Legal

Contractual Compliance

As brand licensing in India grows, so does the risk associated with underlying contractual arrangements

As brand licensing in India grows, so does the risk associated with underlying contractual arrangements. Kapil Arora addresses the commercial, financial and intellectual property management related risks which are assuming greater significance.

Brand licensing is a fast growing phenomenon in India, expanding rapidly from traditional areas such as apparel and footwear to entertainment, food and beverages, hospitality, healthcare and education. This has been primarily driven by the growth of the Indian economy, reflected in the rising disposable incomes, the aspirational lifestyles of a growing middle class and increased consumer spending. Some data that reflects this phenomenon  there are over 600 active franchisors, approximately 40,000 franchisees and the total estimated manpower directly employed by the franchised businesses in India is around 3,00,000.  Whilst there are certain restrictions on foreign direct investment (FDI) in Indian retail, many foreign players have established a foothold through strategic licence arrangements, retail franchising agreements, wholesale cash and carry models, etc. But how does licensing work?
Under a typical licensing model, the licensor (the owner of the brand) enters into an agreement with the licensee (user of the brand). Such an agreement grants various rights to the licensee, including the right to use the brand and sell the products or services using proprietary knowledge or trademark. In consideration for these rights, the licensor is entitled to receive a fee from the licensee, which is usually agreed as a percentage of sales, guaranteed minimums or as timeline based fixed royalty payouts. Such licensing models can work for the advantage of both parties. For the licensor, it represents an opportunity to expand geographical reach and footprint, increase revenues and profitability and improve brand visibility. For the licensee, the advantage is a quick start of a revenue generating business arising from a successful and proven brand.
The basic premise of a brand licensing contract is that both parties, will honour their commitment in the agreement. In order to minimise inadvertent noncompliance, both parties need to establish systems and processes to monitor contractual compliance and share information. The compilation, processing and dissemination of this information relies on an open and free exchange, which helps each party monitor the status of the relationship and identify areas of non-compliance, which then can be quickly resolved. But this is not always the case. Very often, contract related problems centre on the lack of transparency between parties.
Fundamental contract problems could arise for several reasons like:

• Reluctance to share information for confidentiality reasons or lack of trust.
• Lack of appropriately skilled personnel to oversee the contractual commitment.
• Absence of processes or systems to generate the information needed.

The static nature of a contract versus the ever-changing business environment increases the likelihood that the processes, personnel and controls in place at the inception of the licensing arrangement, may have changed by its expiration. Furthermore, the inherent nature of the contracting process increases the likelihood of non-compliance. Most companies have strong internal controls during initiation of licensing contracts, but many do not always have a similar focus in the administration phase.
Undertaking a contract risk review is an important means to address the key business, financial and compliance issues associated with each party and identify areas of remediation and improvement. For the licensor, an effective way to develop a risk assessment of the contract portfolio is to separate the risks into three areas:

• Transactional accounting  these risks are whether revenues have been recorded appropriately. For e.g., when collecting royalties, has the licensee over or under reported?
• Operational  these risks relate to the failure to adhere to contract performance requirements. For e.g., a licensee may not have sourced supplies from the designated vendor.
• Legal/regulatory  these risks are associated with non-compliance with regulatory requirements which result in reputational risks and monetary fines. For e.g., counterfeit products/diversions to grey market or where minimum age of workers employed by the licensee is below the statutory limit.

For each licensing arrangement, it is important to develop and perform compliance verification procedures to verify the accuracy, relevance and completeness of reported information, as well as, to address the key risks identified. Processes and controls should also be compared to leading practices at routine intervals to identify and implement risk remediation, revenue enhancement and cost optimisation strategies.
In conclusion, appropriate structuring and periodical monitoring of the licensing arrangements can lead to optimisation of benefits, for both the licensor and the licensee. Co-existing with an open mind, operating on a principle of mutual-accountability and adopting a long term view are the critical success factors for a long lasting relationship.

The author is a Partner with the Advisory Services practice and the leader for Contract Risk Services at Ernst & Young India. He can be contacted at Kapil.Arora@in.ey.com