Corporate Taxation In Indonesia

A company is important to perform business in gaining profit. In many countries, a company is subject to tax obligation. It needs to comply with a wide variety of taxes. One of them is corporate income tax. According to Indonesian Tax Regime, a company is imposed for tax if it has establishment or domicile (place of management) in Indonesia. A foreign company carrying out business activities through a permanent establishment (PE) and local entity will generally have same tax obligations as resident company. In the case a company does not have any PE in Indonesia but does generate income through business activities in Indonesia, then it needs to settle its tax liabilities through withholding system by Indonesian party paying income.

Generally, a corporate income tax rate in Indonesia is 25 percent. However, there are several exemptions. Firstly, for companies listed in Indonesia Stock Exchange (IDX) or public companies (with additional Tbk in their company name) will get 5 percent tax cut, so they will be imposed tax rate 20 percent. Secondly, for small and medium enterprises (SMEs) with an annual revenue below IDR 50 billion obtain 50 percent tax discount, which is imposed proportionally on taxable income of the part of gross turnover up to IDR 4.8 billion. Furthermore, there is one percent income tax tariff on companies with an annual gross turnover below IDR 4.8 billion.

Those tax liabilities shall be paid to the Indonesian State Treasury through a designated tax-payment bank (bank persepsi) and then accounted for Indonesian Tax Authority through the filing of tax returns. For corporate tax, tax returns must be submitted by the end of the fourth month after the end of the financial year with tax payments having completed prior to filing. But it can be extended by up to two months through written notification and tentative tax calculation filed prior to the deadline to the Directorate General of Tax.

Corporate tax can also be arranged to be paid in a prepayment system based on the previous tax year’s liabilities. In addition, late payments of the taxes will bring interests penalties at two per cent per month at a maximum of 48 per cent. Late filing or failure to file a tax return incurs an administrative penalty ranging between IDR 500,000 to 1 million.

Trade and Protectionism

There were some thought-provoking posts from Pierre Lemieux, a Canadian economist from Universite du Quebec en Outaouais. I took some ideas from his writes international trade and protectionism. In this article “You Can’t Benefit from Free Trade if You Don’t Have a Job. Right?” he carved that:

The important point is that free trade benefits consumers more than its competitive pressure harms producers. Economic theory provides a nice geometric demonstration of the proposition that the total cost of protectionism for consumers is higher than its total benefits to producers. The demonstration can be (imperfectly) explained in plain English: if free trade harmed producers more than it benefits consumers, the former could outcompete their foreign competitors by bribing domestic consumers with better prices and still gain compared to ceding the market to foreign producers – and protectionism would not be necessary. When domestic producers are unable to compensate consumers for not patronizing foreign suppliers, it means that free trade benefits consumers more than it harms producers.

From Pierre’s second post “A Protectionist Utopia?”

That free international trade benefits most people, that it increases general prosperity, can be grasped with a reductio ad absurdum. If protectionism were good between countries, it would also be good between states, regions, towns, etc. It would be worth protecting California against Mississippi, if only because wages are 39% lower in Mississippi than in California. “If it could save only one job…” is as bad an argument against international competition as against domestic competition. Protectionist measures do favour some individuals, but it is at the high cost of reducing opportunities for most individuals. And even those who seem to benefit from protectionism, or their children, are likely to lose out in the long run.

ISDA Determination Committee in Determining Credit Event

Overview ISDA

The International Swaps and Derivatives Association (ISDA) is a trade organisation of participants in the market for over-the-counter (OTC) derivatives. Since 1985, the International Swaps and Derivatives Association (ISDA) has worked to make the global derivatives markets safer and more efficient, for example by creating a standardised contract (the ISDA Master Agreement) for all participants who want to enter into derivatives transactions.[1]

Not only ISDA Master Agreement, but ISDA has also developed standard documentation for derivatives such as schedule to the master agreement, credit support documents (optional), and confirmation.[2] The results of this are that (i) the time and cost involved to negotiate and agree on derivative transactions have been significantly reduced (ii) the use of derivatives has grown significantly.[3] Therefore, it is not surprising that derivatives account nearly half of the total outstanding notional worldwide and up to 85 percent of total outstanding notional of contracts concerning emerging market issuers.[4]

Nowadays, ISDA has over 850 member institutions from 67 countries. In reflecting the global scope of the OTC derivatives markets and its membership, the Association’s presence is divided into several regions, which are Canada, United States, Latin America, Japan, Asia Pacific, Europe and Emerging Markets across Europe, the Middle East and Africa.[5] Besides having specific regional offices, ISDA also has several committees namely:[6]

• Functional Committees;
• Product Committees;
• Region-Specific Committees;
• ISDA Industry Governance Committee (IIGC) and Regulatory Implementation Committees;
• Benchmark Committee; and
• Determination Committees (DC).

The ISDA Credit Derivatives Determination Committee

The Determination Committee (DC) was formally established in 2009 with the publication of the DC Rules in connection with the Big Bang Protocol and the March 2009 Supplement to the Credit Derivatives Definitions.[7] The ISDA Credit Derivatives Determinations Committees (DCs) each comprise ten sell-side and five buy-side voting firms, alongside three consultative firms and central counterparty observer members. The DC currently exists in each of the following regions: Americas, Asia excluding Japan, Australia-New Zealand, EMEA (Europe), and Japan.[8] Each DC deliberates issues involving reference entities traded under transaction types that relate to the relevant region. The determinations made by the DCs are governed by the Determinations Committees Rules. The latest amendment of DC Rules is on 2016 ISDA DC Rules January 10, 2016.[9]

The existence of the DC is to compare the facts of particular events with the provisions of standard CDS contracts (including Credit Derivatives Definitions) to make determinations regarding the key provisions of such contracts, including:[10]

• Whether a Credit Event (an event that would trigger the settlement of the CDS and allow the protection buyer to obtain payment for the credit protection purchased) has occurred;
• Whether an auction should be held to determine the final price for CDS settlement; and
• Which obligations should be delivered or valued in the auction.

However, the Determination Committee is different from international commercial arbitration, because the decisions of DC applies to all affected transactions of market participants who have adhered to the Big Bang Protocol.[11] Additionally, unlike traditional adjudicative bodies, the DCs do not resolve party disputes based on adversarial submissions. Instead, they answer standard-form questions posed by market participants, who choose the questions from a limited menu.[12]

The Role of The ISDA Credit Derivatives Determination Committee in Credit Default Swap Transactions

In principle, when a CDS contract is entered into, the two parties thereto agree that the contract will be governed by the Credit Derivatives Definitions and that the determinations of the relevant DC will be binding on the contract. This section will discuss the procedures of the DC when to examine a question from an eligible market participant.

1. Procedures in Determination Committee

First of all, if there is a potential occurrence of a credit event, in order to convene the Committee, any eligible market participant (any counterparty to a relevant CDS transaction) can request a meeting of the Committee by notifying the DC Secretary (ISDA) regarding the issue. The issue posted is in the form of a question to the Determinations Committee on its website (http://dc.isda.org/submit-a-request/), and it shall include a reasonably detailed description of all of the issues. [13] When raising a question to the DC, supporting publicly available information are required as evidence. Therefore it is essential.

Following valid receipt of a request for a meeting of a Committee, the DC Secretary will determine each affected reference entity, the implicated transaction type and the relevant DC Voting Members for each Region.[14]

In order to hold a meeting of a Convened DC to deliberate the request, at least one Convened DC Voting Member must agree to ponder such request, while regarding to a request that has been designated as a general interest question (anonymous), in this case, at least two Convened DC Voting Members must agree to deliberate such request.  However, in instances where a Convened DC Voting Member proposes a request, such Convened DC Voting Member shall count fulfil the applicable agreement requirements (automatically accepted).[15]

Furthermore, a Convened DC cannot hold any deliberations or take any vote unless a quorum is reached. At least 80% of the Convened DC Voting Members must be present (either in person or by telephone, video conference or web conference), if the 80% Requirement is not satisfied at any meeting of the Convened DC, at least 60% of the Convened DC Voting Members must be present for the next meeting and all subsequent meetings of such Convened DC, and if the 60% Requirement is not satisfied at a relevant meeting, at least 50% of the Convened DC Voting Members must be present for all subsequent meetings of such Convened DC is required for a credit event to be declared.[16

There are two things that matter in determining a credit event. First, the decision can only be made based on publicly available facts submitted to the DC. Second, these facts need to be referenced to the ISDA Credit Derivatives Definitions to determine whether a credit event has occurred. This makes the process objective and predictable as possible; the decisions quickly made as well as providing certainty to market participants.

If the DC members have accepted the question and present in accordance with quorum rules, then the DC begins its discussion. Each Convened DC Voting Member only has one vote on a Convened DC, and it is deemed a binding vote.[17] After obtaining a result, the DC Secretary will promptly publish the result on its Website, and an eligible market participant will know whether a Credit Event has occurred.

If it is deemed that a credit event has occurred, the DC will also consider whether to hold an auction to determine the final price for CDS settlement and which obligations the reference entity that the credit protection buyer must deliver to the credit protection seller or valued in the auction. The DC will also publish the auction settlement terms as a regulation to conduct the auction on its website.

2. Procedures for External Review

If DC has made a binding vote, but it is not by a supermajority. Then it shall be referred to the External Review.[18] The external review contains a minimum of 3 (three) external reviewers and up to five independent experts for consideration (the fourth and fifth members, if any, are primarily back-ups). They are selected by Convened DC from the list which provided by ISDA.[19]

In relation to the external review procedure, each voting members in his particular position shall appoint one or more person to present their argument to the external reviewers and participate in oral argument.[20] Then the decision of external review should be decided by the DC decision based on two conditions. The first condition, if more than 60% but less than 80% of the Convened DC votes for a particular outcome, unless the external reviewers unanimously conclude that other outcome is the better answer.[21]

The second condition, while the DC decision is less than or equal to 60% in favour of a specific outcome, the external review decision will be decided in accordance with such DC decision, unless two of three external reviewers consider that another outcome is the better answer.[22] And such decision shall be deemed as the final determination. The External Reviewers will notify the DC Secretary for publishing the decision of the External Reviewers on its website within 5 hours after receiving such information from the External Reviewers.[23]

 

Case Study: General Motors

On 1 June 2009, General Motors and three domestic subsidiaries filed voluntary petitions for relief under Chapter 11 of the United States Bankruptcy Code in the US Bankruptcy Court for the Southern District of New York.[24] Immediately, ISDA Determinations Committees in America deliberated DC Issue No. 2009060102 containing 4 (four) questions as follows:[25]

• Has a Bankruptcy Credit Event occurred concerning General Motors Corporation?
• If a Credit Event did occur, is the date of the Credit Event June 1, 2009?
• Is the date on which the DC Secretary first effectively received both a request to convene the Committee and Publicly Available Information that satisfies the requirements of Section 2.1(b) for the Credit Event with respect to General Motors Corporation June 1, 2009?
• Should ISDA hold one or more auctions to settle Relevant Transactions with respect to which a Credit Event Resolution has occurred by the terms set out in the form of Credit Derivatives Auction Settlement Terms with respect to General Motors Corporation?

Then The ISDA announced that its Americas Credit Derivatives Determinations Committee resolved that a bankruptcy credit event occurred in respect of General Motors Corporation, one of the world’s largest automakers. All Convened DC Voting Members who were present at that day gave 15 ‘Yes’ votes and 0 ‘No’ votes for all questions. The Committee also voted to hold an auction for General Motors Corporation. The members of America Determination Committee as follows:

No.	DC Voting Members	Vote
1.	Bank of America / Merrill Lynch	Yes
2.	Barclays	Yes
3.	Citibank	Yes
4.	Credit Suisse	Yes
5.	Deutsche Bank AG	Yes
6.	Elliott Management Corporation	Yes
7.	Goldman Sachs	Yes
8.	JPMorgan Chase Bank, N.A.	Yes
9.	Legal & General Investment Management Limited	Yes
10.	Morgan Stanley	Yes
11.	Pacific Investment Management Company LLC	Yes
12.	Primus Asset Management, Inc.	Yes
13.	Rabo Bank International	Yes
14.	The Royal Bank of Scotland	Yes
15.	UBS	Yes

Table 1. DC Voting Members America 2009

In light of the speed, the Obama administration was keen to finalise the situation with General Motors; there was concern that unless the auction was held quickly, there might not be any deliverable obligations remaining due to the speed at which the process was proceeding and the potential for a widespread debt-for-equity swap.[26]

As a result, the DC expedited the auction timetable. The final list was published on 10 June 2009 with the auction on 12 June 2009.

Bibliography

[1] (http://www.investopedia.com/terms/i/isda-master-agreement.asp) last visited (5-11- 2016)

[2] The master agreement is an umbrella document which includes the boilerplate provisions (unless varied by the schedule to the master agreement); The schedule to the master agreement is an amendment of the terms of the master agreement as required by the parties; The credit support documents (optional) is a method of providing collateral or security for the obligations under derivative transactions; The confirmation is a document which contains the economic terms of an individual trade.

[3] (https://www.lexisnexis.com/uk/lexispsl/bankingandfinance/document/) last visited (5-11- 2016)

[4] See J. Chan-Lau, Anticipating Credit Events Using CDS with an Application to Sovereign Debt Crises, IMF Working Paper, at 4 (2003)

[5] (http://www2.isda.org/regions/) last visited (5-11- 2016)

[6] (http://www2.isda.org/committees/) last visited (5-11- 2016)

[7] ISDA Credit Derivatives Determinations Committees, Paper on the four-year history of the formation, structure and workings of the ISDA Credit Derivatives Determinations Committees, at 1-2 (2012)

[8] (http://dc.isda.org/about-dc-committees/) last visited (5-11- 2016)

[9] (http://dc.isda.org/dc-rules/) last visited (5-11-2016)

[10] ISDA Credit Derivatives Determinations Committees, Paper on the four-year history of the formation, structure and workings of the ISDA Credit Derivatives Determinations Committees, at 1-2 (2012)

[11] C. Baker, Regulating the Invisible: The Case of Over-the-Counter Derivatives, Notre Dame Law Review, at 1287 (2010)

[12] A. Gelpern & M. Gulati, CDS zombies, European Business Organization Law Review, at 9 (2012)

[13] ISDA Credit Derivatives Determinations Committees Rules 2016 version Section 2. 2.1 (a)

[14] ISDA Credit Derivatives Determinations Committees Rules 2016 version Section 2.2.1 (e)

[15] ISDA Credit Derivatives Determinations Committees Rules 2016 version Section 2.2.2 (a)

[16] ISDA Credit Derivatives Determinations Committees Rules 2016 version, Section 2.2.3 (a)

[17] ISDA Credit Derivatives Determinations Committees Rules 2016 version, Section 2.2.3 (b)

[18] ISDA Credit Derivatives Determinations Committees Rules 2016 version, Section 4.1. (a)

[19] ISDA Credit Derivatives Determinations Committees Rules 2016 version, Section 4.3

[20] ISDA Credit Derivatives Determinations Committees Rules 2016 version, Section 4.5 (a)

[21] ISDA Credit Derivatives Determinations Committees Rules 2016 version, Section 4.6 (d)

[22] ISDA Credit Derivatives Determinations Committees Rules 2016 version, Section 4.6 (d)

[23] ISDA Credit Derivatives Determinations Committees Rules 2016 version, Section 4.6 (f)

[24] (http://www.isda.org/press/press060109.html) last visited (8-11-2016)

[25] (http://dc.isda.org/cds/general-motors-corporation/) last visited (8-11-2016)

[26] (https://www.whitehouse.gov/the-press-office/fact-sheet-obama-administration-auto-restructuring-initiative-general-motors) last visited (10-11-2016)

 

Credit Default Swap and Credit Event

Introduction

Warren Buffett, the CEO of Berkshire Hathaway, described Credit Derivatives six years before the financial crisis in the US as ‘financial weapons of mass destruction’, carrying dangers that, are potentially dangerous.[1] However, Berkshire Hathaway (Buffet’s Company) gained $633 Million from derivatives transactions in 2015; it was increased significantly from $329 Million in 2014.  Recently, he has reissued a fresh warning that “the complex derivatives lurking on banks’ balance sheets are a potential time bomb that could explode in times of stress”.[2] It can be assumed that credit derivatives can be dangerous on the one hand, but also it can be so beneficial on the contrary.

Credit derivatives are financial instruments that trade over the counter (OTC), and its profits are related to the risk of the default of an underlying asset. Within the credit derivative market, the credit default swap (CDS) is the most popular instrument.[3] A CDS is also categorised as the derivatives with contingent payment which means payment is triggered when a credit events occurred; those can be bankruptcy or default on reference entity or a rating downgrade of a reference entity below a threshold level (default requirement) agreed in the contract.[4]

Credit Default Swap

1. Concept

Basically, Credit Default Swap (CDS) works in a transaction when the seller of protection agrees to pay the buyer of protection with an amount in relation to the reference obligation of a reference entity if during such accepted period credit event occurs.[5] The simple description of the mechanism of the Credit Event in CDS transaction can be seen as follows.

Diagram 1. Credit Default Swap

Many people would argue that CDS transactions resemble an insurance contract, because it protects the protection buyer against pre-defined credit events, in particular, the risk of default, affecting the reference entity, during the term of the contract, in return for a periodic fee paid to the protection seller.[6] However, an important difference is that neither party of a CDS contract needs to own the referenced underlying entity, have an insurable interest, or suffer any loss. These are called “naked swaps”.[7]

In terms of Credit Default Swap, the buyer of protection typically has certain commercial objectives such as to create a right to receive a cash flow in the event that an entity to which the investor has a direct exposure fails to make a payment obligation and to speculate on the performance of a particular entity, or category of entities to perform on their debt or other obligation.[8]

2. Credit event

The system works when there is a credit event. The seller of protection (the party assuming the credit risk) either pays the buyer of protection an amount equal to the loss in value of the reference obligation attributable to credit event, which is called cash settlement, or more usually buys reference obligation or an equivalent obligation at its nominal value which is called physical settlement.[9]

As mentioned above, it is essential that the credit event is properly phrasing and restructuring in the operation of credit derivative transaction. Therefore, ISDA has produced ISDA 2014 Credit Derivatives Definition. There are some possible credit events of CDS transactions based on ISDA 2014 Credit Derivatives Definition. [10]

2.1. Bankruptcy

ISDA 2014 Credit Derivatives Definition has completely defined the term of bankruptcy. It includes not just hard insolvency events determined through a court process, but also various events that may occur prior to an insolvency. Broadly speaking a Bankruptcy event happens if a Reference Entity:

• is dissolved (other than pursuant to a consolidation, amalgamation or merger);
• becomes insolvent or is unable to pay its debts;
• makes a general assignment, arrangement or composition with or for its creditors;
• wound up or liquidated (other than pursuant to a consolidation, amalgamation or merger);
• becomes subject to the appointment of an administrator, provisional liquidator, conservator, receiver, trustee, custodian or other similar for all or substantially of its assets;
• has a secured party take possession of all or substantially all its assets.[11]

2.2. Obligation Acceleration

Obligation acceleration means one or more obligations in an aggregate amount of not less than the default requirement (exceed a minimum threshold) have become due and payable before they would have been due and payable on the basis of a default, other than a failure to make any required payment, in respect of the reference entity under one or more obligations.[12]

2.3. Obligation Default

Obligation default covers the situation, other than a failure to pay, where the relevant obligation becomes capable of being declared due and payable as a result of a default by the reference entity before the time when such obligation would otherwise have been capable of being so declared. The default requirement builds in a minimum threshold which the relevant sum being defaulted must exceed before the credit event occurs.[13]

2.4. Failure to pay

One of the causes of a credit event is a failure to pay. This event is exactly as it says: if a reference entity fails to make a payment when and where due on one or more of its obligations in an amount at least as large as the payment requirement, then once any applicable grace period has passed, a failure to pay event occurs.[14]

2.5. Restructuring

Restructuring means that any one or more of the following events takes place in a form that binds all holders of such obligations, such as [15]

• A reduction, postponement or deferral of Obligation principal or contractually agreed interest payments;
• A decrease of principal or premium payable at redemption;
• A deferral of the payment;
• A change in priority ranking causing subordination to another Obligation.

Restructuring differs than bankruptcy, failure to pay, moratorium, obligation acceleration and obligation default which automatically trigger a credit event. It does not automatically trigger of the CDS contract once a Restructuring occurs. It is up to the protection buyer or protection seller to decide whether or not to trigger (with only one required to trigger for the contract to be triggered).[16]

2.6. Repudiation/Moratorium

Repudiation/Moratorium is an event when an authorised officer of the reference entity rejects or challenges the validity of, one or more obligations or declares a moratorium concerning one or more obligations in an aggregate amount of not less than the default requirement. [17]

2.7. Governmental Intervention

Governmental intervention is caused when a government’s action or announcement results in binding changes to certain obligations of a reference entity including a reduction or postponement of principal or interest or further subordination of the obligation, an expropriation, transfer or other event which mandatorily changes the beneficial holder of the obligation, or a mandatory cancellation, conversion or exchange of the reference entity’s obligations.[18]

Bibliography

[1] W. Buffet, Berkshire Hathaway Annual Report, (2002)

[2] (http://www.telegraph.co.uk/business/2016/05/01/warren-buffett-issues-a-fresh-warning-about-derivatives-timebomb/) last visited (8-11-2016)

[3] (http://www.investopedia.com/terms/c/creditdefaultswap.asp) last visited (8-11-2016)

[4] J. Chan-Lau, Anticipating Credit Events Using CDS with an Application to Sovereign Debt Crises, IMF Working Paper, at 3 (2003)

[5] P. Wood, Law and Practice of International Finance, at 432 (2007)

[6] J. Kiff, et all, Credit Derivatives: Systemic Risks and Policy Options, IMF Working Paper, at 4 (2009)

[7] M. Swantek, A Brave New World: Credit Default Swaps and Voluntary Debt Exchanges, John Marshall Law Review, at 1232 (2012).

[8] A. Hudson, The Law of Financial Derivatives, 3^rd edition, at 77 (2002)

[9] P. Wood, Law and Practice of International Finance, at 434 (2007)

[10] The 2014 ISDA Credit Derivatives Definitions are an updated and revised version of the 2003 ISDA Credit Derivatives Definitions. This document contains the basic terms used in the documentation of most credit derivatives transactions. The ISDA 2014 Credit Derivatives Definitions Protocol was open from August 21 to September 17, 2014.

[11] ISDA Credit Derivatives Definitions 2014, Section 4.2.

[12] ISDA Credit Derivatives Definitions 2014, Section 4.3.

[13] ISDA Credit Derivatives Definitions 2014, Section 4.4.

[14] ISDA Credit Derivatives Definitions 2014, Section 4.5.

[15] ISDA Credit Derivatives Definitions 2014, Section 4.7.

[16] H. Haworth, A guide to Credit Events and auctions, Credit Suisse Paper, at 9 (2012)

[17] ISDA Credit Derivatives Definitions 2014, Section 4.6.

[18] ISDA Credit Derivatives Definitions 2014, Section 4.8.

 

Grounds for Termination of Franchise Contract : a General View

One of the challenges in drafting a contract is the termination clause. The right to terminate a contract is, in practice, often the most important aspect of the law of contract, yet this significance is often concealed in contract texts.[1]  In general, there are two common grounds for terminating the franchise contract, namely (i) termination by provisions in the franchise contract and (ii) termination by legislation. The second basis is usually used to terminate agreements without termination clause. Therefore, either party can propose the termination of the contract if the agreement infringes particular legislation.

1. Franchise Contract with Termination Clause

Termination in Cooling Off Period

It is unusual for a franchisee to be given an early right to terminate. In practice, often the existence of the franchise is in a weak position compared to the franchisor. However, the cooling-off period allows the franchisee to terminate the franchise agreement within a specified period after entering the agreement, or before the payment of any non-refundable money. Some jurisdictions take the view that a cooling-off period is a necessary protection that gives a franchisee the chance to “back out” of an executed franchise agreement.[2] For instance, Australia requires some cooling off period after the execution of the franchise agreement during which the franchisee can withdraw from the relationship.[3]

Termination with no Breach by Franchisee

In general, this circumstance occurs when a franchisor terminates the agreement before it expires and without the consent of the franchisee. Before terminating the franchise agreement, the franchisor shall give reasonable written notice of the proposed termination, and reasons for it, to the franchisee. The right to end a contractual relationship must be found in the express text of the agreement, may arise by necessary implication to give effect to parties’ intentions, or be predicated on the other party’s fundamental breach. In the modern franchise context, the right to terminate is invariably found in the text of the franchise agreement, although it can also arise – in narrow circumstances – by implication of law. [4]

In some states in the USA, there is an obligation of the franchisor to repurchase inventory of franchisee upon termination of the franchise. For example, under the Wisconsin Fair Dealership Law, a franchisor shall repurchase all inventories sold by the franchisor to the franchisee for resale under the franchise agreement at the fair wholesale market value. Under the California Franchise Relations Act, where a franchisor terminates a franchise other than in accordance with the Act, he shall offer to repurchase the franchisee’s resalable current inventory at the lower of the fair wholesale market value or the price paid by the franchisee. Similar statutory protections of the franchisee’s investment exist in Connecticut, Iowa, Michigan, Washington, and Minnesota.[5]

Breach of Franchise Agreement by Franchisee

Franchise agreements usually give to the franchisor pervasive express power to terminate the agreement and many different situations in which the Franchisor is allowed to end. The general mechanism is that a franchisor is required to give notice to the franchisee, and the notification to the franchisee to terminate the franchise agreement with the franchisee should be reasonable. On that case, the key then shifts to the franchisor to decide whether to terminate the franchise agreement. The franchise agreement typically provides a mechanism for doing so.[6]

A franchisor wishing to terminate the franchise agreement earlier (before the end of the term in the franchise agreement) will typically rely on the default and termination provisions of a franchise agreement. For instance, the franchisee conducted infringements such as non-payment of royalties, failure to achieve minimum performance or inability to provide a periodic report. The default and termination provisions also usually set out what acts, or omissions of the franchisee are curable or non-curable.[7] Mostly the agreement will be terminated if the franchisee has done a serious breach. A violation is considered “serious” if and when the continuation of the business relationship between the parties has become completely impossible.[8]

As an example according to American Law, a case of breach of contract by franchisee between 7-Eleven, Inc. v. Chaudhry [2002] was summarized as follows – A convenience store franchisor sued its franchisee for breach of three separate franchise agreements, fraudulent conveyance, and unfair trade practices stemming from the franchisee’s failure to maintain a minimum net worth of $10,000 per store. When 7-Eleven terminated the franchises, it conducted change over audits that revealed unpaid balances on the three open accounts and fraudulent transfers of inventory among the franchisee’s stores. The court granted 7-Eleven summary judgment, based on the franchisee’s failure to respond to requests for admissions and its lack of opposition to the motion, and awarded 7-Eleven damages and legal fees of $567,930.64.[9]

Breach of Franchise Agreement by Franchisor

In many different situations, the franchisee has rights to terminate the franchise agreement as well. The general mechanism is that a franchisee is also required to give notice to the franchisor. Moreover, in order to end a franchise agreement for breach by the franchisor, the Franchisee must show that the franchisor has breached a condition of the Franchise Agreement or fundamentally violated the terms.

The franchisee is required to show that the franchisor broke key terms of the franchise agreement. The breach of the franchise agreement has to be extensive.  So much so that it becomes practically impossible for the franchisee to continue operating the franchise. For instance, the franchisor failures to provide training and support as agreed, fraud concerning potential profits, failure to protect the franchisee’s business opportunity or territory.[10]

As an example according to American Law, a case of breach of contract by a franchisee between Mathis v. Exxon Corp. [2002] was summarised as follows – The franchisee (Mathis) alleged that Exxon had set gasoline prices at a level to drive them out of business and replace them with company-operated retail outlets. The franchise contract was terminated, and the jury awarded the franchisees $5,723,657, exactly 60 percent of the claimed overcharge. The trial court also granted plaintiff’s attorney fees of $2,289,462, or 40 percent of the damages.[11]

1. Franchise Contract with No Termination Clause

The circumstances in which a franchisor may terminate a franchise agreement are generally governed by termination provisions in the franchise agreement. However, there are also some franchise contracts with no termination clause, and the termination of this kind of agreement is usually based on expiry of agreement or legislation of the state.

 Expiry of Franchise Contract

It is common that the franchise agreement will terminate at the end of the term if either the franchisee or the franchisor does not wish to renew it. Indeed franchise agreements usually grant rights to the parties for a significant period, ten or twenty years often with the right to renew. Even longer terms are often seen. Such lengthy terms are justified by some reasons. For instance, local laws sometimes establish that rental agreements for the unit franchise premises must have certain conditions which necessarily influence the term of the agreement.[12]

There are some countries that impose a minimum term for the franchise agreement. A minimum duration ensures that the franchisee has a chance to recoup its initial investment into the franchised business. In Malaysia, the franchise agreement must be for a minimum period of five years. In Italy, the term is three years. The Indonesian legislation requires a minimum term of 10 years for Master Franchise Agreements.[13]

Legislation on Franchise Contract

Nowadays, the franchise business system has obtained extensive attentions of many states. The attention of the states then encourages them to regulate franchise with special requirements, as the absence of franchise legislation obviously gives a detrimental effect on the position of the parties, particularly in the area of the franchisee.  For instance, because franchising is not legislated for a particular problem, in some South American countries, a franchise agreement may be terminated without invoking any cause in the absence of legislation to the contrary covering distribution or agency agreements.[14] In the USA, because of the huge franchisor-franchisee imbalance of power and massive franchise fraud. 18 states have passed franchise investment or similar laws. These laws’ primary purposes were to prevent franchise fraud and to address this imbalance.[15]

Therefore, although the parties did not provide any termination clause in their contract, the contract can still be terminated automatically on the basis of exceptional circumstances as mandated in the state’s legislation, such as:[16]

• Franchisor no longer holds a licence that the franchisee must keep to carry on the franchised business;
• Franchisor or franchisee become bankrupt, insolvent under administration or an externally‑administered body corporate; or
• in the case of a franchisee that is a company—become deregistered by the government;
• Franchisee voluntarily abandon the franchised business or the franchise relationship;
• Franchisor or franchisee is convicted of a serious offence;
• Franchisor or franchisee operate the franchised business in a way that endangers public health or safety;
• Franchisee acts fraudulently in connection with the operation of the franchised business.

Bibliography

[1] J. Birds, R. Bradgate & C. Villiers, Termination of contracts (Contract law series), at 3, (1995)

[2] See J. Sotos, supra note 8, at 9

[3] (https://www.accc.gov.au/publications/the-franchisee-manual/the-franchisee-manual/ understanding -your-agreement/cooling-off-period), last visited (03-10-2016)

[4] J. Lisus & A. Ship, Restrictions on Unilateral Termination of Franchise Agreements, Canadian Business Law Journal, at 114, (2010)

[5] J. Sotos, Recent Trends in Franchise Relationship Laws, the IBA Annual Conference, at 10, (2011)

[6] (http://www.lawworks.ca/franchise-law-blog/ending-the-franchise-relationship/terminating-a-franchise -agreement-a-primer/), last visited (04-10-2016)

[7] Curable defaults refer to defaults of the franchisee which he can diffuse, repair, or cure. The franchisee can get out of trouble by complying with curing requirements set out in the franchise agreement and, by doing that, avoid being terminated. Non-curable defaults refer to defaults of the franchisee which he or she cannot cure.  Having committed non-curable defaults, the franchisee cannot cure those defaults.

[8] C. Sunt, Termination of Franchise Agreements in Belgium—Legal Pitfalls, Franchise Law Journal 5.1, at 3, (1985)

[9] W. A. Scott, J. H. Wolf, & A. P. Hillman, Franchising from An (Arbitration) to T (Termination), Franchise Law Journal, at 193, (2013)

[10] (http://business-law.lawyers.com/franchises-franchising/franchise-termination.html) last visited (03-10-2016)

[11] See W. A. Scott, J. H. Wolf, & A. P. Hillman, supra note 11 at 193

[12] Gardner et al, Key Issues When Advising Master Franchisees and Area Developers (and Franchisors), International Journal of Franchise Law, at 11, (2013)

[13] J. Sotos, supra note 8, at 9

[14] O. Marzorati, Termination of the Franchise Relationship, International Business Lawyer 25, at  217 (1997)

[15] H. Y. Lederman, Franchising and Franchise Law: An Introduction, Michigan Bar Journal, at 3, (2013)

[16] (https://www.accc.gov.au/business/franchising/ending-a-franchise-agreement) last visited (03-10-2016)

 

Breach of Franchise Contract according to DCFR

A franchise has become a new trend of expanding the business. The distribution of goods and services has remarkably developed in recent years. In the past, manufacturers distributed their products by selling them to established wholesale and retail outlets or by using their distribution chains. Now, however, many manufacturers and producers of services frequently license independently to other distributors or dealers to market their products.  They do not face their customers directly. The obligations of the manufacturer and dealer and the allocation of profit, as well as losses between them, is governed by a franchise contract rather than a sales agreement. Franchising has grown steadily in the last 50 years and is estimated to account for more than one-third of the world’s retail sales.[1]

On the basis franchise contract, the manufacturer (franchisor) as an owner of the franchise business grants a license to a dealer (franchisee) as a business operator, allowing the franchisee to run a business in the name of the former. The franchisee is authorised to use and market goods or services under the franchisor’s trademarks, service marks, and trade names, for a particular length of time.[2]

The franchisee runs his own business by using the brand, and by utilising the method and procedures established by the franchisor. The obligation to use the method and system set by the franchisor brings further consequences that a franchise business is an independent business which cannot be combined with other business activities. However, they are not entirely separated; the franchisor still has a relationship based on the agreement. So the relationship within the franchise contract is beneficial to both parties. Because, in the franchise system, a franchisor permits – licenses the franchisee, in exchange for a fee, to exploit the system developed by the franchisor.[3]

Above all, one of the critical parts of almost any franchise agreement is dealing with how, when, and by whom the franchise can be terminated, and what the parties are required to do. This will analyse the requirements for termination of a franchise contract from the view of Draft Common Frame of Reference (‘DCFR’) originating in an initiative of the European legal scholars.

By privity of contract, the standard rule is that the parties may provide for termination on any provisions they want even a minor non-performance of any obligation under the contract will entitle to the other party to terminate the legal relationship. However, the termination rules regarding franchise agreement under DCFR are different.

Article IV.E.–2:304 DCFR concerning termination for non-performance of the commercial agency, franchise and distributorship contract says:

• (1) Any term of a contract within the scope of this Part whereby a party may terminate the contractual relationship for non-performance which is not fundamental is without effect.
• (2) The parties may not exclude the application of this Article or derogate from or vary its effects.

So it can be concluded that in the case of non-performance of the obligations under a commercial agency, franchise or distribution contract, or similar marketing relationship contract, the contractual relationship may be terminated for non-performance only when the non-performance is fundamental.[4] The DCFR incorporates rules for commercial agency, franchise or distribution contract, or similar marketing relationship contract in the same scope. It is because they have the same nature i.e. businesses supplying goods or services to consumers.

The background of the Article is merely considerable investments of the parties in long-term relationships, and where they are frequently dependent on the continuity of such a relationship.[5] The freedom of contract principle to stipulate for a right to terminate for any minor non-performance is not compatible to contracts in which parties sometimes make such a relationship. The contract shall not be terminated by one party on account of the other party’s mere nonperformance of an obligation unless the non-performance is fundamental.

Therefore, these long-term commercial relationships may be terminated for non-performance if (i) the non-performance is intentional or reckless and gives the aggrieved party reason to believe that it cannot rely on the other party’s future performance, or (ii) the non-performance substantially deprives the aggrieved party of what it was entitled to expect under the contract.[6]

An illustration regarding fundamental non-performance in DCFR as follows – An international chain of hamburger restaurants provides its franchisees with a book containing hundreds of pages and thousands of very detailed instructions relating to all aspects of hamburger selling. The franchise contract says that strict compliance with each of these directions is of the essence of the contract. During a monthly inspection, the franchisor discovers that hamburgers in one particular restaurant are on average 2% too hot. The franchisor may not terminate the franchise.[7] It is evident that 2 % too hot is not a fundamental non-performance.

As comparison regarding the expired period of the franchise contract, the DCFR divides termination of franchise contract into two types: contract for a definite period[8] and contract for an indefinite period[9]. Regarding contract for a definite period, Article IV.E.–2:301 DCFR states:

A party is free not to renew a contract for a definite period. If a party has given notice in due time that it wishes to renew the contract, the contract will be renewed for an indefinite period unless the other party gives that party notice, not later than a reasonable time before the expiry of the contract period, that it is not to be renewed.

The article mentioned above provides a rule for a detailed situation regarding the end of a contract with a definite period. As a basic rule, the contractual relationship will come to an end on the expiry of the definite period, and parties are restricted to renew a contract for a definite period after the expiry of its duration. If one side gives notification to the other in sufficient time that it requests to renew the contract and if the other party desires not to renew the contract, the other party has to reply not later than a reasonable time before the expiration of the contract period. If other party fails to respond by that time, the contract will be renewed for an indefinite period.

Furthermore, in different condition, when the parties, in fact, continue performing the agreement after the end of contract duration, an agreement that was concluded for a definite term does not stop due to the expiry of the fixed term. As a substitute, the contract becomes a contract for an unfixed duration and depending on the same settings. This is the effect of the general rule in tacit prolongation.[10] Under Article III.–1:111 DCFR any contract providing for continuous or repeated performance of obligations for a definite period may be tacitly prolonged if the obligations continue to be performed by both parties after that period has expired and the circumstances are not inconsistent with the parties’ tacit consent to such prolongation.

On the other hand, there is also contract for an indefinite period, Article IV.E.–2:302 DCFR states:

• (1) Either party to a contract for an indefinite period may terminate the contractual relationship by giving notice to the other.
• (2) If the notice provides for termination after a period of reasonable length no damages are payable under IV.E.–2:303 (Damages for termination with inadequate notice). If the notice provides for immediate termination or termination after a period which is not of reasonable length damages are payable under that Article.
• (3) […]

The article above explains that a contract for an unfixed period occurs when (i) it does not contain any detailed duration or (ii) it explicitly states that it is for an indefinite period. In this case, each party has a right to terminate the agreement because the contractual relationship may be terminated individually by giving notification to another party. If the period of notice is not reasonable, the compensation will be payable. However, by Paragraph 2 of this Article, a reasonable period of notice is not a condition for the effective termination of the agreement.

To sum up, according to DCFR, in the case of non-performance of the obligations under a franchise, the contractual relationship may be terminated for non-performance only when the non-performance is fundamental. Regarding an expiration clause, the DCFR divides the termination of a franchise contract into two types: contract for a definite period and contract for an indefinite period. Relating to the contract for a definite period, the contractual relationship will come to an end on the expiry of the definite period, and parties are restricted to renew a contract for a definite period after the expiry of its duration.  But in the case of the indefinite period, each party has a right to terminate the agreement by giving notification to another party.

Bibliography

[1] (http://www.wipo.int/sme/en/documents/franchising_fulltext.html), last visited (03-10-2016)

[2] See E. Gellhorn, Supra note at 467

[3] (http://www.wipo.int/sme/en/documents/franchising_fulltext.html), last visited (03-10-2016)

[4] The list of definitions in the Annex DCFR provides that A non-performance of a contractual obligation is fundamental if (a) it substantially deprives the creditor of what the creditor was entitled to expect under the contract, as applied to the whole or relevant part of the performance, unless at the time of conclusion of the contract the debtor did not foresee and could not reasonably be expected to have foreseen that result, or (b) it is intentional or reckless and gives the creditor reason to believe that the debtor’s future performance cannot be relied on.

[5] See Von Bar & Clive, supra note 1, at 2331

[6] See Von Bar & Clive, supra note 1, at 2331

[7] Von Bar & Clive, supra note 1, at 2331

[8] Article IV.E.–2:301 DCFR

[9] Article IV.E.–2:302 DCFR

[10] Article III.–1:111 DCFR

 

Hypothec for Vessel

Law No. 17 of 2008 on Shipping defines hypothec over a vessel as a collateral right over a vessel that listed to secure certain loan payments and that gives priority rights to certain creditors over other creditors. Given that definition, hypothec over a vessel is one of the types of security rights, together with pledge, fiducia security, security over warehouse receipts and hak tanggungan, that gives its holder priority rights over other creditors.

The definition of vessel includes water vehicles of certain shape or type that are moved by wind power, mechanical power or other energy, pulled or tugged, including vehicles with dynamic support power, submarine vehicles, and floating tools and fixed floating buildings (such as oil rigs).

The Creation

Only vessels registered in Indonesia are considered as Indonesian vessels and therefore if they are encumbered, it should be done in accordance with Indonesian Law.

If the vessels concerned are registered offshore, then they should be encumbered in accordance with the laws of their country of registration or must be re-registered first with Indonesian Flag and registered in the list of Indonesian Vessels. However, there are certain requirements for the registration of vessels such as the size and the ownership status of vessels.

Hypothec over a vessel is conducted with deed of hypothec in Bahasa Indonesia prepared by a vessel registration and listing of transfers of ownership official (Pejabat Pendaftar dan Pencatat Balik Nama Kapal) or (Registration Official) at the relevant Director General of Sea Transportation office where the vessels is registered, and listed in the List. The effective date of the encumbrance is the time the hypothec is registered in the Master List of Vessels Register (Daftar Induk Pendaftaran Kapal). A vessel can be encumbered by more than one hypothec and they are ranked in accordance with their respective dates and numbers written on their respective deeds of hypothec.

The Enforcement

A creditor should serve the borrower with a clear and unequivocal Letter of Demand before enforcing its hypothec. If the borrower does not comply with this letter, then the creditor may proceed with the following methods to enforce its hypothec:

1. The hypothec grantee based on the grosse deed of hypothec may enforce the hypothec through a public auction. This method is similar with the enfocement of hak tanggungan.
2. If there is resistance from the hypothec grantor, the hypothec grantee may apply to a court for a court order. The court order will be used to enforce the hypothec.