January 2009 Franchising World

The United States, although an open market without legal complications of franchising in other countries, has unique legal challenges for foreign franchisors.
 
By Erik Wulff 

Although those of us sitting on the United States side of the pond often view franchising as uniquely American, the reality is that franchising   is an increasingly global phenomenon crossing many different borders–not just outbound from the United States. Consumer brands are being promoted cross borders globally, including many retail and service brands that emanate from other countries. And in connection with this global activity, much research and discussion takes place about the strength of various markets, and the advantages and disadvantages of pursuing those markets. Aside from issues relating to the size of market, economic growth, demographics and other commercial and cultural issues, the legal hurdles or challenges are not often addressed. Not surprisingly, a market which may be commercially very attractive may be difficult from a legal perspective or present unusual legal risks. Although one might be inclined to place major markets like China, India and Russia in this category, the United States itself presents a unique set of legal challenges and risks for the foreign franchisor.  
  
Looking at the United States from the perspective of a foreign business person, it is undeniably the largest consumer market in the world and for many highly attractive. There are, of course, business challenges–an extremely competitive environment, a diverse population and demographics; large geographic territory; difficulty in developing brand awareness–but often the legal challenges give foreign business persons the most pause about expanding into the U.S. market. Anecdotal stories lead to a widespread perception that the United   States has a mind-bogglingly-complex legal system with severe consequences for non-compliance; the United States is a litigious society, with disputes being litigated rather than resolved, and risks of class-action lawsuits with potential for huge jury verdicts; and U.S. laws seeking to reach conduct and defendants beyond its own borders.
  
Certainly there is some basis for this apprehension. Rather than address these general conceptions (or misconceptions), let’s look specifically at some of the legal challenges to the non-U.S. brand owner seeking to franchise in the United States.
  
Typically, when expanding into a foreign country through franchising, there is a host of legal issues to be considered, such as non-resident withholding taxes, foreign exchange controls, import duties, government approvals, protection of intellectual property rights, filings with competition and intellectual property authorities, central-banks clearances and so forth. In this respect, the United States perhaps is unique in that the list of initial concerns is relatively short, being that it is a relatively open market. But what looms large is franchise law compliance and legal liability emanating there from. Unlike many other countries, the offer and sale of franchises in the United States is regulated throughout the country under the Federal Trade Commission Rule on Franchising and also in 15 states, including the most populous and industrialized ones.   Both federal and state regulations require the delivery of a franchise disclosure document to prospective franchisees, with most states having an additional requirement that the franchise be registered with the authorities before offering and selling franchises. Failure to comply can result in significant legal liability.
  
For non-U.S. franchisors, expanding into the U.S. market typically involves a number of different structural choices, but the most prevalent alternatives are to: grant master franchise rights for the entire country;     or establish a “beachhead operation” in the United States through a wholly owned subsidiary that offers franchises throughout the country. Although there are any number of other alternatives, including establishing a joint venture with a U.S. partner (essentially a variation of master franchising) or direct cross-border franchising (a structure mostly viable only from Canada), the focus here will be on the two alternatives described above.  
  
Master Franchising 
In the context of master franchising, a non-U.S. brand owner typically would look for an established business partner who has successful operations in a related field or who brings a needed skill-set to the relationship, and who has the financial capacity and infrastructure to undertake the development of the U.S. market. In these circumstances, depending on a number of factors, the initial entry can be quite simple.
  
From an FTC rule perspective, a foreign franchisor typically would have   to comply with the rule and deliver a disclosure document because the transaction involves a franchise offering in the United States. However, there are a number of exemptions from these requirements (such as large investment, sophisticated franchisee or fractional franchise), one or more of which typically will be available in connection with the sale of a master franchise for the entire United States. This would obviate the necessity from a federal level to provide disclosure. Yet, this only starts the analysis, as one needs to look beyond the FTC rule and consider state laws, most of which do not have the same types of exemptions as are available under the rule. If the prospective franchisee resides in one of these franchise registrations states (or the “offering” activity, i.e. the negotiations, takes place in that state), the foreign franchisor likely will need to register the master franchise offering, prepare a franchise disclosure document and deliver the franchise disclosure document within a prescribed time period before the sale of the master   franchise, even though the transaction may be exempted at a federal level. On the surface, this may not appear to be terribly difficult, but consider the following:
  
   • The law contemplates a standard offering that would be registered before it is offered to the prospect. However, in connection with master franchise transactions, one typically doesn’t have an opportunity to register before engaging in substantive “offering” discussions with the prospect.
   • As part of what is probably the most comprehensive franchise disclosure rules in the world, the franchisor must also attach audited financial statements that conform to U.S. Generally Accepted Accounting Principles or otherwise have been reconciled to U.S. GAAP by a Securities Exchange Commission authorized accountant.
   • The statutes typically provide for strict liability for the franchisor, rescission and damage remedies and recovery of attorneys’ fees for any violations, and liability for individuals involved in the sales process and individuals who control the franchisor entity. There are also criminal sanctions.   
  
Even if the franchisee is not located in a franchise registration state or the negotiations do not take place in a franchise registration state, state laws may still be triggered. Under some of these state laws, if the master franchise is for a territory that includes the specific state, that in and of itself, under certain circumstances, may trigger application of that state’s franchise law.
  
But this is not where foreign franchisor‘s franchise compliance obligations end. Once the master franchise has been sold and the master franchisee starts selling sub-franchises, the master franchisee will likely have to comply with the FTC Rule on Franchising and the various state franchise registration laws relating to the offer of sale of its sub-franchises. In connection with that activity, disclosure rules require relevant information from both the franchisor and the master franchisee. The exact scope of what is required of the foreign     franchisor is left unclear and it can certainly be interpreted to require comprehensive disclosures, including the attachment of the foreign franchisor‘s financial statements (as noted above, audited consistent with U.S. GAAP), particularly in franchise registration states.
  
Both the FTC rule and the various state franchise registration laws provide for liability for franchise law violations against franchisors and master franchisees, jointly and severally. Thus, it is critical for the foreign franchisor to ensure that its U.S. master franchisee fully complies with U.S. franchise laws, because the foreign franchisor is subject to liability risks as a result of a master franchisee‘s actions or omissions.  
  
Wholly-Owned Subsidiary 
Another approach many foreign franchisors take is to create a U.S.-based, wholly-owned subsidiary that would enter into franchise relations in the United States, whether unit franchises or regional master franchises or development arrangements. With this structure, the U.S. subsidiary would typically not be deemed to be a master franchisee of the foreign franchisor, with the broad and uncertain disclosure requirements with respect to both of them. Indeed, under these circumstances, the disclosure rules respect the insulation of liability of the parent for the subsidiary’s actions, unless the parent company guarantees its subsidiary‘s obligations to franchisees. Although the U.S. franchise offering is the responsibility of the U.S. subsidiary, there are limited disclosures that will be required with respect to the foreign parent company. However, unless the foreign parent company provides mandatory services and products directly to franchisees, or otherwise voluntarily guarantees the obligations of its subsidiary to franchisees, there will be no need for the foreign parent company to have audited   financial statements attached to the disclosure document that conform to U.S. GAAP. Thus, ironically, a foreign franchisor has greater insulation from liability relating to its U.S. franchising activities by establishing a U.S. subsidiary to conduct those franchising activities than by using a third-party master franchisee.  
  
Nevertheless, there are several caveats to this conclusion. First, if the U.S. subsidiary does not itself own the U.S. trademarks and intellectual property rights, these are likely to be licensed from the foreign parent company or an affiliate. Depending on the terms and wording of that agreement, it is conceivable that the relationship between the foreign parent company and its U.S. subsidiary might actually be viewed as a master franchise relationship, triggering the broader disclosure requirements relating to the foreign parent company and the attendant legal liabilities. Another important caveat is the importance of adequately funding the U.S. subsidiary and respecting the necessary corporate formalities of a U.S. corporation. U.S. case law is replete with circumstances where U.S. subsidiaries’   liabilities are attributed to its foreign parent company under theories like “piercing the corporate veil,” as a result of failure to adequately capitalize and or respect corporate formalities. One prime example where this occurred was in the Broussard v. Meineke lawsuit, in which the English parent company of Meineke (a U.S. company) was held liable for a $300 million class-action verdict against Meineke. (Ultimately this verdict was reversed on appeal.)
  
Although the United States is an open market without many of the legal complications of franchising in other countries, it has its own unique legal challenges and risks that should caution foreign franchisors to proceed carefully. The anecdotal stories about the U.S. legal system are not without basis, and although the United States may be a most lucrative market, legal compliance cannot be approached cavalierly.

Erik Wulff is a partner in the Washington, D.C. office of DLA Piper US LLP. He can be reached at 202-799-4271 or  erik.wulff@dlapiper.com  .

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