Member Article

During the last years franchise agreements receive growing acceptance as an effective tool for establishing or expanding business in Lithuania. This is particularly true for foreign producers and suppliers which have already established extensive franchise networks in Lithuania, e.g. fast food restaurants “McDonald’s”, office supply network “Office 1” or real estate brokers “Re/Max”. However, during the recent years Lithuanian companies have also shown their growing interest in business expansion through creation of franchise networks. This is evidenced by the recent development of franchise based Lithuanian companies which already managed to take market leader positions in the field of consumer and household products, public catering and automobiles repair service and planning their expansion into markets of neighbouring countries.
For many years Lithuania had no franchising-specific legal regulation, therefore franchise agreements had been concluded and performed in accordance with general principles of civil and contract law as well as number of various legal acts regulating different legal issues. This situation lasted until the adoption of the new Civil Code of the Republic of Lithuania (“Civil Code”) which became effective in 1 July 2001. The new Civil Code introduced a comprehensive franchising-specific legal regulation which is supplemented by various legal acts related to such issues as protection of intellectual property, competition etc.
It is important to mention that despite the introduction of franchising-specific regulation in 2001, to this date there is no publicly available case practice dealing with the disputes arising from the conclusion or performance of franchise agreements. On the one hand this might be explained by the fact that despite the growing popularity the number of franchise agreements is still relatively low. On the other hand, this might also be due to the fact that parties to the franchise agreement usually opt arbitration as an appropriate forum of dispute settlement. Thus, franchise-related disputes (if any) most probably remain outside of public domain. In result of absence of settled case-law, some franchise-related provisions of the Civil Code still remain subject to broad interpretation. Due to such lack of legal predictability parties to franchise agreements occasionally opt foreign (i.e. non-Lithuanian) law to govern their contracts.

Concept

The concept of franchise agreement is established in Article 6.766 of Civil Code which defines franchise agreement as a contract whereby one party (franchisor) undertakes to grant to the other party (franchisee) for a specified or unspecified period the right to use in the business activity of the franchisee a complex of exclusive rights which belong to the franchiser (right to the firm name, right to the trade or service mark, right to protected commercial (industrial) information, etc.), and in return the other party (franchisee) is obliged to pay remuneration stipulated in the contract.
The essential feature of franchise agreement, enabling to distinguish it from distribution agreement, is the provision of exclusive rights to franchisee. For this reason Civil Code stipulates that franchise agreements must clearly determine the extent of the use of a complex of exclusive rights, business reputation and commercial experience of the franchisor. In addition, parties to the agreement may specifically establish limitations as to a territory or type of commercial activities (sale of goods, provision of services etc.) where such exclusive rights, business reputation and commercial experience may be exploited by the franchisee. However, one should always keep in mind the requirements of competition law prior to establishing such limitations.


Form and registration

Article 6.766 of Civil Code provides that franchise agreement, in order to be valid and enforceable, must be concluded in a written form., i.e. by signing one document or exchanging separate documents . Furthermore, such agreement may be invoked against third parties only if agreement, its amendments (if any) and termination are registered within the Register of Legal Persons. As a principle, a franchise agreement shall be registered within the register which holds the registration of a franchisor. However, if a franchisor is registered outside Lithuania, a franchise agreement shall be registered within the register in which the franchisee is registered. Notable, according to a general rule stipulated in the Civil Code the registration of franchise agreement falls within the responsibility of franchisor unless the agreement provides to the contrary. Therefore, contracting parties should agree who shall perform the obligation of registration during the negotiations for the conditions of franchise agreement, especially if franchisor is a foreign entity and the agreement must be registered in Lithuania.
The process of registration is fairly simple. The registration at the Register of Legal Persons requires the general information concerning franchisor and franchisee, description of the subject matter of agreement and dates of conclusion, amendment and termination of agreement to be provided. In addition, contracting parties are required to pay stamp duty and provide the register with a full copy of franchise agreement.
It is important to mention the latter obligation raises many problems related to protection of confidentiality and usually determines the decision of contracting parties to refrain from the registration of franchise agreement within the Register of Legal Persons. The main issue relates to the Law on Register of Legal Persons which establishes the principle that all data submitted to the register is public. From a practical point of view, such principle means that all franchise agreements registered within the register become public to their entirety and easily accessible to anyone from the moment of their registration. In our view, this is a clear problem of legal regulation which induces parties to the franchise agreements to withdraw the possibility to invoke the agreement against third parties, granted by the registration within the Register of Legal Persons, in order to secure the confidentiality of the agreement.
It is worth mentioning that in addition to the abovementioned requirement to register franchise agreement, special rules apply in case the subject matter of franchise agreement appears to be intellectual property rights. In such cases Article 6.767 of Civil Code provides that licences to use certain intellectual property rights under franchise agreement must be registered within the State Patent Bureau, i.e. if the subject matter of franchise agreement is intellectual property rights, two registrations will be required: the registration of franchise agreement within the Register of Legal Persons and registration of licences to intellectual property rights within the State Patent Bureau.


Obligations of the parties

The main obligations of franchisor under franchise agreement are established in Article 6.770 of Civil Code. Item 1 of the said Article establishes two obligations which are mandatory to every franchise agreement, i.e. under franchise agreement the franchisor is obliged:
(1) to provide franchisee with the relevant technical and commercial documentation and provide other information necessary to the franchisee in order to exercise the rights granted to him under the franchise agreement, as well as instruct the franchisee and his employees with regard to the questions related with the execution of the transferred rights;
(2) to issue to franchisee licences provided in the agreement and ensure their formalisation in accordance with the established procedures.
In addition to these obligations, Item 2 of Article 6.770 of Civil Code establishes complementary obligations assumed by the franchisor under franchise agreement. In contrast to the abovementioned, these obligations are binding upon the franchisor only in case contracting parties do not agree to the contrary. Accordingly, franchisor is obliged:
(1) to ensure the registration of franchise agreement;
(2) permanently render to the franchisee technical and consultative assistance, assist in training of franchisee’s employees;
(3) to execute control of the quality of goods produced by the franchisee, work performed or services rendered by him under the franchise agreement.
It is worth mentioning that the abovementioned list of franchisors obligations established in Article 6.770 of Civil Code is not restrictive, therefore contracting parties are free to agree on any other obligations undertaken by the franchisor under the franchise agreement.
Similarly to the franchisors obligations, Civil Code also provides the list of obligations which must be undertaken by franchisee under franchise agreement, i.e. in accordance with Article 6.711 of Civil Code franchisee is obliged:
(1) in the manner specified in the franchise agreement, use in his activity the firm name, trade and service mark of the franchisor;
(2) to ensure the quality of the goods produced, works performed or services rendered under the franchise agreement;
(3) to comply with the directions and instructions of the franchisor in respect of the use of the rights, external and internal designing of the business premises of franchisee, as well as to any other conditions of activity specified in the franchise agreement;
(4) to render to purchasers (customers) any additional services which they could reasonably expect in acquiring (ordering) goods (work, services) directly from the franchisor;
(5) not disclose to other persons any commercial (industrial) secrets or any other confidential information received from the franchiser;
(6) to conclude a contract of sub-franchise in the event of such duty thereof being provided for in the contract of franchise;
(7) to inform purchasers (customers) by the most obvious means for them that the franchisee is acting under a contract of franchise and is using the firm name, trade and service mark of the franchisor or any other symbols of individualisation thereof.
Civil Code provides that those obligations are mandatory and cannot be changed by the agreement of contracting parties, nevertheless, parties may agree on additional obligations undertaken by franchisee under franchise agreement as the list of obligations provided in Article 6.771 of Civil Code is not restrictive.


Royalties

Article 6.769 of Civil Code provides that the essential feature of franchise agreement is franchisee’s obligation to pay royalties to the franchisor. Civil Code does not establish any requirements as to the form or nature of royalties and provides only examples thereof, i.e. according to Civil Code royalties may be paid in a form of a fixed lump-sum, periodical payments or deductions from income of franchisee. Thus, contracting parties may conclude that royalties under franchise agreement will be paid in a form stipulated by Civil Code or agree on their own alternatives.
It is worth mentioning that with regard to Lithuanian tax regulation, the royalties paid under franchise agreement will be tax-deductible expense to franchisee and taxable income to franchisor, charged by 18 percent of value added tax.


Sub-franchise agreements

Article 6.768 of Civil Code establishes specific regulation for conclusion of sub-franchise agreements. It entitles contracting parties to stipulate in the agreement franchisee’s right (as well as obligation) to conclude sub-franchise agreements whereby third persons would be granted with the right to use the complex of exclusive rights (or part of it) provided to franchisee in accordance with franchise agreement. The conditions of such sub-franchise agreement can be determined in franchise agreement in advance or stipulated by contracting parties later.
In regard to the abovementioned dependence of sub-franchise agreements on franchise agreements, Civil Code prohibits conclusion of sub-franchise agreements for a term exceeding the term of franchise agreement. Moreover, if franchise agreement is declared void, the same also happens to sub-franchise agreement.
Considering the legal regulation of sub-franchising, it is important to mention that according to general rule stipulated in Civil Code, franchisee bears subsidiary liability against franchisor for all actions of sub-franchisor. That means that in case of sub-franchisee’s refusal to honour the claim of franchisor or failure to respond to the claim within reasonable period of time, franchisor will be entitled to file a claim against the franchisee. The contracting parties are entitled to change this rule by their agreement, therefore, they should carefully negotiate this issue during the negotiations for the conditions of franchise agreement. This is especially so, if the conclusion of sub-franchise agreement is stipulated in the franchise agreement as franchisee’s obligation.


Franchisors liability against third persons

Article 6.773 of Civil Code, stipulating the rules designed to protect the interests of consumers, provides that in certain cases franchisor may be held liable for actions of franchisee. The said article provides that franchisee shall be primarily responsible for the quality of goods or services produced under franchise agreement. However, in case of franchisee’s refusal to honour the claim or failure to respond to the claim within reasonable period of time, the third party-claimant will be entitled to file a claim against the franchisor. Moreover, the franchisor may be held jointly and severally liable with franchisee if the defective products caused damage to the consumers irrespectively of actual producer of the defective products.


Change of contracting parties

Civil Code places emphasis on the protection of continuance of franchise commercial relations by establishing special rules that entitle to change the parties of franchise agreement instead of invalidating it.
Article 6.777 of Civil Code deals with situations when all or some of exclusive rights licensed to the franchisee under franchise agreement are assigned by the franchisor to a third party. The said article stipulates that such assignment does not impede validity of the whole franchise agreement. Instead of that, the assignee of exclusive rights automatically becomes a party to the franchise agreement in respect of the rights and obligations relating to the assigned rights.
In addition to the abovementioned, Article 6.777 of Civil Code provides special rules which apply in case of death of a natural person appearing to be a party to the franchise agreement. The said article provides that in such cases, the rights and obligations of franchisor or franchisee under franchise agreement shall pass to their successor on condition that he is an entrepreneur and continues the business or starts the business within six months from the date of opening the inheritance. It is important to mention that the performance of the rights and duties of the deceased under the franchise agreement before the acceptance of these rights and duties by franchisors or franchisee’s successor are executed by the property administrator appointed by the court.
In connection therewith it is important to mention that the change of counterparties to the franchise agreement undoubtedly influences further performance of the agreement as the party stepping into the agreement may not have appropriate knowledge and experience. This is particularly true in case of temporary performance of franchise agreement by the property administrator appointed by court in case of death of franchisee or franchisor. Therefore, in practice contracting parties usually foresee the possibility to terminate the franchise agreement in case of change of counterparties to that agreement.


Change of firm name or trademark and termination of exclusive rights

A similar policy aiming to secure the stability of franchise commercial relations is also apparent in the provisions regulating the consequences of change of firm name, trademark and termination of exclusive rights.
Article 6.778 of Civil Code stipulates that in case of a change of franchisor’s firm name or trademark constituting the subject matter of franchise agreement the agreement shall remain valid in respect to a new firm name or trade mark. Nevertheless, in such cases franchisee is entitled to protect its interests by exercising one of the two options. First, the franchisee can terminate the agreement forthwith and claim for compensation of damages. Second, franchisee may withdraw its right to terminate the agreement and claim for the respective reduction of royalties paid under franchise agreement. Its worth mentioning that Civil Code entitles contracting parties to withdraw the right to claim for reduction of royalties in a event of change of franchisors firm name or trademark, therefore, contracting parties should discuss this issue when negotiating the terms of franchise agreement.
Article 6.779 of Civil Code that deals with the issue of termination of exclusive right stipulates generally the same consequences. The said article provides that termination of exclusive rights which constitute subject matter of franchise agreement does not invalidate the entire agreement, except the conditions that are related to the terminated right. As previously, in this situation franchisee is entitled to protect its interests either by terminating the agreement and claiming for compensation of damages, either by requiring the reduction of royalties paid under the franchise agreement. However, it should be born in mind that in contrast to the previous situation in this situation franchisee is entitled to terminate an agreement only if the termination of exclusive rights amount to essential breach of franchise agreement.
It is important to mention, that the abovementioned Article 6.779 of Civil Code, dealing with termination of exclusive rights, does not apply to such exclusive rights as a right to firm name and trademark. The consequences of termination of such rights are regulated by Article 6.776 of Civil Code which stipulates that in such situations when the franchisor is deprived of the right to a firm name or trademark and does not replace it by a new analogous right, the franchise agreement is deemed to be terminated.


Termination of agreement

The termination of a franchise agreement is regulated by the general provisions of contract law and franchising-specific legal regulation.
General principles of contract law in relation to the termination of a franchise agreement are set in Article 6.217 of Civil Code. According to the said article, the contracting party may terminate a franchise agreement if the counterparty to the agreement fails to perform the agreement or unduly performs and it is considered to be an essential breach of agreement. The aggrieved party may exercise this right by notifying the other party in advance within thirty days or other term established in the agreement.
The termination of franchise agreements in accordance with franchising-specific legal regulation is mainly established in Article 6.776 of Civil Code. The said article stipulates three situations entitling contracting parties to a franchise agreement to terminate it without essential breach of agreement, i.e.:
(1) franchise agreement concluded for indefinite period may be terminated by notice of either party served at least six months prior to the termination, if the agreement concluded between the parties does not establish a longer term;
(2) franchise agreement may be terminated in case franchisor is deprived of the right to a firm name or trademark without a replacement thereof by a new analogous right;
(3) franchise agreement may be terminated in case bankruptcy proceedings are initiated against a franchisor or franchisee.
The abovementioned grounds for termination of a franchise agreement are supplemented by the other grounds stipulated in individual provisions, i.e. a franchisee agreement may terminate if:
(1) upon the franchisor’s or franchisee’s death their successors do not continue the business of the deceased (Article 6.777 of Civil Code);
(2) franchisor’s firm name or trademark changes (Article 6.778 of Civil Code).
Notable the fact of termination of a franchise agreement, irrespective of its grounds, must be also notified to the Register of Legal Persons.

Pre-emptive rights of franchisee

An important feature of franchising regulation of Lithuania is the protection of franchisees interests after the termination of franchise agreement by providing him with pre-emptive right to conclude agreement for a new term. Article 6.774 of Civil Code stipulates that in case of expiry of a franchise agreement concluded for a fixed term, the franchisee, provided he duly performed contractual obligations, has a pre-emptive right to enter into a new franchise agreement on the same terms and conditions as previous one. The franchisor is entitled to refuse to enter into new agreement with the franchisee only if he undertakes not to conclude franchise agreements for the same territory with other third parties for the period of three years. If before the expiry of the three-year time period the franchisor wishes to grant the same exclusive rights to other persons, he must propose conclusion of a new contract to the franchisee or compensate the damages incurred by him.
The abovementioned regulation of franchisee’s pre-emptive right raises many questions related to its application and interpretation, therefore without a settled case practice the actual scope of this regulation remains unclear. On the one hand this provision can be interpreted as an obligation to conclude new franchise agreements on the same terms as their predecessors. On the other hand it could be argued that this provision does not prohibit adoption of terminated franchise agreement to the actual market conditions. Nevertheless, as this question remains unsettled, it would be recommended to establish in franchise agreements clear conditions determining the right to renew the agreement and choose arbitration as a dispute settlement body, which may show more flexibility in interpreting this provision than courts.


Conclusions

Introduction of the abovementioned franchising-specific legal regulation provided strong incentive to the conclusion of franchise agreements and development of franchise based business in Lithuania. Nevertheless, the implementation of the said regulation still causes practical issues, in particular, issues related with confidentiality of information provided to the registers and franchisees pre-emptive right to conclude agreement for a new term on the same conditions as set in its predecessor. It is hopped that those problems soon will be settled by case practice or respective amendments to legal acts. Meanwhile, contracting parties are recommended to stipulate their commercial relations in franchise agreements in a detailed manner and choose arbitration as a dispute resolution body.

 

Footnotes: 1 The English translation of Civil Code of the Republic of Lithuania can be found on the website of the Parliament of the Republic of Lithuania, http://www3.lrs.lt/pls/inter3/dokpaieska.showdoc_l?p_id=245495. Although this translation of Civil Code is not up to date, Chapter XXXVII of Book 6 of Civil Code establishing legal regulation of franchising as to 12 October 2007 is up to date. 2 Civil Code provides that documents signed by the parties and transmitted by means of telegraph, facsimile communication or over any other means of communication terminal equipment shall be conferred the same power as having been made in the written form, provided the protection of the text is guaranteed and the signature can be identified.