics: all three regulate a relationship where one party holds the knowledge and valuable intangible or tangible assets, and the other party, through its work and effort, is looking to exploit such knowledge and assets. The reasons for engaging an agent or distributor are also often the same as for engaging a franchisee.

The local party can overcome language and cultural (including business culture) barriers and may already have an established network of business contacts that will help the franchised business expand faster than if the franchisor were to try to establish itself in the new market. The local party will have knowledge of local trade practices and know how to navigate the local bureaucracy necessary to obtain necessary permits and licenses. It may even be necessary to have a local party fulfil the function if local law restricts certain types of business activities to citizens of the country.

The local party can also provide service locally in a way that the foreign party will not be able to do from a distance: help with installation, provide warranty repairs, and offer aftermarket sales of products and service in a way convenient to the local customer. The local party can also provide invaluable assistance in adapting the foreign party’s offering to local tastes and preferences, be that adapting the product itself, or marketing and product information. Finally, and typically one of the reasons a company chooses to franchise, the cost for getting started in the new market is often significantly less when the local establishment is set up by a local party and not the franchisor itself.

Because of a perceived imbalance of power in the franchisor-franchisee, supplier-distributor and principal-agent relationships, consumer protection laws have been drafted to protect the “weaker” party. Frequently in international dealings the allocation of power in these business relationships is often quite different. It is not unusual that the franchisee, distributor, or agent is a large organization and, at the very least, has significant local market knowledge that may be as important as the franchisor’s, supplier’s, or principal’s know-how. But be that as it may, the laws are there to protect the perceived weaker party, and franchisors expanding internationally need to take commercial agency and distributorship laws into consideration, so as not to find themselves unable to terminate the relationship as they wish according to the terms of their express agreements, or only able to terminate at considerable cost.

Differences Between Agencies and Distributorships

Before delving into more detail about common features of agency and distribution laws, it is important to point out that agencies and distributorships are not the same. While the definitions of agents and distributors vary between countries just as the definition of a franchise does, generally speaking, in an agency relationship the agent never takes title to the goods being sold. The agent solicits buyers for the supplier’s products or services, but the purchase agreement is then entered between the supplier and the customer directly. The agent is compensated on a commission basis, typically at a percentage of the sales price that the supplier receives.

A distributor, on the other hand, usually takes title to the goods sold. The distributor typically buys the products from the supplier and then resells them to its own customers. The distributor’s compensation is the margin between the price at which it purchased the products from the supplier and the price at which it sold the product to its customers.

The distinction between agents and distributors matters for many reasons and not in the least because they are often subject to different governmental regulatory regimes, statutes, or jurisdictional departments in different countries. For example, in many European countries there is no specific regulation of distributorships, but agency agreements are heavily regulated. However, in Germany (and most other European countries), distributorships are not specifically regulated, but agency relationships are. As a result, while a supplier may freely terminate its distributor in Germany, it must give its German agent as much as six months’ notice and may have to pay a termination payment to the agent.

A franchisor should also not assume that simply because the structure of its agreement made it an agency agreement or distributorship in one country, that will be the case in all other countries. As already alluded to, this is a country-specific determination.

For example, in the United Arab Emirates, a commercial agency is defined as the “representation of the principal by an agent for the purpose of distribution, selling, display or rendering of a commodity or service in the state, against a commission or profit.”

Under German law, an agent is a self-employed intermediary who has continuing authority to negotiate transactions on behalf of a principal or conclude transactions in the name of the principal.

The Swedish law regulating commercial agents defines a commercial agent as somebody who, for profit, has agreed with another, the principal, to act on behalf of the principal independently and continually for the purpose of selling or purchasing goods through the act of passing orders to the principal or entering into agreements in the name of the principal.

These three definitions are quite different. To some extent they simply approach the agency relationship from different perspectives: the definition in the UAE is focused on the activities that the agent will undertake, while the German and Swedish definitions are more focused on the end result. But there are more material differences: the German and the UAE definitions appear to cover both products and services, while the Swedish definition only applies to products. In other words, a relationship that falls under one of the statutes may not fall within the scope of the other. These are but three examples and it is important to always understand the scope of agency and distributorship laws in countries a franchisor is entering.

Public Policy Laws and Default Contract Terms

Similar to franchise laws, in many countries both agency and distribution laws are deemed to be public policy laws, and as such, cannot be contracted or assigned to third parties. However, even if that is the case there may still be room to structure the agreements to minimize any perceived negative impact of those laws.

An additional point to be made is that the absence in a country of a specific statute regulating agencies and distributorships does not necessarily equate with a lack of regulation of those types of agreements. Even if there are no statutory rules specific to agency and distributorships, a franchisor should not assume that the country does not have rules regarding agency agreements or distributorship agreements. In many countries there is a commercial code with general rules regarding different types of agreements and there may be case law specific to agency and distributorship agreements. For example, in Germany there is no specific statute applicable to distributorships. However, through case law many statutory provisions applicable to agency agreements have been expanded to also apply to distributorships. And, even though there is no statutory requirement regarding termination notices for distributorship agreements under German law, there is case law supporting the idea that some of the statutory requirements for agency agreements should apply to distributorship agreements as well in some cases.

Specific Issues Arising Under Agency and Distributorship laws

Understanding the applicable agency and distributorship laws upfront is extremely important for at least two reasons. First, agency and distributorship laws often impose default provisions that will apply to the parties’ agreement if the agreement is silent on that point. Second, though the agency and distributorship laws are public policy laws, the default provisions (excluding termination-related provisions) can often be amended by contract. In other words, understanding these laws will help the franchisor draft an agreement that will reduce the number of surprises later on in the relationship, and that may help regulate the relationship in a way as close as possible to the supplier’s intent.

Some may presume that the statutorily imposed rights and obligations are always in the agent’s or distributor’s favor. While this is often the case, it is not always the result. Agency and distribution laws also impose obligations on the agent or distributor, such as the party’s best efforts to not compete with the supplier; keep the supplier informed about developments in the territory that may impact the business; maintain books and records; maintain a sufficient inventory of spare parts; and provide service to customers in the market. For example, under the Swedish agency law, the agent is required to use its best efforts, follow reasonable instructions from the supplier, inform the supplier of important developments in the market, take good care of inventory in its possession, and keep its funds separate from those of the supplier. German law similarly requires the agent to provide the supplier with necessary information and must perform its obligations with due care. These types of provisions are not limited to EU countries and can also be found in other parts of the world, for example in Argentina.

Restrictions on Right to Terminate

One of the most common restrictions imposed by agency and distributorship statutes is on the supplier’s right to terminate the agreement.

On this point, contract drafting choices may have a significant impact on the legal obligations of the franchisor. Franchise agreements are typically for a definite term and require at least some steps to be taken by the franchisee, agent, or distributor in order to be renewed, so typically they would be considered agreements for a definite term under agency and distributorship statutes. From a supplier’s perspective, it is typically better to have an agreement for a definitive term. It avoids local law provisions regarding notice periods and termination indemnity. However, the just cause requirements described below in at least some countries apply not only to termination, but also to non-renewal, thus capturing within their scope definite term agreements.

Agreements for an indefinite term can be significantly harder to terminate in some countries than a franchisor may be used to, as they can often only be terminated for “just cause.” But this is not an issue solely for indefinite-term agreements. For all agreements, termination during the term is often restricted to just cause termination, which may render express contractual termination provisions unenforceable. Just cause is not necessarily the same thing as the often-exceedingly long enumeration of defaults that the supplier may have included in its agreement. Often statutes will contain relatively short lists of what constitutes just cause (though it is also not unusual for statutes to simply refer to material breaches by the other party as constituting just cause).

Just cause may generally include breach of contractual obligations to the supplier, but will typically require a truly material breach of the contractual obligations. The agency law in the Dominican Republic provides a good example in that it requires a failure to comply with “the essential obligations of the (agreement), any action or omission that could adversely affect in a substantial way the interest of the (supplier) in the promotion or negotiation of the import, distribution, sale, lease, or any other form of trade of his merchandise, products or services.”

In other jurisdictions general contract law provisions will affect a party’s right to terminate. For example, in Argentina the general termination provisions of the Civil and Commercial Code apply to agency agreements. The Civil and Commercial Code allows a party to terminate when the supplier is deprived of essential or substantial benefits of the agency agreement.

Termination Notice Requirements

Even if the applicable laws do not require just cause for termination, it is not uncommon that a lengthy notice of termination be provided. In EU countries in particular, termination notice for agency agreements can be significant, starting with one month for agreements that have lasted a year, and up to six months for agreements that have lasted six years or longer. However, an agreement for a definite period of time will expire upon the end of its term, without any notice. Long termination notice periods are not unique to the EU though. For example, in Argentina, for indefinite term agency agreements, the terminating party must give the other party one month’s notice per year of the contract term.

Termination Payments

Together with statutes that limit a franchisor’s ability to terminate an agreement other than for just cause, the statutory provisions that tend to give franchisors and other suppliers and principals the most grief are provisions requiring some type of termination payment. Often these payments are due whether the termination is for just cause or otherwise, though they tend to be significantly higher if a franchisor or other supplier terminates without just cause.

For example, in Germany and Sweden (reflective of other EU countries), an agent is entitled to termination payments, up to an amount of the total commissions for one year, if the agent has brought new clients to the supplier, or otherwise increased sales to existing customers.

In Colombia, agents are also entitled to payments upon termination, in the amount of one-twelfth of their commissions per year of the contract duration. This is assuming the supplier had just cause to terminate. If the agreement was terminated without just cause, then the supplier must pay indemnification reflecting the efforts the agent put in to promote the supplier’s goodwill.

But in other countries, these payments may be significantly higher. For example, in the Dominican Republic, an agent is entitled to payment to compensate them for the business that the agent is deprived of because of the termination (or non-renewal) of the agreement without just cause, the value of the services rendered to the supplier, the agent’s investment in equipment, furniture and fixtures used specifically for the agency business, and any inventory that the agent may have had that it can no longer use after the termination or non-renewal. More importantly, the agent is also entitled to the supplier’s gross profits from the sale of the products or services for the past five years, or possibly even more.

However, not all countries afford this level of protection to agents. For example, in Argentina termination payments are limited to situations where the supplier terminated its definite term agreement without just cause, or where an indefinite term agreement was terminated without proper notice.

Restrictions on Competition

Another topic often covered by agency and distributorship laws is the agent’s or distributor’s right to compete.

In Germany, a post-term non-compete is permitted in agency agreements for up to two years after termination. However, the scope of the non-compete must be narrowly tailored to the territory of the agent or the customers the agent was assigned, and the supplier must pay reasonable compensation for the non-compete. Similarly, post-term non-compete provisions are permitted in Argentina for up to one year after termination, but must also be reasonable in scope.

Compensation

Many agency and distributorship laws set at least general parameters for how agents and distributors may be compensated. For example, both German and Swedish law dictate what agreements an agent is entitled to receive commission on and when. The payments are tied to the agent’s performance and value that is perceived to have been created through the agent’s efforts. In the UAE, a supplier is restricted to how many agents it may have (no more than one per state) and consequently the agent is entitled to commission payments not only on sales it helps close itself, but on all sales into the agent’s territory.

Registration

Another feature of agency and distributorship laws that is relatively unusual for franchise laws, is that the agreement must be registered. Many countries do not require registration of agents or agency or distributorship agreements, but in those that do, suppliers need to make sure they understand the implications of the registration. Leaving aside such practicalities as whether the entire agreement needs to be registered (or just an excerpt), and if the agreement or excerpt needs to be translated into the local language before it can be registered, registration often raises many other issues. For example, in some countries, the registration obligation may be on the agent, and the franchisor has little need of, or derives little value from the registration. In those situations, the franchisor may not wish to encourage registration. In other countries, the registration requirement may be on the franchisor or supplier, or it may be impossible for the agent to perform its duties without proof of registration. In some instances, the registration triggers the applicability of the statute, and in others, the supplier may not be able to register a new agency agreement until the previous one has been properly terminated.

Nationality Restrictions

While agency and distributorship laws are always consumer protection laws, they can sometimes also serve as laws reserving domestic enterprise to the citizens of the country. This is particularly common in the Middle East (though not exclusively in that part of the world). In some instances, only certain industries are protected, but sometimes the restrictions can be broader. It is crucial for a franchisor to be aware of these restrictions before entering countries with these types of restrictions. For example, in Saudi Arabia and the United Arab Emirates, an entity acting as an agent must be 100 per cent owned by nationals, and in Bahrain, Kuwait and Oman, at least 51 per cent must be owned by nationals.

The Fine Line Between Employee and Agent

The question of how franchisees, distributors and agents should be classified for labor and employment law purposes has received significant attention over the past several years in the United States and elsewhere. This is a serious concern in many countries and the consequences may be significant. Reclassification of an agent as an employee can have an impact on the obligations of the franchisor, both with respect to taxes and benefits, but also with respect to the supplier’s ability to terminate the relationship with the agent or employee. In addition, reclassification can have additional tax consequences in that the agent’s business could be considered a permanent establishment of the franchisor.

As with other issues raised in this article, it is often possible to structure the contract and relationship to avoid an employer-employee relationship. Generally, the agent or distributor taking economic risk and having contractual independence are likely to be important factors. It is also generally advisable that franchisors do not appoint individuals as their franchisees, agents, or distributors in other countries. But rather, select established companies with a strong management team and marketing expertise.

Written By: Kosnar Group - Cardiff by the Sea, CA 92007
Email: [email protected], Tel 619-994-2258 • Fax 760-632-0772, Website: www.kosnar.com