To franchise or to license?

THERE are various ways for companies to expand their businesses, including by franchising, licensing, partnerships and joint ventures. Here, we will explore franchising and licensing as two methods of doing business in Malaysia.

Franchising and Licensing

Both “franchising” and “licensing” are methods that allow an owner of a business, (“licensor” or “franchisor”) who establishes the brand’s trademarks and a business system for operating the business with defined store designs, product specifications, operations procedures and business reporting systems (“Business Systems”) to charge a fee for granting another (the “licensee” or “franchisee”) the right to use the owner’s Business Systems to operate its business.

In many countries, “franchise” and “license” are interchangeable terms describing the granting of rights by a franchisor/licensor to a licensee/franchisee under a contract. In Malaysia, franchises are regulated by the Franchise Act 1998 (FA) meaning franchises are not solely governed by the law of contract but also regulated by the FA. The distinction between “license” and “franchise” then becomes important because a “franchise” is regulated by the FA whereas a “license” is not.

(The Franchise (Amendment) Act 2020 (“Amendment Act”) was gazetted on March 6, 2020. It is anticipated that the Amendment Act will come into force at the end of this year or early next year.)

Examples of FA terms include that:

franchise agreements are required to include certain mandatory terms;

franchisors, franchisees, franchise consultants and franchise brokers must be registered with the Registrar of Franchises (“Registrar”);

the franchisor is required to submit an annual report to the Registrar within 6 months of the end of each financial year of the franchise business;

the franchisor is required to register his trademark or service mark in accordance with the Trademarks Act 2019 before applying for the registration of the franchise.

Thus, while franchising is still subject to the contract between a franchisor and franchisee, such a contractual relationship must comply with the provisions of the FA.

Key elements of a franchise

Under the FA, the two key elements identifying whether the business falls within the ambit of a “franchise” are:

(i) a “franchise system” determined by the franchisor; and

(ii) the franchisor’s right to administer “continuous control” over the franchisee’s business operations.

Although these key terms are not defined in the FA, (i) and (ii) above can be established by a franchise agreement requiring the franchisee to do one or more of the following as part of its franchises business:

adhere to the operations manuals provided by the franchisor;

seek the franchisor’s approval on the design and layout of the premises;

use only marketing materials designed or approved by the franchisor;

undertake to sell only products supplied by the franchisor or persons approved by the franchisor;

use only financial reporting software specified by the franchisor;

set product prices in accordance with the franchisor’s directions;

allow the franchisor the right to inspect the franchisee’s store and financial records.

If the licensee/franchisee is required to do all of the above, it is likely there is a “franchise system” and “continuous control” over the business, thus making it a “franchise” relationship regulated by the FA.

However, if the licensee/franchisee is required to do only some of those obligations, the relationship may no longer be regarded as a “franchise”, as the absence of those obligations removes, to a certain extent, the two key elements. Hence, the relationship is not governed by the FA.

Thus, given that there is no clear line demarcating a “license” arrangement from a “franchise”, each arrangement must be reviewed on a case-by-case basis to determine whether the business is a franchise or not.

Legal implications

If parties intend to adopt a franchising arrangement, the franchise agreement needs to strictly comply with the FA. Failure to comply can, in many instances, render a franchise agreement null and void.

By contrast, parties entering into a licensing agreement must ensure such agreement does not contain any of the key elements of a franchise. If it is regarded as a “franchise”, the franchisor and franchisee must be registered with the Registrar. Failure to register the franchise with the Registrar is an offence under the FA.

Conclusion

Whether one chooses to adopt a franchising or a licensing model depends on the nature of the business and the amount of external control that one is willing to commit to. It is important to examine the substance of an agreement or the business to determine whether it is a “franchise” under the FA thereby making it essential to obtain legal advice before entering into such agreements.