The Impact of Risk and Compliance on Cross-Border Sales and Franchising Agreements, Part 1

The impact of risk and compliance to a franchisor looking to expand and sell their brand/franchise overseas is seen in two ways:

1) A franchisor looking to expand into a foreign territory must conduct significant and thorough risk and compliance assessments. A franchisor cannot import the system they have into another country without looking at the following:

• Assess your system and be clear on what it is and what it is offering.

• Research the country and its laws. Do not pick a country and then try to force the system through. Be careful about employment laws, privacy laws, halal/kosher, etc.

• Decide on the structure of the relationship, e.g., area developer, master franchisor, joint venture.

• Do you need to adapt your system including suppliers (look at the recipes, the brand, the methods, the whole system).

• Check if the franchise agreement needs to be adapted for the target country.

• Be realistic about the costs involved—it will not be cheap.

• Engage expert counsel in the target country.

• A consequence of risk and compliance is that the franchisor will need to adapt the franchise system (including products and the name itself) to be successful in the other country.

2) If a franchisor does not conduct the due diligence and assess the impact of risk and compliance on their system and expanded too quickly into a country perceived to bring big rewards, the brand name has suffered and has cost the company significant amounts of money.

Many factors must be taken into account, including the following:

• Cultural: the name of your franchise.

• Translation issues: Translations of agreements must be rendered by lawyers knowledgeable in the local law.

• Consumer preferences: Do you need to vary your system to address local preferences? For example, McDonald’s offers menu items specific to the country.

• Sourcing: Availability of products, fixtures, and equipment is not just about suppliers—it is about the franchisor’s ability to protect the look and feel of the franchised business and the instant recognition of the brand.

• Products/logistical issues: It is essential to ensure that the quality and availability of products is assured. McDonald’s suffered brand damage in China when their meat supplier sold expired meat.

• Measurement: You must adapt everything, including unit measurement.

• Legal issues: These include sanctions laws/anti bribery laws (cartels in NZ), unfair contract terms, dispute resolution, intellectual property issues, etc.

• Knowledge/application of territorial preferences: Examples include ethnic and political makeup. If it is important to observe the ethnic and cultural makeup, it may be better to have the local person be the face of the brand.

Due diligence of business considerations

A franchisor may typically leave some business due diligence to its local partner, relying on the local partner’s knowledge of the market and its industry expertise. If a franchise arrangement covers multiple jurisdictions, the due diligence conducted should cover each target market. The initial business due diligence on any new target market should, at a minimum, include the inquiries detailed below:

• Composition of product or offering of service. Does the product sold require modification to make it locally compliant or culturally acceptable? For example, some jurisdictions regulate whether a product can be labeled and sold as a particular type of food (e.g., halal or kosher). Such required or desired adaptations may also affect a franchise’s services as opposed to products. A franchise may need to inquire whether locally prescribed business hours or religious holidays or practices could affect the proposed operations of the franchised business.

• Suitability of offering. How suitable is the product or service for the target market? Does the name of the brand translate poorly, or is the product culturally insensitive or unpopular? How have competing brands in the marketplace performed? Is there adequate infrastructure to support the franchisor’s business operations? Is there a demand for the product or service in the target market?

• Import and local costs. Will certain supplies or products used or sold in the franchise need to be imported into the target market? Are there tariffs or other local taxes imposed? For those franchises that rely heavily on local supply chains, are affordable suppliers available? Moreover, are there rebates to local or offshore suppliers? Employment of workers, licences and permits, real estate costs, and/or the cost of goods in the target market may lead to significantly higher cost of sales.

• Political and social risks. A franchisor will need to analyze whether the target market presents significant risks, such as political threats or the threat of civil unrest or terrorism. It is also valuable for a franchisor to consider the reputational harm or social backlash it may face in its home country should it decide to expand into an unpopular country.

• Payments. Will local exchange control regulations and/or tax laws restrict the repatriation of profits to the franchisor’s home jurisdiction? Must payments be made in local currency of the target market?

Due diligence on legal matters

A franchisor must also conduct legal due diligence on the potential impact that local laws may have on the expansion of the franchise system to the target market. Often these issues are vetted with local counsel, who is familiar with the analysis needed to address the typical matters presented and is able to make the changes necessary to the franchisor’s franchise agreement. Initial legal issues that should be investigated include the following:

• Legality. Is it legal to sell the goods or services in the target market?

• Trademarks. The franchisor must inquire whether the system’s principal trademarks are registered or are available for registration. The franchisor must also inquire whether the franchisor’s trademark must be registered before it is licensed to a third party to avoid violating local law in the target market. A franchisor should investigate the typical duration of trademark registration in the target market, particularly if registration is required before the offer or sale of the franchise.

• Disclosure or registration. The franchisor should know whether any local laws require disclosures before signing a letter of intent or before accepting any payment from a prospective local partner, and whether disclosure is required before the franchise is advertised or before representatives of the franchisor speak to or meet with a prospective local partner candidate. A franchisor should also know whether local franchise laws require a regulatory filing or approval before a franchise agreement can be offered or executed or upon its execution.

• Mandatory provisions. Jurisdictions that have franchise laws often require that certain provisions be included in franchise agreements. Some of these provisions affect the fundamental elements of the franchise offering—for example, the term of agreement, a mandatory “cooling-off” period, a requirement that the agreement be written in the local language to be enforceable, or mandatory governance by local law.

• Franchise structure. The franchisor should analyze whether the structure of the franchise violates any local laws, such as those related to pyramid selling.

• Local presence. The franchisor should know whether the target market requires it to establish a local subsidiary or branch in the jurisdiction, or whether the franchisor must operate its own units of the franchise being offered for a certain period before it engages in franchising with other local parties. The franchisor should also determine whether foreign investment or ownership laws restrict the franchisor from establishing a presence or investing locally.

• Industry regulations. Are there industry-specific regulations that could introduce additional costs or impractical requirements?

• Travel restrictions. The franchisor should know what is required for the local partner’s personnel to visit the franchisor’s home country or the franchisor’s personnel to visit the target market.

• Compensation and competition. Are there local laws related to termination or non-renewal of franchises? Will the franchisor be required to compensate the local partner at the end of the franchise relationship? The franchisor should also investigate whether it will have the right to require non-competition covenants as they are not always permitted or may be heavily regulated in some countries.

Stewart Germann is a franchising lawyer and partner of Stewart Germann Law Office at Auckland, New Zealand. He is actively involved in international franchising, speaks at international franchising events, and has published articles in the International Journal of Franchising Law. Contact him on +649 308 9925 or at stewart@germann.co.nz.