Making life easier for franchise operators in Russia: modernization of legislation

20.06.2017

Over the last few years the commercial titles of the Russian Civil Code have been modernized so as to more closely align them with international commercial practices, and Russian courts are enforcing the new standards. These improvements are noticeable in the area of franchise law.

Franchise agreements

In years past, franchise agreements only took effect once they had been successfully registered with the Russian Patent and Trademark Office, Rospatent. The registration process required that the entire prospective franchise agreement be submitted to Rospatent for substantive review and approval, something that generally took months. The slightest substantive deficiency could result in rejection. All amendments to franchise agreements had to go through a similar registration process. Moreover, since franchise agreements often contain commercially sensitive information, it was common practice to prepare an abridged version of the agreement for filing.

Fortunately, franchise agreements no longer need to be registered. Only the grant of intellectual property rights to the franchisee needs to be registered – and the registration process no longer involves a months-long substantive review. Instead, the process takes about forty-five working days and only a notification about the granted intellectual property rights, and not the franchise agreement itself, must be submitted.

Whereas previously any unregistered agreement was void, courts now consider the underlying franchise agreement valid even if the requisite grant of rights is not effective because it was not properly registered. In such a situation, either party may enforce the underlying agreement and the franchisor is obliged to register the grant of rights – an obligation the franchisee may enforce through specific performance.

Pre-contractual liability

Current Russian law does not require that specific types of information be disclosed to prospective franchisees (unlike, for example the U.S. FDD). There is, however, a good-faith requirement and failure to act in good faith can result in liability for the consequential damages. A party lacks good faith if it provides insufficient or untrue information, or fails to disclose material facts. As a practical matter, this means that franchisors would be well-advised to provide more detailed business information to future franchisees than under previous laws.

It is good practice to enter into an “agreement regarding discussions” with each potential franchisee limiting the franchisor’s disclosure obligations, imposing non-disclosure obligations on both parties and, to the extent legally permissible, limiting the franchisor’s liability for damages. Damages for breaching such an agreement may be limited, other than damages for actions or omissions made in bad faith.
A lack of good faith also occurs if a party discloses or inappropriately uses for its own purposes confidential information received in the course of negotiations, or if a party unjustifiably terminates negotiations or provides incomplete or untrue information that, when discovered, leads to justifiable termination of negotiations.

Where a party has misused confidential information, the resulting damages have no specified limit. Otherwise, the remedy for a breach of good faith is limited to restitutionary damages and, if the negotiations prior to termination had the effect of precluding the other party from entering into a contract with a third party, to damages for lost opportunity.

Post-contractual liability

Until recently, a party that was misled into entering into a franchise relationship was limited to rescission and restitutionary damages, and even those remedies were available only if the rescission was due to material mistake caused by the misrepresentation or by fraud. If the misled party decided to continue with the franchise agreement, it was not even possible to claim damages. Now, a party that is misled into entering into a franchise relationship can claim consequential damages (which can be liquidated) while still retaining the franchise agreement. Or, if the party no longer wishes to retain the franchise relationship, it can terminate the agreement and still claim consequential damages. Such a party has the right to be restored to the same position it would have been in had the representation upon which it relied been correct. A condition for such liability is that the party that misled knew or reasonably should have known that the other party would rely on its misrepresentation. A commercial entity can be held liable even without proof of knowing misrepresentation, unless the parties contractually agree otherwise. Interestingly, even if the franchise agreement is rescinded due to fraud or material mistake arising out of misrepresentation, full consequential damages are still available to the party that relied if it can prove that such misrepresentation was caused by the other party.

Protecting the franchisor by establishing the franchisee’s indemnification obligations

Franchisors in Russia are exposed to somewhat different potential liabilities than in other countries, and as a result franchise agreements in Russia contain franchisor-protective provisions specifically tailored to Russian law. One such potential liability relates to product and service liability claims. For years a Russian statute has provided that a franchisor and franchisee are jointly and severally liable for third-party claims with respect to products manufactured by the franchisee; the franchisor is also secondarily liable for claims made against a franchisee with respect to products provided or services rendered by a franchisee under a franchise agreement. While the purpose of this statutory imposition of liability is obviously to ensure that franchisors police their franchisees to ensure quality, for non-Russian franchisors such liability is an anathema. To address this issue, franchise agreements typically oblige the franchisee to indemnify the franchisor for any such liabilities.

Thus, franchise agreements typically include indemnification provisions for breach-of-contract claims. Russian law now also allows contractual provisions applicable to losses unrelated to breach of contract: impossibility of performance, third party claims, financial costs of government authorities’ claims and the like. The indemnification amount must be liquidated or the contract may specify a means for determining the amount (which may be capped). Since this type of indemnity does not arise out of a breach but is essentially a type of insurance, a court may not reduce the indemnification amount even if it is disproportional to the losses incurred. The amount may only be reduced if the indemnified party deliberately contributed to the loss. If an indemnified loss results from the unlawful action of a third party, the indemnitor has a statutory right of recoupment from the third party. An indemnity clause automatically survives invalidation of a contract unless the parties specify otherwise.

Protecting the franchisor by securing the franchisee’s financial obligations

To be meaningful, a franchisee’s financial obligations (including an indemnification obligation), must be backed up with some form of security. Russian law now permits a variety of means for doing so. The simplest is to post financial collateral, which may consist of money, bonds or other securities, or tangible assets. Alternatively, the franchisor can arrange – with a third party having sufficient resources – a suretyship, guaranty and/or delegation of the franchisee’s debts to a third party, or the franchisee or a third party can provide a pledge to secure the franchisee’s financial obligations.

If a suretyship is used, the limits on the surety’s liability must be specified in the suretyship agreement, but the agreement need not describe the secured obligations in detail; it is sufficient to refer to the main agreement containing franchisee’s financial obligations. The main drawback to using a surety is that a surety may raise the same defences that the debtor can raise, and may even suspend payment until the creditor has set off its claim against any obligation it may have toward the debtor.

Another method of securing franchisee’s financial obligation is a guaranty. In the past, guarantors could be only banks, insurance companies and other credit institutions. Other companies or private individuals were not permitted to provide corporate or personal guarantees. Now any commercial entity can serve as guarantor. The limit of the guarantor’s liability must be specified, although the parties may agree that the guaranty limit may be determined as of the date when the guarantor has to pay. From the franchisor’s perspective, a guaranty has the distinct advantage that a guarantor, unlike a surety, may not raise defences arising out of the guaranteed obligations. Moreover, the guarantor is not entitled to set off its obligations against any claim it may have against the beneficiary unless otherwise provided in the guaranty or agreed between the guarantor and the beneficiary. The invalidity of the guaranteed obligations constitutes a ground for suspension of payment for seven days, but not for refusal to pay. In this case the franchisor must compensate the guarantor, or the franchisee, for having paid the non-existent debt. It is also possible for a franchisor to delegate the franchisee’s payment obligations toward the franchisor to a third party such that the third party becomes legally responsible for paying them as they become due. Upon such delegation, both the delegee and the franchisee remain jointly and severally liable to the franchisor/creditor unless the delegation agreement specifically states otherwise. The delegee can raise the same defences that the franchisee could raise, but is not entitled to set off any claim the franchisee may have against the franchisor.

Finally, the franchisee or a third party can provide a pledge to secure the franchisee’s financial obligations. A pledge involving titled intangible property must be registered with the State Register of Real Estate Rights and Transactions. A pledge of tangible property must be recorded in the official register maintained by the uniform system of notaries. Recently-enacted Russian law protects bona fide purchasers of pledged properties. As a result, if a registrable/recordable pledge was not registered/recorded and the pledged assets were acquired by a purchaser in good faith without knowledge of the existing pledge, the pledge automatically terminates.

Interest charges

Two types of interest charges may be imposed in Russia: statutory interest and contractual interest. Statutory interest is usually imposed when a payment is overdue, and thus is considered to be a penalty for delayed payment, whereas contractual interest is generally considered to be a fee for the use of money. Statutory interest will apply only if the agreement in question does not specify a separate late payment penalty (although the agreement may provide for both a late payment penalty and statutory interest on the unpaid balance). Both the statutory interest rate and the contractual interest rate are equal to the Central Bank of Russia key rate that was in effect during the period in question, unless the parties have agreed on a different rate. If a default interest rate specified in the contract is obviously not commensurate with the consequences of breach, it may be decreased by a court upon application by the debtor, but in any event will not be lower than the statutory rate.

Options in franchise agreements

Many franchise agreements contain rights that the franchisee may choose to exercise at some later date such as the right to open more shops, to extend its territory, or to enjoy certain exclusivity rights – usually conditional on the fulfilment of certain covenants. Russian law categorizes such arrangements as conditional rights. In the past, such arrangements risked being unenforceable: since the obligations of one party were subject to the satisfaction of conditions under the other party’s exclusive control, some Russian courts viewed such arrangements as invalid. Now such arrangements are valid, and the exercise, amendment and termination of contractual rights may be dependent on actions taken or not taken by any one party or the occurrence of events which may be within only one party's control.

Franchise agreements often grant the franchisor an option to purchase the franchisee’s business assets at the end of the franchise relationship. Under new Russian law the parties may enter into an option agreement under which the franchisee makes an irrevocable offer to sell and the franchisor has the option to purchase the assets pursuant to the terms of the option. Option rights may be freely bought, sold or transferred unless the agreement provides otherwise. The main statutory restriction is that the option must include the essential terms of the future agreement and must describe the assets with sufficient detail that they can be identified at the time the option is exercised. If that is not possible, the parties may enter into a preliminary purchase agreement, which under current Russian law will be binding as long as the parties include the subject matter of the main agreement plus those terms which one or other of the parties want to have included. The preliminary purchase agreement should contain a deadline for finalising the main agreement; otherwise the standard deadline of one year applies. If the parties do not meet their own deadline, within six months either party may petition a court for specific performance which if granted will mean that the main agreement will be legally binding as of the date of (or specified in) the court order. If the parties disagree about the contractual terms, the court itself will decide the terms of the main agreement.

Because these statutory provisions are new, judicial guidelines on their practical implication are not yet well developed. Thus, before structuring transactions based on them, franchisors should check the latest court decisions for additional guidance.