Franchising Law in Malaysia

Lim Yen Hui provides a comprehensive analysis of the Franchise Act

 

Introduction

1. The business of franchising has transformed the face of most business practices in Malaysia and has become a revolutionary way for Malaysian companies to develop, increase their production capability and expand their distribution chain both vertically and horizontally.

     

    Franchising fosters business opportunities for Malaysian franchisees, particularly small start-up companies (the “Franchisee”) under the guidance and assistance of another company (the “Franchisor”), which has the requisite experience and knowledge of the market practice and industry. The Franchisee may leverage on the Franchisor’s international and/or regional reputation and goodwill through its use of the Franchisor’s trade marks and intellectual property rights as well as the Franchisor’s tested technologies, trade secrets and business systems.

     

    Before the enactment of the Franchise Act 1998 (the “Franchise Act”) on 8 October 1998, franchising in Malaysia was governed by contractual principles and the absence of complex statutory provisions or guidelines allowed parties to freely negotiate the terms of their franchising arrangement. In contrast, the Franchise Act highly regulates the franchising industry as it not only controls the terms of any franchise agreement but also implements a systematic scheme of registration for the Franchisor, Franchisee and franchise brokers. Although this has created a regimented legal structure for the franchising industry in Malaysia, the Franchise Act brings with it certainty and greater protection for Malaysian businesses, particularly the small medium businesses.

     

     

     

    Elements of a Franchise

     

    2. Principally, the Franchise Act applies to the sale of any franchise in Malaysia whereby the franchised business operates in Malaysia. A “franchise” falls within the purview of the Franchise Act if all of the following elements are met: -

       

      • the franchisee operates a business according to a franchise system which is determined by the franchisor;
      • the franchisor grants to the franchisee the use of its trademarks and intellectual property rights;
      • the franchisor has the right to exercise continuous control over the franchisee’s business operations in accordance with the franchise system;
      • the franchisor provides assistance to the franchisee in terms of training, marketing, business or technical assistance and the provision or supply of materials;
      • the franchisee pays a fee or some other non-financial consideration in return for the franchise; and
      • the franchisee operates business separately from the franchisor. (So, a partnership or agency does not constitute a franchise.)

       

      Generally speaking the crux of a franchise is the grant of a licence from one party to another for the operation of a business in accordance with a business system or modus operandi.

       

       

      System of Registration

      3. In terms of the requirements for registration the Franchise Act makes a distinction between a foreign franchisor and a Malaysian franchisor.

         

        (a) Foreign Franchisor

          It is interesting to note that the language of the Franchise Act indicates that a foreign franchisor must obtain the Registrar of Franchises’ (“Registrar”) approval before it intends to sell its franchise in Malaysia or to a Malaysian. This suggests that approval must first be obtained before the foreign Franchisor commences any discussions or negotiations with prospective Malaysian franchisees since at this juncture an intention on the part of the foreign Franchisor manifests itself to sell a franchise in Malaysia. Any approvals by the Registrar under the Franchise Act may be subject to the imposition of conditions.

           

          Upon the Registrar’s approval, the foreign Franchisor may proceed to take steps to sell its franchise in Malaysia by entering into franchise agreements and related arrangements. However, the commencement of the franchise agreement would be subject to the registration of the Malaysian Franchisee with the Registrar soon after its appointment as the foreign Franchisor’s Franchisee for Malaysia. It is at this stage that a copy of the franchise agreement, amongst other documents, needs to be submitted to the Registrar as part of the registration requirements. The Registrar’s approval for such registration would be subject to the imposition of any conditions as it deems fit, which may include a direction to vary the franchise agreement if there is inconsistency with the Franchise Act. The rationale for the registration of the local Franchisee is for the regulation of the franchise through the local Franchisee since the Franchise Act has no extra-territorial effect and the Registrar would have difficulty enforcing any of its directions against the foreign Franchisor.

           

          If the foreign Franchisor appoints the Franchisee as its master franchisee (the “Master Franchisee”) then the Master Franchisee will also need to register itself as a franchisor before it may grant franchises in Malaysia or to any Malaysian, failing which the Master Franchisee will be regarded as having committed an offence under the Franchise Act.

           

           

          (b) Malaysian Franchisor

            The Malaysian Franchisor is required to register its franchise with the Registrar before it may make an offer to sell its franchise to any person, unless exempted by the Minister. Failing this, the Franchisor would be deemed to have committed an offence under the Franchise Act. In its application for registration the Franchisor must submit its application in a prescribed form, together with disclosure documents, a sample of the franchise agreement, the operation and training manual of the franchise and a copy of the latest audited accounts, financial statements and reports of the auditors and directors of the Franchisor. It is worth noting that a Franchisor is only considered eligible to apply for registration after having completed a minimum of 3 years in the operation of the franchised business in Malaysia.

             

            There is no requirement for a Malaysian Franchisee of a Malaysian Franchisor to register itself with the Registrar since the Registrar may control the franchise operation through the Malaysian Franchisor.

             

            4. Similarly, a franchise broker is required to register itself with the Registrar by submitting the relevant documents and forms, whereby such registration will be effective for one year unless otherwise determined by the Registrar. The Registrar may impose conditions on the registration of a franchise broker, which may include conditions governing the conduct, suspension, termination, prohibition or denial of registration of a franchise broker as well as conditions regulating the manner in which the franchise broker may sell the franchise.

               

              5. Prior to the submission of an application for approval or registration to the Registrar both the foreign and Malaysian Franchisor (or relevant proprietor) would be required to register or apply to register the trademark relevant to its franchise (if they are so registrable) in accordance with the Trade Marks Act 1976. Registration of trademarks will provide the Franchisor with statutory protection and rights afforded under the Trade Marks Act 1976 vis-à-vis the Franchisee or third parties who may potentially misuse the Franchisor’s trademark or cause detriment to the goodwill and reputation acquired by the Franchisor in relation to its trademark.

                 

                6. Extensive in its administrative role, the Franchise Act also regulates advertisements offering to sell or to buy a franchise. Any person who wishes to publish, distribute of use any such advertisement is required to file a copy of the advertisement with the Registrar at least five days, before its first publication, distribution or use. The Registrar is thus sanctioned to prohibit the use of any advertising that is deemed to be false, fraudulent, misleading or deceptive.

                   

                   

                  Decisions of the Registrar

                  7. Upon receipt of the application for registration or approval, the Registrar will inform the applicant in writing of its decision. If the Registrar approves such application then the registration or approval of the franchise shall be effective from the date stated in the Registrar’s written notice and shall remain in effect unless and until the (a) Registrar issues an order to the applicant or Franchisor to suspend, terminate, prohibit or deny the sale or registration of the franchise under the Franchise Act; or (b) Franchisor cancels its registration from the register by submitting its application to the Registrar. In order to maintain the effectiveness of the registration, the Malaysian Franchisor must update the Registrar of any developments in the operation of the franchised business on an annual basis.

                     

                    In the event the Registrar refuses the application for registration and has notified the Malaysian Franchisor of his intention to suspend, terminate, prohibit or deny the sale or registration of a franchise, the Franchisor is given the opportunity to make a written representation on the matter within fourteen days from the date of service of the notice. The Registrar will give its decision accordingly. Any Malaysian Franchisor or franchise broker aggrieved by the Registrar’s decision is entitled to appeal to the Minister of Entrepreneurial and Co-operative Development within one month from the date of the Registrar’s decision. However, the Minister’s decision on the appeal shall be final.

                       

                      The Franchise Agreement

                      The Franchise Act mandates the inclusion of certain terms and conditions in the franchise agreement, whereby failure to comply renders the franchise agreement null and void. First and foremost, a franchise agreement must be in writing and must contain the obligations of both the Franchisor and the Franchisee/Master Franchisee.  A franchise agreement must also include, amongst others, the name and description of the product and business under the franchise, the territorial rights granted to the Franchisee. The franchise fee, promotion fee, royalty or any related type of payment payable by the Franchisee, must also be reflected in the franchise agreement. Finally, the Franchise Act requires the inclusion of the type and particulars of assistance to be provided by the Franchisor, the duration of the franchise and the terms of renewal and the effect of termination or expiration of the franchise agreement.

                         

                        It is compulsory practice for the Franchisor to submit a copy of the franchise agreement and disclosure documents, to the Franchisee at least ten days before the Franchisee enters into the franchise agreement with the Franchisor. This requirement suggest the paternalistic approach taken by the Franchise Act in giving the Franchisee a reasonable period to assess the risks for entering into the franchise agreement in order to make an informed decision for proceeding down this path. As an added safeguard the franchise agreement must provide for a cooling-off period of at least seven working days, during which the Franchisee may terminate the franchise agreement and seek a refund of any monies paid to the Franchisor in relation to the franchised business. The Franchisor is however, entitled to retain an amount to cover reasonable expenses relating to the preparation of the franchise agreement.

                           

                           

                          Term and Termination

                          It is mandatory for the term of the franchise agreement to be at least five years with an option to renew for a further term at the election of the Franchisee. Once the Franchisee elects to renew the franchise term for a further term, the Franchisor is obliged to agree, unless the Franchisee has breached the terms and conditions of the previous franchise agreement. The minimum term of the franchise agreement affords the Franchisee with some certainty to assess the timeframe in which it is able to succeed in the operation of the franchised business in terms of the likelihood of recouping its capital outlay and financial expenditure, developing in roads into the relevant market, etc.

                             

                            The prospect of terminating a franchise agreement with a Franchisee should be regarded with reluctance by the Franchisor, as it raises the question as to the consequences of termination such as the future development of the franchise operations in the territory after termination of the franchise agreement. At a minimum, the Franchise Act recognises that termination of a franchise agreement may be necessitated by the Franchisee’s breach of the franchise agreement after giving the Franchisee an opportunity to remedy the breach. Common examples for breach which are usually considered reasonable are breach of confidentiality covenants, non-competition restrictions, false accounting, non-payment, etc. Other grounds for termination permitted by the Franchise Act include the Franchisee’s repeated breach of the franchise agreement, insolvency, voluntary abandonment of the franchised business and misuse of the Franchisor’s trademarks or intellectual property rights. Undoubtedly, the franchise agreement may come to an end if either the Franchisor or Franchisee mutually agree to a termination or where the court has decided that there are certain conditions in the franchise agreement which merit the earlier termination of the franchise agreement. It is apparent that the circumstances for termination of the franchise agreement are monitored by the Franchise Act to ensure that the interests of the parties are not compromised.

                               

                               

                              Confidential Information

                               

                              As a consequence to termination of the franchise agreement the Franchise Act allows the Franchisor to protect its interest by requiring the Franchisee and its employees to continue observing their obligation of confidentiality with regard to the Franchisor’s confidential information and trade secrets for a specified timeframe following the expiration or termination of the franchise agreement. Confidential information would probably refer to the Franchisor’s operation manual and any other confidential information obtained by the Franchisee or its employees during the franchise term.

                                 

                                However, legal restrictions may in practice provide very little safeguard for the Franchisor who should be wary of passing on confidential information and trade secrets to the Franchisee. The very nature of confidential information and trade secrets requires such information to be kept away from the public domain. Once such information is leaked out the value and proprietary nature is lost forever. Trade secrets are best preserved by not being revealed to the Franchisee. Essential material in the form of a secret process or secret formula such as the ‘KFC Secret Recipe’ or the ‘Coca Cola Formula’s can be supplied to the Franchisee ready-made. This strategy is well known in manufacturing licence and may well be applicable to some franchise operations.

                                 

                                In situations where the Franchisor finds that it is necessary to licence the use of confidential information to the Franchisee, such as technical information, know how and the methodology of operating the franchise system, it is crucial that the Franchisor ensures that the manner and purpose of use of such confidential information are detailed in the franchise agreement to ensure against unwanted disclosure and unauthorised access. The requisite undertakings, covenants and indemnities should be sought from the Franchisee in relation to the scope and manner of use of such confidential information. Furthermore, it is advisable for the Franchisor to ensure that any improvements or developments made to such confidential information or licensed technology in the course of the Franchisee’s usage is disclosed to the Franchisor upon discovery and that the intellectual property rights and title in such improvements or developments vest absolutely with the Franchisor at the end of the day.

                                 

                                 

                                Conduct of a similar business

                                The concept of ‘cloning’ is the basis of franchising and has both positive and negative consequences. On the positive side it helps to ensure the uniform quality of the product and business and so strengthens the brand and the profitability of the business. However, on the negative side, it potentially produces the most effective competitor that the Franchisor could possibly imagine. Imposing non-competition restraints in a franchise agreement and monitoring the business practices of the Franchisee during the term of the franchise agreement and for a period after termination or expiration of the franchise agreement is essential in any franchise transaction. A franchise agreement would be self-defeating if after the end of the term of the franchise agreement, Franchisees were able to compete with the Franchisor especially where the Franchisee has been acquainted with protected business know-how which may be used to the detriment of the Franchisor.

                                   

                                  Fortunately, the Franchise Act requires the Franchisee and its employees to comply with their non-competition covenants during the term of the franchise agreement and for a period of two years after the expiration or termination of the franchise agreement. A non-competition clause which would otherwise be considered void under the Malaysian Contracts Act 1950 is regarded as enforceable under the Franchise Act for two years after termination or expiration of the franchise agreement.

                                   

                                   

                                  Payment and Royalty

                                  Where the Franchisee is required to pay any franchise fees, royalty or promotion fees to a Franchisor, the rates must reflect the amounts declared by the Malaysian Franchisor in the disclosure documents registered with the Registrar or provided for in the franchise agreement submitted by the local Franchisee of a Foreign Franchisor.

                                     

                                    Where a Franchisor requires its Franchisee to contribute to a fund for the promotion of the franchise by the Franchisor, the Franchisor is required to establish a promotion fund, managed under a separate account and solely used for the purpose of payment by all Franchisees, in relation to the promotion of the product under the franchise. In an exertion of supervisory control over the franchise, the Franchise Act requires the Franchisor to submit a financial statement of the promotion fund, endorsed by a registered public accountant, and the annual report to the Registrar within thirty days following the conclusion of the last financial term. The close monitoring by the Registrar of the outflow and inflow of payments to the promotion fund purports to limit unauthorised use of the Franchisee’s contributions by the Franchisor.

                                     

                                     

                                    Waivers

                                     

                                    Once again the Franchise Act shows its paternalistic approach towards Franchisee by determining any condition, stipulation or provision in a franchise agreement, which purports to bind a Franchisee to waive compliance with any provision of the Franchise Act, to be void.

                                       

                                       

                                       

                                      Offences and Penalties

                                       

                                      The Franchise Act lays down various offences and penalties in the event of the commission of an offence under this statute by the offending party. Sanctions take the form of fines and/or a term of imprisonment, whereby the amount of the fine or duration of the term will depend on the severity of the breach and whether a specific penalty has been provided for under the Act. Consideration will be given to whether the offence is a repeated offence or whether the offence is committed by an individual or a body corporate.  For example, a person who has committed a first offence under the Franchise Act is liable upon conviction to a maximum fine of Ringgit Malaysia 50,000/- (approximately equivalent to US$ 15,000/-). Upon sentencing a Franchisor for a first offence, the court may also nullify the franchise agreement, order the Franchisor to refund any form of payment to the Franchisee or prohibit the Franchisor from making any new franchise agreement or appointing any new Franchisees.

                                         

                                         

                                        Enforcement

                                        1. During the course of the franchise, the Franchise Act empowers an authorised officer to not only investigate the activities of any Franchisor, Franchisee and any relevant person but also to enforce the provisions of the Franchise Act. Further, in the event that it appears to a Magistrate of the Malaysian courts that there is reasonable cause to believe that an offence under the Franchise Act is being or has been committed on any premises the Magistrate is empowered to issue a warrant authorising any authorised officer to enter the premises at any reasonable time by day or by night, with or without assistance and if need be by force.

                                         

                                        In addition to these powers afforded by the Franchise Act, all or any of the powers relating to police investigation in seizable cases pursuant to the Malaysian Criminal Procedure Code shall also apply, and include the power to search premises and any person who is in or on such premises, and to seize, detain or take possession of any articles for the purpose of carrying out the investigation of the offence. Such powers encompass the authority to require attendance of persons acquainted with the case for questioning whereby such persons shall be legally bound to state the truth and answer all questions relating to the case that are put to such persons.

                                         

                                         

                                        Conclusion

                                        In an endeavour to ensure the protection of the rights of Franchisors and Franchisees, the Franchise Act purports to extensively and continuously regulate and supervise the area of franchising. Invariably, the commencement of the Franchise Act engendered legal ramifications to existing and potential franchises as well as other contractual business relationships. Some non-franchise arrangements, such as distributorship arrangements, technical assistance or licensing arrangements that satisfy the criteria of a “franchise” may be considered a loose franchise arrangement, although it may not be intended as a franchise arrangement by the contracting parties.

                                         

                                         
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