Franchising and preliminary agreements in Italy: the letters of intent (LOI) and option agreements
Franchisors have been re increasingly expanding in the Italian market in recent years, as the global economy has become more and more connected and brand recognition has flowed across borders. Franchise or master franchise agreements in Italy can be complex, often highly negotiated; they are usually long-term commercial agreements that obligate both parties to commit and/or invest considerable time and resources. Negotiations over such arrangements frequently take months, sometimes years. The first step for many franchisors, in Italy as well as in other countries, is often to negotiate interim deal documents, called letters of intent (“LOI”) before drafting, negotiating, and agreeing on the final agreement terms. Other common preliminary agreements used before signing a franchise agreement in Italy are option agreements.
1. The importance of the LOI (letters of intent) in the context of franchise negotiations in Italy
Franchisors have been re increasingly expanding into Italian markets in recent years, as the global economy has become more connected and brand recognition has flowed across borders. Franchise or master franchise agreements in Italy can be complex, often highly negotiated, long-term commercial agreements that frequently obligate both parties to commit and/or invest considerable time and resources. Negotiations over such arrangements frequently take months, sometimes years.
The first step for many franchisors, in Italy as well as in other countries, is often negotiating interim deal documents, called letters of intent (also called term sheets or memorandum of understandings: in this paper “LOI”, letters of intent). Franchisors frequently use letters of intent as the prelude to the more serious business of drafting, negotiating, and agreeing on the final agreement terms. As international franchising has matured, the use of letters of intent have increasingly become a customary tool used by most franchisors in their activities in Italy.
LOI can provide considerable value in agreeing on material terms, setting expectations, and providing a roadmap for the transaction before engaging in extended negotiations of a franchise agreement. Setting expectations upfront in an interim deal document like a LOI can be extremely helpful as the franchisor may be less familiar with Italian local business practices, especially if coming from countries outside the EU.
As for international franchise transactions in general, franchise agreements in Italy can be multifaceted, costly and lengthy processes. An executed LOI, depending on its terms, may indicate to a foreign franchisor willing to expand its franchise in Italy that it is dealing with a serious prospective franchisee or master franchisee.
Generally, a LOI is signed when the parties have already started or are about to start a negotiation concerning the franchise contract (or, more often, the master franchise contract), but have not yet defined the essential aspects of this agreement. A LOI has essentially the following purposes:
- take stock of the state of the negotiations (“where we are”), separating the issues already resolved from those still open;
- set the terms of the future negotiation, for example by establishing whether and in which terms a feasibility study and/or a due diligence will be made, etc.;
- justify management to continue negotiation, especially if it is expensive and demanding;
- document the status of the negotiation to third parties (for example authorities that must grant authorizations, or financing banks).
2. The letters of intent are binding or not binding agreements?
There is a tendency to believe that a LOI is always a non-binding agreement, which therefore does not expose to liability and risks from a legal point of view; and for this reason, it is often arranged superficially, or in a hurry, or without a good legal supervision. But in fact, this is not always true, under Italian Law. “Non-binding” simply may not mean what you think that words mean.
It is common to enter a LOI in order to agree on key terms as a precursor to further negotiations. At this stage, the parties are typically still evaluating the franchise transaction and each other, and usually do not wish to be held to a binding agreement. Accordingly, a LOI usually contains provisions stating that a party will not be in breach of the interim agreement and/or liable to the other party as a result of a failure to enter into the franchise agreement.
Still, a LOI is subject to the general principle of good faith during negotiations, which exposes the parties to a legal binding obligation. As a civil law country, in Italy the principle of freedom to negotiate has certain limits. Regardless of whether it is expressly provided for in a LOI, under Italian law parties have a duty to negotiate in good faith: this means that they may terminate negotiations at any time, provided that the duty of good faith is fulfilled. If contract negotiations fail, then the party preventing the completion of the contract negotiations may be subject to liability to the injured party, if it can be shown that the party that broke off the negotiations acted improperly, .i.e., violating the duty of good faith.
Unlike common law courts, which are loathe to impose a contract upon a party that allegedly could not come to an agreement, and where in general, the presence of a contract is a pre-condition to a damage recovery, civil-law courts (including Italian courts) are more willing to find liability for broken or ruptured contract negotiations, even at the preliminary stages of these negotiations.
3. The legal liabilities arising out of a LOI
Franchisors often tend to provide enough information for a prospective franchisee to evaluate the deal; however they should take care not to provide too much detail. In fact, the more the parties have indicated information and business points (such as fees, royalties, territories, performance criteria and compliance with system standards, sources of required products or operating systems, etc.) in a LOI, and the more the parties have conduct extensive negotiations after signing a LOI, the more there is the risk that the parties face legal responsibilities if they decide not to proceed with negotiations.
For example, if of the parties, after signing a LOI containing detailed business points), and after months of extensive and serious negotiations, suddenly and without good reason abandons the negotiations, it could incur pre-contractual liability towards on the other party, and therefore could be required to compensate the costs of the negotiations and the loss of favorable contractual opportunities to the latter.
One obvious area of risk for franchisors arises in connection with situations where after a LOI the franchisee is permitted to start operations (for example to sign a lease for the first unit or to attend training), while the franchise contract has not been signed yet. Another common risky situation is where a LOI has expired, but the franchisor and franchisee still continue to negotiate after the term. In all these situations, a refusal to continue negotiations by the franchisor could imply a breach of the pre-contractual duty of good faith.
In case of pre-contractual liability, the damages payable to the other party are typically limited to wasted effort (eg legal fees, travel costs). However, loss of profit claims can also be made where another equal or better opportunity has been lost. For example, an area developer franchisee may have been looking at two alternative franchise concepts; he may have chosen to focus on the first concept telling the other franchisor that they are unable to develop two brands in parallel. If the first concept abandons negotiations unreasonably and the second concept has at that point appointed another developer, the franchisee may attempt a loss of opportunity claim.
4. Binding obligations in a LOI
Often a LOI contains some specific obligations, such as:
- confidentiality agreements, which provide for the obligation not to disclose to third parties the confidential information exchanged between the parties during negotiations. Confidentiality covenants are important to protect the inappropriate use and disclosure of the franchisor’s confidential and proprietary information, regardless of whether or not the parties progress beyond the LOI. Even if the parties do not enter into a franchise agreement, any confidential or proprietary information to which the prospective franchisee (or master franchisee) has become privy during or after negotiation of the interim deal document should be protected.
- no trademark license: since franchisor’s trademarks are essential elements of its brand, a LOI frequently contains provisions making it clear that the franchisor does not grant a license to the prospective franchisee (or master franchisee) to use the franchisor’s trademarks, until a franchise agreement is entered into and then only pursuant to its terms.
- exclusive negotiation: franchisor and prospective franchisee agree not to enter into negotiations in respect of a competing system and territory during the LOI.
All these agreements are binding and enforceable between the parties, and therefore their non-fulfillment is a source of contractual liability, with the consequent obligation of the defaulting party to compensate the damage (in this case in full measure, .i.e., equal to the emerging damage and to loss of profit).
A LOI can also contain other elements from which it can be inferred that the parties have already concluded a definitive and binding agreement. In such cases, even if the parties have signed an agreement (improperly) called “LOI”, the substance prevails over the form.
For example, if in a “LOI” the parties have inserted, in addition to the typical elements of the negotiation phase, also some fundamental elements of the final agreement, such as the price, while referring to a subsequent definition of a series of accessory points, we might be faced not with a simple preliminary interim agreement, but with a real definitive contract, with all consequences in terms of responsibilities.
In particular, -requiring a prospective franchisee (or master franchisee) to make payments or a deposit in connection with the execution of a LOI could create the risk of interpreting such an agreement as binding, obligations, and in some cases create additional issues (such as tax implications).
5. The conduct of the parties after a LOI
The conduct of the parties is important, as it may determine the real intent of the parties by signing a LOI. In fact, if the parties begin performance based on the terms in a “non-binding” LOI, such conduct may evidence the intent to represent binding terms, such as would be found in a purchase order. The more performance by one or both parties, the easier it is to reach this conclusion.
For example, if the parties have stated in a LOI that they are just evaluating the terms of a possible future franchise contract, but at the same time the conduct of a party conflicts with the terms of the LOI (for example, the prospective franchisee makes some payments, or the franchisor performs a due diligence), then there is a practical risk that the LOI could be viewed as a binding agreement. Similarly, allowing the franchisee to use of the franchisor’s trademarks or delivering product or proprietary systems could reasonably indicate that the LOI reflects a definitive agreement.
In this regard, it should be carefully considered if the franchisor has provided the other party with disclosure documents, together with the signing of a LOI. In Italy, franchise Law n. 129/2004 provides for disclosure requirements.
Disclosure information is not required by Italian franchise law as far as preliminary interim agreements are concerned (such as a “real” LOI), but is required in connection with a binding agreement. Therefore, if a franchisor signs a “LOI” with a potential franchisee but at the same time discloses to him the information provided for Italian franchise law, this could mean that in this case the parties have signed not only an interim preliminary agreement, but a real binding agreement.
6. Option agreements
Other widely used preliminary agreements in Italy, to be signed before the franchise agreement, are option agreements. Through an option agreement, the franchisor grants the aspiring franchisee the right to conclude the franchise agreement, within a certain period and under certain conditions. In fact, the franchisor formulates an irrevocable proposal to conclude the franchise contract to the aspiring franchisee, who, as an option, is free or not to accept it, within a certain period.
By signing an option agreement, therefore, the aspiring franchisee is not bound to conclude the franchise contract; this will only happen if the same decides to exercise the option, notifying the franchisor within the agreed terms (in which case the franchisor will be required to enter into the franchise agreement, under penalty of his liability for non-fulfilment). If, on the other hand, the aspiring franchisee does not exercise his option right within the established term, the legal bond ceases and the franchisor will be free to enter into agreements with third parties.
Usually, by the signature of the option agreement the aspiring franchisee pays the franchisor a fee, which remunerates the franchisor for the exclusivity in a specific area that is granted to the aspiring franchisee. In fact, as a result of the exclusivity right, the aspiring franchisee has the guarantee that, over time and in the territory provided for in the option contract, the franchisor will not stipulate franchise agreements with other parties.
Often, moreover, the amount paid by the option holder also serves to remunerate the franchisor for a series of consultancy and assistance services that the latter undertakes to provide to the aspiring franchisee during the option agreement, such as, for example, the identification of a suitable location for the point of sale, carrying out market research, a personalized business plan, etc.
If the option holder (aspiring franchisee) decides not to exercise his option right and therefore not to sign the franchise contract, the franchisor will retain the fee paid by him, as remuneration for the obligations assumed. If, on the other hand, the aspiring franchisee decides to exercise the option and sign the franchise agreement, generally the sum paid by them is considered as an advance for the entry fee, to be paid by the franchisee at the signature of the franchise agreement.
Option agreements are widely used in Italian franchising practice, as they allow aspiring franchisees to take advantage of a certain amount of time available to choose the location of the store and familiarize themselves with the network, without losing exclusive territory. In fact, it may happen that an aspiring franchisee evaluates positively the proposal to join a franchise network, but for many reasons is not ready to sign the franchise agreement. Through the option right granted to him by the franchisor, he can thus sign the franchise agreement at a later time, exercising this right within the conventionally established term.
7. Conclusions: the importance of a good local legal advice
If drafted correctly, LOI and option agreements can provide a useful road map of the essential business terms for the definitive franchise or master franchise agreement. However, franchisors (or of course franchisees) may face legal consequences if a LOI is deemed binding, especially if the agreement is not well drafted or ambiguous on the agreement’s binding or non-binding nature. The same may happen if an option agreement is signed improperly.
While there is no “one-size-fits-all” approach to starting an international franchise transaction, it is essential that foreign franchisors know, or hire someone who knows, the legal implications of its franchise activities in Italy, to ensure that a LOI or an option agreement is written thoughtfully and carefully, as to protect them from unnecessary legal risks. While nothing will act as a safe harbor against claims for wrongful termination of contract negotiations, knowing the duties imposed on foreign franchisors in advance will make those negotiations less problematic.
Not every international franchise deal needs a preliminary agreement, though. The goal is to enter into definitive franchise agreements on a timely and cost-effective basis; instead of negotiating a LOI, sometimes going straight to definitive documents makes sense, if the parties clearly agree on the basic business points, especially if the timeframe is compressed. Knowledgeable local counsel is, again, of great assistance in determining if such an approach is consistent with the Italian business and legal culture.
Avv. Valerio Pandolfini
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The information contained in this article is of a general nature and is not to be considered an exhaustive examination of the various issues, nor is it intended to express an opinion or provide legal advice. Specific legal advice must be provided with regard to individual cases.