Q&A: offer and sale of franchises in Malaysia

Laws and agencies regulating the offer and sale of franchises

What is the legal definition of a franchise?

Under section 4 of the Franchise Act 1998 (as amended by the Franchise (Amendment) Act 2012) (FA), the statutory definition of a franchise is a contract or an agreement, either expressed or implied and whether oral or written, between two or more persons, by which:

• the franchisor grants to the franchisee the right to operate a business according to the franchise system as determined by the franchisor during a term to be determined by the franchisor;
• the franchisor grants the franchisee the right to use a mark, or a trade secret, or any confidential information or intellectual property owned by the franchisor or relating to the franchisor, and includes a situation where the franchisor who is the registered user of, or is licensed by another person to use, any intellectual property grants such right that it possesses to permit the franchisee to use the intellectual property;
• the franchisor possesses the right to administer continuous control during the franchise term over the franchisee’s business operations in accordance with the franchise system; and
• in return for the grant of rights, the franchisee may be required to pay a fee or other form of consideration.

To fall within the purview of the FA, the arrangement must consist of all of the above elements and the franchisee must operate the business separately from the franchisor and the relationship must not at any time be regarded as a partnership, service contract or agency. This arrangement will then be regarded as a franchise, whether it is called a franchise or otherwise.

Which laws and government agencies regulate the offer and sale of franchises?

The FA came into force on 1 January 2013. The Franchise Development and Direct Sales Division of the Ministry of Domestic Trade and Consumer Affairs is the governmental agency that regulates the offer and sale of franchises and approval or registration of franchisors and franchisees in Malaysia.

Describe the relevant requirements of these laws and agencies.

The Malaysian government has long been aware that franchising is one of the fastest ways to create and increase the number of local entrepreneurs and promote growth in the franchise industry in Malaysia. Essentially enacted to facilitate and monitor the growth of the franchise industry, the FA applies throughout Malaysia and to the sale of any franchise in Malaysia. Pursuant to the FA, franchisors, master franchisees and foreign franchisors are required to seek approval from or register with (or both) the Franchise Development and Direct Sales Division of the Ministry of Domestic Trade and Consumer Affairs before they can offer to sell or buy franchises in Malaysia.

Under the Franchise (Amendment) Act 2012, a franchisee of a foreign franchisor must register the franchise before commencing the franchise business. A franchisee of a local franchisor or a local master franchisee must register the franchise within 14 days of the date of signing the franchise agreement.

What are the exemptions and exclusions from any franchise laws and regulations?

If a person is able to demonstrate that its business model does not fall within the definition of a franchise, in that it does not satisfy all the ingredients in the definition of the franchise, such business would not be covered by the provisions and purview of the FA. Based on the requirement in the FA that a franchisee must operate the business separately from the franchisor, the Registrar of Franchises (ie, the Franchise Development and Direct Sales Division of the Ministry of Domestic Trade and Consumer Affairs) has interpreted this provision to mean that if a franchisor holds any shareholding in an entity, such relationship shall not be regarded as that of a franchisor and franchisee, regardless of the extent of shareholding. 

Under the Franchise (Exemption) Order 2004, any person who has sold a franchise in Malaysia or to any Malaysian citizen prior to the commencement of the FA (8 October 1999) would be exempted from complying with section 54 of the FA, namely the requirement to submit an application to the registrar.

Pursuant to section 58 of the FA, the minister may, by order published in the Malaysian Gazette, exempt, subject to such conditions as he or she deems fit to impose, any person or class of persons or business or industry from any or all of the provisions of the FA. To date, the only industry that is exempted under this provision is the petroleum industry.

Under the Franchise (Exemption) Order 2001 (PU(A) 27/2001), the minister has exempted from the provisions of the FA the petroleum industry’s franchising:

• a petrol station business; and
• any other business operating together with the petrol station business referred to above, subject to the condition that the business operating together with the petrol station business is:
  • operated in the same premises as the petrol station; and
  • franchised by the same petroleum industry franchising the petrol station business.

Does any law or regulation create a requirement that must be met before a franchisor may offer franchises?

One requirement that is highly unpopular among franchisors and local master franchisees is that they must operate their own outlets profitably for at least three years before they are permitted to appoint sub-franchisees. While this requirement is not expressly provided in the FA or any of the regulations, the authorities have taken the view that it is one of the prescribed requirements under law due to section 18 of the disclosure document, which requires the franchisors or master franchisees to submit audited financial statements for the past three years.

Are there any laws, regulations or government policies that restrict the manner in which a franchisor recruits franchisees or selects its or its franchisees’ suppliers?

Although the FA does not expressly restrict the manner in which a franchisor recruits franchisees or selects its suppliers, the government does exercise some form of control and impose certain conditions (when granting its approval during the approval application or registration process). For instance, if the territorial area granted to a potential franchisee is considered to be too small or restrictive, the Registrar of Franchises (ie, the Franchise Development and Direct Sales Division of the MDTCA) would request the applicant to extend the territorial right to a larger area (usually by reference to a radius in kilometres). The Registrar of Franchises would also require the franchisor to submit a list of its suppliers in granting approvals. If the franchisor has not shown profitability or healthy growth in its financial statements for the franchise business, the Registrar of Franchises is likely to refuse the approval application or registration on the basis that the franchisor is not ready to sell its franchise systems to franchisees in Malaysia.

What is the compliance procedure for making pre-contractual disclosure in your country? How often must the disclosures be updated?

In the case of a sub-franchising structure (namely where the foreign franchisor appoints a local master franchisee who will in turn appoint sub-franchisees in Malaysia), the local master franchisee is the one providing presale disclosures to sub-franchisees. The local master franchisee must disclose the fact that it is a master franchisee, not the franchisor of the franchise in question, and that the trademarks belong to the foreign franchisor. As the foreign franchisor should have submitted an application for the franchise prior to the sale of the franchise to the master franchisee pursuant to section 54 of the FA, all relevant information pertaining to its operations and experiences would have been provided to the Registrar of Franchises (ie, the Franchise Development and Direct Sales Division of the MDTCA) during such application. It should also be noted that the Franchise (Amendment) Act 2020 (ie, gazetted on 6 March 2020, but not in force yet as at the date of the publication of this chapter) has imposed a mandatory requirement on foreign franchisors to seek approval applications under section 6 of the FA before they are able to make an offer to sell the franchise to any person in Malaysia.  The Franchise (Amendment) Act 2020 is scheduled to come into force on 31 December 2020.

Section 16 of the FA provides that an updated disclosure document must be filed annually by the franchisor, within six months of the end of the financial year of the franchise business.

In the case of a sub-franchising structure, who must make pre-sale disclosures to sub-franchisees? If the sub-franchisor must provide disclosure, what must be disclosed concerning the franchisor and the contractual or other relationship between the franchisor and the sub-franchisor?

A local franchisor must submit to a franchisee a copy of the franchise agreement, together with the disclosure documents, at least 10 days before the franchisee signs the franchise agreement with the franchisor. Basically, disclosure documents provide a full overview of the franchise business system that will be franchised to the franchisee. A franchisor’s failure to submit these documents is an offence under the FA. If there is any material change in the disclosure documents, they must be amended and filed with the Franchise Development and Direct Sales Division of the MDTCA (Registrar of Franchises). The franchisor must submit an annual report with the Registrar of Franchises within six months of the end of the financial year of the franchise business, failing which is an offence. The report must contain updated disclosure documents.

What due diligence should the parties undertake before entering a franchise relationship?

Both franchisors and franchisees should undertake due diligence before entering into a franchise relationship. Although there is no specific process or exhaustive checklist for the due diligence, it can entail taking a number of action items or steps, namely from checking if the franchise in question has been registered and approved by the Franchise Development and Direct Sales Division of the MDTCA to operate in Malaysia, to speaking with other franchisees in the network and conducting desktop research online. An important and relevant source of information would be the disclosure document and franchise agreement, which must be provided by the franchisor at least 10 days before the franchisee signs the franchise agreement. The franchisor should conduct a company or business search (on the legal entity) and credit checks on the franchisee (or its key person).

What information must the disclosure document contain?

The disclosure documents contain a large amount of information, including, without limitation, the following:

• name, business address and type of business, including the franchisor’s business experience;
• details of the intellectual property rights granted to the franchisee;
• types and amount of fees imposed on franchisees;
• other financial obligations, including advertising, training or service fees payable;
• whether the franchisee is required to purchase equipment or products from the franchisor or from a source designated by the franchisor and, if so, the identity of the source;
• the obligations of the franchisor, prior to operating or during operation, in determining the business site;
• the territorial rights granted to the franchisee and circumstances when the boundary of the territory may be altered;
• the franchise term, terms for renewal and termination of agreement by the franchisor or franchisee, and the parties’ obligations upon termination; and
• the franchisor is required to submit audited financial statements for the past three financial years and financial forecasts for five years. The requirement for financial forecasts for five years (instead of three years previously) were amended pursuant to the Franchise (Forms and Fees) (Amendment) Regulations 2007, which came into operation on 15 December 2007.

Is there any obligation for continuing disclosure?

Section 15 of the FA provides that a franchisor must submit to a franchisee a copy of the franchise agreement and disclosure documents at least 10 days before the franchisee signs the agreement with the franchisor. This seems to suggest that if the franchisors were to sign new franchise agreements (for the renewed terms) with the current franchisee, they would have to provide such disclosure documents.

How do the relevant government agencies enforce the disclosure requirements?

It is a criminal offence under the FA to make false statements of material fact or to omit a material fact that renders the statement misleading in the disclosure documents. It is also a criminal offence if the franchisor fails to submit copies of the disclosure documents to the franchisee at least 10 days before the franchisee signs the franchise agreement. Failure to update the disclosure documents when submitting an annual report would also amount to an offence.

What actions can franchisees take to obtain relief for violations of disclosure requirements? What are the legal remedies for such violations? How are damages calculated? If the franchisee can cancel or rescind the franchise contract, is the franchisee also entitled to reimbursement or damages?

In the event of violations of disclosure requirements, the franchisees may lodge a complaint against the franchisor with the Registry of Franchises.

A contract induced by misrepresentation is voidable at the choice of the innocent party. The innocent party may rescind the contract by giving notice to the other party and any party who has received any advantage under the contract is bound to restore it, or compensate the other party for it.

The general rule governing the extent of damages payable is laid down in section 74 of the Contract Act 1950:

When a contract has been broken, the party who suffers by the breach is entitled to receive, from the party who has broken the contract, compensation for any loss or damage caused to him or her thereby, which naturally arose in the usual course of things from the breach, or which the parties knew, when they made the contract, to be likely to result from the breach of it.

In the case of sub-franchising, how is liability for disclosure violations shared between franchisor and sub-franchisor? Are individual officers, directors and employees of the franchisor or the sub-franchisor exposed to liability? If so, what liability?

Unless the franchisor is a party to the contract between the master franchisee and sub-franchisees, the franchisor will not be liable to the sub-franchisees as there is no privity of contract between them. Nevertheless, in most agreements between the franchisor and sub-franchisor, there would be an appropriately drafted warranty and indemnity clauses to address this issue. Individual officers, directors and employees of the franchisor or sub-franchisor, as the case may be, will not be liable unless they are personally party to the contract or if the other party is able to lift the corporate veil to impute liabilities to them personally.

In addition to any laws or government agencies that specifically regulate offering and selling franchises, what are the general principles of law that affect the offer and sale of franchises? What other regulations or government agencies or industry codes of conduct may affect the offer and sale of franchises?

Apart from the FA, the provisions in the Contracts Act 1950 would be relevant and may affect the offer and sale of franchises.

Other than franchise-specific rules on what disclosures a franchisor should make to a potential franchisee or a franchisee should make to a sub-franchisee regarding predecessors, litigation, trademarks, fees, etc, are there any general rules on pre-sale disclosure that might apply to such transactions?

There is a requirement to provide the franchisee with the disclosure documents and the franchisee’s right of termination under section 18(5) of the FA during the cooling-off period, as well as a provision in section 37 of the FA that provides that a person who, whether directly or indirectly, makes any untrue statement of a material fact or omits to state a material fact that renders his or her statement to be misleading commits an offence. Apart from this, no other general obligations for presale disclosure apply to franchise transactions.

What actions may franchisees take if a franchisor engages in fraudulent or deceptive practices in connection with the offer and sale of franchises? How does this protection differ from the protection provided under franchise sales disclosure laws?

If the franchisor engages in any act, practice or course of business that operates or would operate as a fraud or deceit upon any person in relation to an offer to sell or a sale of a franchise, the franchisor commits a criminal offence under the FA that will entitle the franchisee to lodge a complaint against the franchisor with the Registrar of Franchises. If convicted, the franchisor may be liable for a maximum fine of 250,000 ringgit for the first offence. Further, the court may declare the franchise agreement null and void and may order the franchisor to refund any payments obtained from any franchisee or prohibit the franchisor from making any new franchise agreement or appointing any new franchisee.

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3 May 2020