Originally published in UJBL, February 2009

Franchising as a vehicle for a franchisor's products and services to capture new distribution markets is expanding rapidly in Ukraine. By comparison with last year this year saw the number of legal entities working under franchising schemes rise significantly from 301 to 380, for outlets/stores of different franchising chains from 18 170 to 33 631.

At the same time, the institution of franchising continues to be a rather new for Ukrainian legislation. Franchising relations were specially regulated for the first time in Ukraine only on 1 January 2004, when the Civil Code of Ukraine (the Civil Code) and the Commercial Code of Ukraine (the Commercial Code) came into effect. However, adoption of the said codes has not eliminated all factors impeding franchising development in Ukraine as the relevant provisions of the Civil Code and the Commercial Code do not fully take into account the commercial nature of franchising generally accepted in foreign countries being flagship in this field. Besides, mandatory state registration of franchising agreements is another "hidden reef" hindering the expansion of franchising in Ukraine.

Moreover, Ukrainian courts have not yet established a firm practice of ruling and interpretation of issues related to franchising. Even though Ukraine is a civil law country, analysis of those few judgements on franchising matters recently rendered by Ukrainian courts is essential in order to fully understand major legal concerns in Ukraine and the approach of courts thereto.

Our intention in this article is not to cover the legislative provisions on franchising and its loopholes, which have already been generally touched upon in recently published articles, but canvass mainly the "weald" of case law on franchising-related matters, summing up its landmark trends and its impact on franchising development in Ukraine. In this article we shall not evaluate the legality and substantiation of the said judgements, but merely analyze them from the perspective of market players.

Trademark License vs. Franchising Agreement

Quite often many franchisors and franchisees, both national and international, use several different agreements instead of a franchising agreement. Usually the main reason for such a complex contractual structure is to bypass certain mandatory requirements applicable to franchising agreements and/or relations.

Ukrainian parties are not exceptions in this regard. The requirement of mandatory state registration for franchising agreements and absence of the applicable registration procedure in Ukraine became a byword in the franchising world. Therefore, entering into a set of agreements instead of a franchising agreement has become a normal business practice in Ukraine. The judgment analyzed below deals with the issue of essence of the franchising relations, its distinctive features as well as risks pertaining to veiling a franchising agreement by a set of other agreements.

Company "A" ("Licensor") and company "B" ("Licensee") entered into a license agreement. Under the said license agreement the Licensee was (a) granted an exclusive license for the Licensor's trademark in respect of classes 5, 35 and 42 under the International Classification of Goods and Services; and (b) provided with the technical documentation to be used by the Licensee, while manufacturing products (i.e. medicines). The license agreement also provided that the Licensee should produce medicines of the same quality as the Licensor's ones, whereas the Licensor was entitled to control the quality of the medicines produced by the Licensee.

The Licensee sued the Licensor and requested that the licensing agreement being recognized as simulated and fictitious. The Licensee's claims stemmed from the fact that the licensing agreement stipulated (a) transfer of rights to the Licensor's trademark; (b) transfer of the technical documentation; (c) the Licensee's obligation to ensure compliance of quality of the medicines produced by it with the quality of the Licensor's medicines; (d) the Licensor's right to control quality of the Licensee's medicines. Hence, the Licensee regarded the licensing agreement as simulated hiding.

Pursuant to the Licensee, another important issue to be considered by the court was that the technical documentation provided under the franchising agreement was not sufficient for the Licensee to produce the medicines. The Licensee also contended that the franchising agreement should be regarded as fictitious.

The court reasoned that pursuant to valid Ukrainian legislation under a license agreement a licensor grants to a licensee rights to use certain intellectual property objects, whereas under a franchising agreement a franchisor grants to a franchisee the rights to use a scope of the rights vested in the franchisor for production and/or sale of certain products and/or services. Moreover, pursuant to a franchising agreement the franchisor is obliged to provide the franchisee with technical and commercial documents and to control the quality of the franchisee's products and services. The court concluded that the franchising agreement differed from the licensing agreement through the complexity of rights transferred as well as objectives (i.e. to use the transferred rights for production and/or sale of certain products and/or services). Consequently, the court declared the licensing agreement concluded between the Licensor and the Licensee as an agreement hiding the franchising agreement and, therefore, us, as simulated.

In addition, taking into account Ukrainian legislation in the field of medicine production (i.e. obligation to receive numerous permits, licenses, approvals etc.), the court found that the technical documentation provided by the Licensor was, indeed, not enough for the Licensee to produce the medicines. As a result, the court ruled that the franchising agreement was fictitious and thus, null and void.

In the light of the foregoing, while negotiating the contractual structure of their relations, both franchisors and franchisees should be aware that concluding mentoring into the set of contracts, instead of a franchising agreement, may entail the risk of the said contracts being declared to be simulated. Another essential issue of high importance for franchisors is that the franchise i.e. set of rights granted shall be sufficient enough for franchisees to set up their franchising business. Otherwise, there is a risk that the franchising agreement may be regarded as fictitious and thus, null and void.

Price Setting and Restrictions Under Franchising Agreements

Franchising agreements usually stipulate a number of restrictions on the franchisor's and/or the franchisee's rights aimed at making the franchise profitable for both parties thereto. For example, the franchisor's obligation not to grant other persons an identical set of rights within the territory allocated to the franchisee or to refrain from its own identical activity on this territory, the franchisee's obligation not to compete with the franchisor on the territory covered by the franchising agreement, etc. At the same time, it is important to highlight that not all restrictions are allowed under Ukrainian legislation. The judgment commented below deals with issues pertaining to restrictions of rights of parties to franchising agreements.

Company "A" ("Franchisor") concluded a franchising agreement with company "B" ("Franchisee"). Under the franchising agreement the Franchisor and the Franchisee concluded sale and purchase agreement obliging the Franchisee to purchase from the Franchisor products to be subsequently sold on under the Franchisor's trademark. At some stage the Franchisee stopped paying for the supplied products. Therefore, the Franchisor brought a claim in court to oblige the Franchisee to pay for products supplied and for payment of damages.

The Franchisee, in turn, resisted the Franchisor's claim. According to the Franchisee, the franchising agreement contained provisions which were null and void. For example: (a) the Franchisee's obligation to resell the products supplied by the Franchisor at prices defined on the basis of methodology determined for the whole franchising chain; (b) establishment of minimum prices for the products to be sold by the Franchisee; (c) acquisition of products only from the Franchisor. Therefore, in the view of the Franchisee the franchising agreement shall, as a whole, be regarded as invalid.

It should be noted that while considering the case the court did not focus on the detailed analysis of the said provisions of the franchising agreement. At the same time, in the end the court found that the invalidity of certain parts of the agreements should not result in invalidity of either the franchising agreement or the sale and purchase agreement. Therefore, the court satisfied the Franchisor's requirements and obliged the Franchisee to pay for the products supplied and to indemnify damages caused.

Even though the court did not analyze in depth whether the mentioned provisions were invalid, it is essential to stress that according to the Civil Code provisions of a franchising agreement entitling a franchisor to define prices of products or fix a minimum or maximum price level shall be regarded as null and void. As far as the provisions obliging franchisee to acquire the products only from the Franchisor is concerned, such provisions are in general permitted under Ukrainian law. However, parties to franchising agreements should take into consideration that if in practice such activities have a negative effect on competition on the market, they may be regarded as anti-competitive concerted actions and, therefore, may be prohibited. Moreover, the parties to such activities may be fined under Ukrainian competition protection legislation.

Shall Unregistered Franchising Agreement be Regarded as an Invalid Agreement' Grounds for Termination of Franchising Relations

Due to different reasons, unilateral termination of a franchising agreement can be a "stumbling block" in relations between franchisors and franchisees. In the cases analyzed below the courts considered a number of essential issues in franchising relations. At the same time, in this article we would like to focus only on the core issues related to grounds for terminating franchising agreements as well as consequences of non-registration thereof.

Case 1

Company "A" ("Franchisor"), owning intellectual property rights to the trademark, the commercial brand name and the know-how system concluded entered into a franchising agreement with a company "B" ("Franchisee").

Having performed under the franchising agreement, both parties infringed their provisions. Finally, the Franchisor brought a claim in court (a) for termination of the franchising agreement stemming from significant violations by the Franchisee and (b) for indemnification of the Franchisor's damages suffered due to the said violations. In its turn, the Franchisee brought a counterclaim for declaring (a) the franchising agreement as unconcluded in view of its non-registration and (b) the Franchisor's violation of the termination procedure set out in the franchising agreement.

(i) Consideration of a case by a court of first instance and court of appeal

Having considered the case, the court of first instance ruled that as the franchising agreement was not duly registered and the Franchisor did not meet its obligations, as set out in the franchising agreement , the Franchisee was not able to tap into the franchise. The appeal court upheld the said decision. Finally, an appeal was brought in the case in the Highest Commercial Court of Ukraine.

(ii) Consideration of the case by the Highest Commercial

Court of Ukraine

Pursuant to the Highest Commercial Court, the court of first instance and the court of appeal did not duly verify all the information and evidence related to the case and did not take into account that the Franchisee had, in fact, tapped into the franchise. The Highest Commercial Court also concluded that both the court of first instance and the court of appeal did not rule lawfully regarding the legal consequences of the absence of state registration of the franchising agreement. The Highest Commercial Court stated that state registration of franchising agreements has legal effect only in respect of the relations of the parties to the franchising agreements with third persons (being not parties to the agreements). Therefore, the absence of state registration shall not be regarded as grounds for invalidating the franchising agreement and dismissing the Franchisor's claims. In addition, the Highest Commercial Court ruled that neither the first instance court nor the appeal court duly established whether the relevant Ukrainian legislation set out the procedure of state registration for franchising agreements and, thus, whether there was a mere possibility for the Franchisor to fulfill its obligations related to state registration of the franchising agreement. Consequently, the Highest Commercial Court decided to reverse both decisions in question and to return the case for reconsideration.

(iii) Reconsideration of the case by court of first instance

Following the decision of the Highest Commercial Court, the court of first instance reconsidered the case and concluded as follows.

(a) Regarding the Franchisor's claims

The Franchisor believed that the franchising agreement should be terminated due to the following Franchisee's significant infringements: (a) the Franchisee did not use the Franchisor's software programs; (b) the Franchisee hindered the Franchisor to conduct inspections of the Franchisee's business; (c) the Franchisee did not ensure a high quality of goods and services sold/rendered under the Franchisor's brand; (d) the Franchisee did not pay royalties, advertising fees as well as set up fees. The court of first instance found that, in fact, the Franchisee did not significantly violate the franchising agreement as the Franchisor was not able to prove the alleged breaches. In this respect the court ruled as follows.

Regarding the Franchisee's obligation to use the Franchisor's software programs. The franchising agreement stipulated that the Franchisor should transfer to the Franchisee software programs to be used in the Franchisee's business. At the same time, the fact of transfer of the said programs should be confirmed by the relevant acceptance acts signed by both parties. The court found that the Franchisor did not submit such acceptance acts. Therefore, the court concluded that the Franchisor did not provide the Franchisee with such software programs (i.e. there was no appropriate evidence thereof, namely: duly executed acceptance acts). Thus, as the Franchisee was not able to use the said software programs due to the Franchisor's infringement, it did not violate its respective obligations under the franchising agreement in this regard.

Regarding hindering by the Franchisee the Franchisor's inspections of the Franchisee's business and quality of goods and services sold/rendered by the Franchisee. The court stated that the Franchisor did not prove by means of appropriate evidence (i.e. testimonies, acts of inspection of quality of the Franchisee's goods/services, acts executed by the relevant state authorities etc.) the fact that the Franchisee hindered the Franchisor to inspect the Franchisee's business or that it sold/rendered poor quality goods and services. Hence, the court emphasized that the Franchisee did not infringe its obligations in this regard either.

Regarding the Franchisee's obligation to pay fees to the Franchisor. The franchising agreement provided for the following kinds of payments to be made by the Franchisee to the Franchisor: (a) set up fees for each additional franchising restaurant; (b) royalties and (c) advertising fee. The Franchisor claimed that the Franchisee had not paid a fee for setting up the second franchising restaurant within the set terms. The court emphasized that as the franchising agreement did not provide for exact terms and conditions for paying the said fee, there were no grounds to believe that the Franchisee infringed its obligations in this respect. As far as royalties and advertising fee are concerned, in the view of the court, the Franchisor's infringements of its obligations under the franchising agreement relieved the Franchisee from paying any royalties and fees and so the latter should not be regarded as an infringement of its respective obligations under the franchising agreement.

Regarding use of the Franchisor's intellectual property rights. The Franchisor alleged that it transferred to the Franchisee copies of certificates and patents for the Franchisor's intellectual property objects granted to the Franchisee. At the same time, the franchising agreement did not stipulate the terms and conditions of such transfer. The Franchisor requested the court to oblige the Franchisee to return all the said certificates and patents. However, the court stated that as the Franchisor did not submit evidence confirming transfer of the said certificates and patents to the Franchisee, the Franchisor's demands shall not be satisfied. Consequently, the court concluded that there were no significant violations of the franchising agreement from the Franchisee as alleged by the Franchisor. Moreover, the court stated that damages claimed by the Franchisor occurred not due to the Franchisee's breaches, but due to the Franchisor's own significant breach (i.e. in respect of non-provision of software programs, non-transfer of intellectual property objects etc.). Therefore, the court dismissed the said claim made by the Franchisor.

(b) Regarding the Franchisee's counterclaims

As far as the Franchisee's counterclaim was concerned (i.e. declaring (a) the franchising agreement as unconcluded in view of its non-registration and (b) the Franchisor's violation of the termination procedure set out in the franchising agreement), the court ruled the following:

Regarding non-registration of the franchising agreement. The court concluded that absence of state registration of the franchising agreement should not be regarded as a reason to declare the latter as not being concluded. Moreover, the local state agency vested the right to register franchising agreements rejected the Franchisor's application for franchising agreement state registration as they believed that it was beyond the scope of the said agency (as proven by a relevant letter).

Regarding violation by the Franchisor of the termination procedure set out in the franchising agreement. The court stated that the franchising agreement stipulated the exact termination procedure, namely: a party intending to terminate a franchising agreement should dispatch a termination notice to the other party, which, in its turn, was further entitled to eliminate reasons for termination indicated in the termination notice. In the latter case, such party should immediately provide the other party with an elimination notice. Pursuant to the case file, the Franchisor dispatched the termination notice to the Franchisee. In its turn, the Franchisee provided the court with its elimination notice and with evidence that the latter had been sent to the Franchisor. However, the Franchisor simply did not collect the said elimination notice from the post office (as proven by the relevant post notice). In this regard, the court concluded that the termination procedure set out in the franchising agreement was infringed upon by the Franchisor. Therefore, the court ruled that there were no justified grounds to regard the franchising agreement as terminated.

Consequently, the court of first instance dismissed the Franchisee's counterclaim.

(iv) Further reconsideration of the case by the court of appeal and the Highest Commercial Court of Ukraine

Both the Franchisor and the Franchisee brought appeals to the appeal court. However, the court of appeal decided that the decision of the court of first instance was fully justified and objective and so the court of appeal upheld thereof. Unsatisfied with the said decision, both the Franchisor and the Franchisee appealed against it at the Highest Commercial Court. In the end, the Highest Commercial Court of Ukraine upheld both the decision of the court of the first instance and the decision of the court of appeal.

Case 2

Company "A" ("Franchisor") concluded a franchising agreement with company "B" ("Franchisee"). The franchising agreement was registered by the relevant local authority as required by the Civil Code and Commercial Code. The franchising agreement provided for, among other things, that if it is terminated at the Franchisee's initiative, the latter should pay a certain sum of compensation to the Franchisor, notwithstanding the grounds for termination. Moreover, the franchising agreement entitled the Franchisor to terminate thereof and to recover damages in the event that the Franchisee systematically infringed the franchising agreement.

After performing under the said agreement for a certain time, the Franchisee sent a termination notice to the Franchisor. The Franchisor simply ignored the said notice. Later on the Franchisee dispatched another notice to recall the sent termination notice. However, the Franchisor ignored the recall notice as well. Having not received the Franchisor's responses, the Franchisee believed that the franchising agreement was fully effective and acted accordingly.

As the Franchisee did not pay royalties for several months, the Franchisor, in its turn, brought a claim in a court for termination of the franchising agreement due to the Franchisee's systematic infringement thereof. At the same time, the Franchisor claimed for compensation as the Franchisor believed that termination was initiated by the Franchisee (to prove the latter the Franchisor referred to the respective Franchisee's termination notice).

Having considered the case, the court found that the Franchisee had actually not paid royalties for several months. The latter was regarded by the court as systematic infringements of the franchising agreement. Therefore, the court satisfied the Franchisor's claim in respect of termination of the franchise agreement.

At the same time, the court stated that the Franchisor's claim for compensation should not be satisfied due to the following: (a) the franchising agreement did not provide for the order of unilateral termination thereof by the Franchisee; (b) the Franchisee's termination notice sent to the Franchisor should not be regarded as grounds for termination as such notice was further recalled by the Franchisee and the Franchisor did not object to the said fact; (c) as pursuant to the Civil Code an agreement shall be terminated in the form in which it is concluded and termination of the franchising agreements shall be registered, the franchising agreement shall be regarded as terminated only after the state registration of such termination is carried out.

Proceeding from the above, while negotiating franchising agreements, parties shall consider that such agreements must be as detailed and precise as possible. Furthermore, the parties shall perform their obligations following all the terms and conditions of the relevant agreements, especially provisions providing certain defined procedures. Furthermore, despite the fact that no legislative act on state registration of the franchising agreements has yet been adopted in Ukraine, it is highly advisable to make the best efforts to register a franchise agreement. Even though local authorities will most probably refuse to register a franchise agreement in the view of the lack of a registration procedure, the parties to the franchising agreement will receive an official written rejection which, in the event of a dispute, may be used in court to prove that the parties acted in good faith.

Conclusions

Franchisors and franchisees making a decision to set up and develop a franchising business in Ukraine should ideally indulge in course-correction observation and learning from mistakes made by franchisors and franchisors in various aspects of the franchising business not only in the countries where they are from, but also in Ukraine. The case law analyzed above provides indispensable lessons for prospective franchisors expanding into the Ukrainian market and potential franchisees setting up their new businesses and for experienced market players too.

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