Validity of Commercial Franchise Contract

Substantive Conditions Maintaining the Validity of Commercial Franchise Contract

Authors: Joey Huang, Kimberly Zeng

We will discuss the commercial franchise contract involved in the franchise business model in the catering industry, and the franchise contract in other industries, it should be discussed upon particular circumstances.

Case Background

Let’s take two companies as an example. Company A and Company B have signed a franchise contract, with Company B joining one of the catering brands under Company A. During the cooperation between the two parties, Company A provided Company B with management training on a business model, trademark authorization, and other business resources, and Company B paid Company A relevant expenses, such as the license fee and resources cost as a return. However, Company B incurred poor loss due to management default, while they claimed compensation from Company A with the excuse that Company A did not actually have the franchise qualification and did not comply with the requirement of “owning two direct-sale stores and operating them for more than one year” (The requirement refers to the franchisor should own two direct-sale stores, both of which have been operating for more than one year and are in a profitable status).

Given that both parties have no agreed right of rescission, and no collusion in false, fraud between them, whether the franchise contract can be announced invalid or be rescinded? Let’s go through the substantive requirements for the validity of a commercial franchise contract first before concluding the answer.

Relevant Regulations

According to Article 143rd of the Civil Code of the People’s Republic of China, a contract would be deemed valid if conforming to the provisions of laws such as 1) all parties involved having the corresponding civil capacity, 2) with their true wills, and 3) obeying the laws and regulations, and not contrary to public order and morality.

The law has defined a couple of circumstances, according to Article 563rd of the Civil Code of the People’s Republic of China, that any party of a contract would be entitled to rescind the contract, if 1) the purpose of the contract becomes impossible to achieve due to force majeure, 2) either party of the contract expresses the willingness through its conduct that the main obligation of this party would not be performed, prior to the due period, 3) either party of the contract delays its main obligation, and still indulges it even being demanded by the counterpart of the contract, 4) either party of the contract delays its obligations, or breaches the contract in some other manner, making it impossible to achieve the purpose of the contract, and 5) other circumstance as provided by the law.

According to the summary of the above laws and regulations based on the actual situation of the case, the franchise contract, in this case, can be determined as invalid or can be rescinded only under the following three circumstances: 1) the contents of the contract are against the imperative provisions, 2) the purpose of the contract cannot be achieved due to either party to the contract, and 3) either party fails to perform its principal obligations.

The commercial franchise contract conduct in China is mainly governed by the Regulations on the Administration of Commercial Franchise, stipulating in detail the standards to meet, including but not limited to the franchisor should provide business operation guidance, technical support, and other services to the franchisee, and the franchisor should comply with the requirement of “owning two direct-sale stores and operating them for more than one year”. Moreover, the franchise contract should be filed with the competent authorities, and the franchisor, an enterprise, shall not conceal or provide false information to mislead.

If the violation of the above provisions is deemed as the violation of the mandatory provisions, or a failure to perform the main obligations of the contract or will result in the failure to achieve the purpose of the contract, then according to the case, the franchise contract should be determined to be invalid, and Company B also has the right to request the rescission of the contract. Otherwise, the contract should not be determined to be invalid, and Company B has no right to rescind the contract.

Similar Cases

During the judicial practice, according to the Annual Report of the Supreme People’s Court on Intellectual Property Cases (2010) and the Guiding Opinions of Beijing Higher People’s Court on Several Issues Concerning the Application of the Law in the Trial of Disputes over Commercial Franchise Contracts, except that “no entity or individual other than an enterprise shall engage in franchise activities as a franchisor” belongs to the mandatory provisions of effectiveness, and the remaining provisions of the Regulations on the Administration of Commercial Franchise belong to the mandatory provisions of management, and the content of the contract will be determined to be invalid only when it violates the mandatory provisions of effectiveness.

Meanwhile, the guiding opinion of the Beijing High People’s Court and the precedents of some courts have emphasized that the violation of the mandatory provisions of management in the Regulations on the Management of Commercial Franchise generally will not lead to the invalidation or rescission of the contract, and only when the behavior of one of the parties to the contract has a “substantial impact” on the effectiveness or performance of the franchise activities, the contract may be determined to be invalid or can be rescinded.

Conclusion

According to the documents of the Supreme People’s Court and the Beijing High People’s Court, we can learn that the substantive requirements for the validity of commercial franchise contracts are not the conditions stipulated in the Regulations on the Administration of Commercial Franchise. Unless the franchisor is an organization or an individual other than an enterprise, the franchisor’s violation of relevant provisions will not generally lead to the invalidation of the franchise contract. At the same time, the substantive requirements for the validity of a commercial franchise contract should be closely related to the acts that have a “substantial impact” on the effectiveness or performance of the franchise contract.

Article 3rd of the Regulations on the Administration of Commercial Franchise defines franchising as a business activity in which an enterprise with a registered trademark, enterprise logo, patent, proprietary technology, and other operating resources, which licenses its business operating resources to other operators in the form of a contract, and the franchisee shall operate under a unified operating mode according to the contract and pay the franchise fee to the franchisor.

According to the provisions of this article, we can conclude that the basic characteristics of franchising are: 1) The franchisor owns the business operating resources, 2) the franchisee is authorized to use the franchiser’s operating resources under a unified operating mode; 3) the franchisee pays the franchise fee to the franchisor. It can be inferred that the fundamental purpose or operation mode of a franchise contract is that the franchisee pays fees to the franchisor so as to be allowed to use the operating resources and operation mode of the franchiser. To determine whether an act has a “substantial impact” on the effectiveness or performance of the franchise contract, it should be judged whether the act has an impact on the purpose or operation mode of the franchise contract.

In summary, the substantive requirements for the validity of a commercial franchise contract or the standard for determining whether a franchise contract is valid are whether the legal relationship between both parties has the three basic characteristics of franchising, that is, whether the legal relationship is compatible with the fundamental purpose or operation mode of the franchise contract.

In this case, the legal relationship between Company A and Company B will not be inconsistent with the operation mode of the franchise contract due to the absence of the condition of “owning two direct-sale stores and operating them for more than one year”. Therefore, if Company B requests the court to invalidate or rescind the contract on the basis that Company A does not meet the condition of “owning two direct-sale stores and operating them for more than one year”, it is difficult to obtain support from the court.