Withdrawal of Western brands from Russia - a franchising perspective

Following the decision of the Russian Government to invade Ukraine, the UK, USA and EU were quick to announce a raft of sanctions over key individuals and businesses.

This has had an immediate impact on some businesses' ability to trade with Russia. However, there are a significant number of Western consumer brands with a presence in Russia, which do not fall within the orbit of sanctions but are nonetheless facing growing pressure to close their operations in Russia.

The threat of brand boycotts and consequential damage to the brand is understandable, but it belies a lack of understanding of how many Western brands will have structured their Russian operations. Many of these brands will operate under either a pure franchise, a joint venture or a hybrid model of wholly owned stores and franchised stores.

While it is relatively easy, in theory, to take and implement a decision to withdraw from a market where the brand has direct control over the operations, it becomes much more complicated, and potentially more expensive, when third parties are involved. Brands such as Burger King and M&S have announced that they are unable to close operations due to complex franchising structures. Other companies such as McDonalds operate a hybrid structure, and have closed their own stores, but some franchised stores remain open.

Russia is a big market, and these are big, long-term investments, so these brands are having to make quick unilateral decisions with no clear sense of whether this is a permanent or temporary closure.

What are the key challenges facing a foreign franchisor?

Franchising is a long-term business relationship, requiring a high degree of co-operation and mutual investment. Franchise agreements are often long and complex documents and they vary between markets, industries and brands.

Nevertheless, operating a western-branded franchise in Russia will typically follow one of the following structures:

• the franchisor grants rights to a Russian entity to operate the brand in Russia and in exchange the Russian entity pays royalties to the foreign franchisor. The franchisor has no direct presence in Russia, but it will provide support and training remotely and by visiting the territory, and may supply products, equipment and services, or
• the same as above, but the Russian entity may operate the franchise itself and also appoint sub-franchisees. In this context, the Russian ‘master franchisee’ takes on a role similar to a franchisor in providing support to and collecting royalties from sub-franchisees. It is likely that the franchisor will have no contractual relationship with the sub-franchisees and this can make enforcing contracts difficult, or
• there could be variations to the above, such as where the brand operates a direct presence alongside a Russian franchisee(s), or the brand/franchisor and the Russian partner invest in a joint venture company which is the de facto franchisee.

While franchise agreements usually contain extensive termination provisions in favour of the franchisor it is rare for a franchise agreement to contain a right for the franchisor to terminate at will, particularly due to the level of investment made by a franchisee at the outset of entering into the agreement. Commercially, it would not make sense for a franchisee to invest in a business which could be terminated by the franchisor before the franchisee has had reasonable time to make the business profitable and see a return on its investment.

As the conflict in Ukraine is no fault of the Russian franchisee, save for where the franchisee is connected with 'sanctioned individuals', it is very unlikely that a franchisor will have a contractual right to terminate the agreement and require the franchisee to cease operations.  There may however be other aspects of the franchise agreement which could come into play.  Some franchise agreements may contain an 'adverse change of law' clause, which would require both parties to use their best efforts to co-operate with each other to amend the franchise agreement or seek an alternative way to comply with the change of law to allow each party to continue to enjoy the benefits of the agreement. If this is not possible, such clauses often give the franchisor an option to terminate the agreement without liability to the franchisee. However, unless the products or services, or ownership or operation of the franchisee is restricted under the sanctions list of the franchisor's operating country (ie, the jurisdiction in which the franchisor receives royalties from the Russian-based franchisee), it is unlikely that the parties can rely on this type of clause for the time being.

A 'force majeure' clause may be helpful if a franchisor is operationally restricted or delayed from providing support or supplies to franchisees for an event or circumstance outside of its control, such as an action by a government imposing an export restriction or travel ban to Russia, but these have to be causes which are outside of the control of either party and cannot be reasonably overcome. The coronavirus (COVID-19) pandemic has shown that franchise systems can be very flexible and creative in ensuring continuing operations, so again it seems unlikely that the current situation could be treated as a force majeure for most franchise systems in Russia.

In the absence of any express termination rights, or the alternative types of exits mentioned above, franchisors are faced with the following options:

• allow the franchise to continue, and risk damaging the reputation of the brand in the eyes of Western consumers - some brands have announced that they will donate any profits they receive from the Russian business to humanitarian charities, but query whether this ‘half in/half out’ position is sustainable if the conflict continues for the medium to long term
• take unilateral action to terminate the franchise agreement, but risk facing a substantial claim from a franchisee - query the likelihood that a Russian franchisee will seek redress in a foreign/Western jurisdiction. In the alternative, it is possible that a franchisee may simply continue to operate the business post-termination (or the Russian master franchisee may feel compelled to allow its sub-franchisees to continue to operate in order to limit its own liability), and the brand is faced with the prospect of enforcing its rights in a hostile local environment
• close company-owned stores and allow franchised stores to continue to operate (if operating a hybrid structure) - this will be financially painful, but it is unlikely to resolve the potential damage to the brand, as it will continue to operate in Russia
• agree a mutually acceptable early termination or temporary suspension of the franchise agreement - this may be in the interests of both parties. It will resolve the brand damage issue outside of Russia, may limit damage to the perception of the brand within Russia, and it keeps alive the possibility of a re-entry into the market when the situation is resolved. However, it is likely to come with a financial cost

Clearly the stakes are high and it is therefore important that legal advice is sought and franchise agreements are siloed and reviewed individually before any decisive action is taken.

Additional considerations

Franchisees see themselves as stakeholders in the brand and those franchisees operating outside of Russia may feel that their business is being adversely impacted by the refusal of a franchisee to close its operations in Russia, or by the refusal of their franchisor to take action in this regard. This may cause a further difficulty with brands as they seek to reassure these franchisees that the actions or omissions of the Russian franchisees will not impact on those outside of the jurisdiction. It will be important for the franchisor to ensure good lines of communication with affected franchisees to provide reassurance and allow for the franchise network to be consulted in respect of ongoing business decisions. Taking proactive steps now will undoubtedly generate goodwill in the relationship with the network going forward.

Depending on the level of dissatisfaction among franchisee groups, some franchisors may need to weigh up the contractual risks of closing or suspending operations in Russia against the reputational damage that may flow from continuing to operate in Russia. Some franchisees may feel that the franchisor is in breach of any obligations surrounding maintaining and upholding the reputation of the brand if it takes no decisive action in respect of Russian operated franchisees. This could leave the franchisor repelling a double-ended sword in respect of both franchisees inside and outside of Russia.

The parent company of Burger King, Restaurant Brands International (RBI) has suggested its joint venture partner, Alexander Kolobov, who runs the franchise operations day-to-day in Russia has refused to close restaurants in the jurisdiction, but that the company has suspended all corporate support for its business in the country and will dispose of its 15% ownership stake in Russia. RBI have indicated that they would require the help of the Russian government to ‘enforce its contracts’. This appears to be in relation to Kolobov's statement that he does not have the authority or power to decide whether to suspend restaurant operations in Russia. It is likely that Kolobov is alluding to sub-franchise agreements with individual restaurant owners, which, like the master franchise agreement / joint venture agreement with RBI, do not contain rights for termination at will of either party but may contain adverse change of law clauses as discussed above.

Negotiating franchising agreements going forward

Burger King have suggested that there are ‘no legal clauses that allow [them] to unilaterally change the contract or allow any one of the partners to simply walk away or overturn the entire agreement’. It will be difficult to negotiate the inclusion of a right for the franchisor to terminate in circumstances where the contractual territory is affected by a conflict or other event which in turn creates a material reputational issue for the franchisor, unless the exercise of such a right goes into detail about the process and sharing of the resulting financial burden.  In reality, this is a risk which affects a very limited number of countries, and is not something we expect to see forming a part of typical negotiations.  Nevertheless, the current conflict highlights the importance of franchisors taking a considered approach to their expansion strategy and knowing who their prospective franchisee is, the identity of the owners and their other business interests before entering into the franchise agreement. For territories which are as vast as Russia, franchisors should consider the benefits of carving up the territory between different operators and limiting the risk of a single operation being too big to fail.

With potential litigation set to unfold as tensions rise between franchisors and Russian-based franchisees, it will be important for franchisors to take local law advice (and serve as a reminder for those franchisors entering into international agreements before the deal is signed) on its rights under the franchise agreements.

For more information on this topic or advice on any specific franchising queries, please contact Gordon Drakes or Kate Williams.

This article was originally published on Lexis PSL.