Franchise Report

Preparing for International Franchise System Expansion - Key Considerations For Every Franchisor

As franchisors and their counsel well know, franchise system expansion in the U.S. has been significantly hindered by the economic conditions over the past 24 months, including the lack of readily available financing and general softness in consumer demand.

However, as the U.S. and global economies recover, franchisors are looking forward to better times, and many franchisors will consider expansion opportunities outside of the U.S. borders as the global economy continues to become more interconnected and demand for international brands increases. Although not every franchise system is a good candidate for international expansion and some systems simply need more time developing their concept domestically before expanding internationally, franchisors that are ready should be proactive in planning for expanding their brands outside of the U.S.

Whether a franchisor is venturing outside of the U.S. for the first time or a franchisor that has already begun expanding internationally is going into new countries, there are some key issues that every franchisor must consider before pursuing new international franchising opportunities.

International Trademark Considerations

One key issue for international expansion is whether the primary trademarks of the franchise system will be available for use in the target country. Trademark rights are limited to the borders within which they are established, either through use of a mark or through registration. Because of the cost of registration and other considerations, it is not practical or cost efficient to register a trademark in all countries. Therefore it is important to carefully consider a strategy for registration of trademarks that precedes expansion of the franchise system.

In certain countries, such as the U.S., Canada, Australia, Hong Kong, the U.K. and South Africa, trademark rights can be established through use of a mark. In “first-to-use” countries, the first user is generally entitled to the mark over a subsequent user or intervening registrant. Registration is not mandatory in these countries, however, most first-to-use countries have a procedure for filing an “intent to use” application, which will provide protection for a mark during the pendency of the application prior to it being in use. In general, the mark will be required to be in use within approximately 3-5 years in order for a registration to be granted.

On the other hand, in most countries, trademark rights are established by the party that is “first-to-file” a trademark application. Unless a mark is famous in a significant portion of the world, any party can file an application to register a trademark and gain the exclusive rights to use the mark in that country.

In “first-to-file” countries such as Argentina, Brazil, China, Japan, Saudi Arabia, the U.A.E. and most countries in Europe, use of the mark is not required in order to file an application or obtain a registration. However, if the mark is not in use after 3 to 5 years, depending on the country, the registration becomes vulnerable for cancellation for non-use. Therefore, franchisors should periodically consider where they expect expansion to occur in the next 3 to 5 years and file applications for registrations in those countries as part of their overall intellectual property protection strategy.

Certain protocols among countries may help reduce the cost and administrative burdens of filing for trademark protections in the member states. However, with a few exceptions, each country maintains its own trademark registration system. While the underlying principles of trademark rights are similar throughout the world, each country sets its own standards for registration, including whether descriptive marks are registrable, how similar a mark can be to another mark and still be eligible for registration, and whether it will accept consent from the owner of a cited mark to overcome an objection.

Careful consideration should be given to filing international trademark applications. In first-to-file countries, a potential or current franchisee or other party may attempt to hijack the mark and may effectively prevent the franchisor from registering and using the mark. Accordingly, in order to preserve future expansion opportunities, special consideration should be given to registering primary trademarks in countries where there is interest in the franchise system, regardless of whether expansion is currently planned. Furthermore, even in first-to-use countries, enforcing trademark rights is stronger and more efficient with a registration.

Agreement Changes

Most U.S. franchisors that expand outside of the U.S. use their domestic franchise agreement (and development agreement, if applicable) as a starting point for the document they use in international markets. Of course, if the franchisor implements a different structure internationally (e.g., master franchising), new documents will need to be developed and/or existing documents may need to be significantly modified to address the structural differences, and if the business terms generally offered for international deals will differ from the U.S. business terms, those differences will need to be contemplated as well.

More generally, before using any domestic franchise agreement or related agreement outside the U.S., the document will need to be “internationalized.” For example, provisions must be added to address currency issues and possible government restrictions on payments or exchange controls, an enhanced tax “gross-up” provision or other mechanism should be added, and the dispute resolution provisions will likely need to be revised. Additionally, other provisions should be examined and may need to be supplemented or modified, including development/construction provisions (e.g., removal of Americans with Disabilities Act language and replacement with more general language regarding compliance with applicable disabilities laws), trademark provisions (e.g., requiring that the franchisee cooperate with the franchisor with respect to required filings, including executing registered user agreements), advertising fund provisions (e.g., whether the franchisee will be required to contribute to the U.S. advertising fund or whether a separate international or country-specific advertising fund will be created), and the operations manual provisions (e.g., whether the franchisee will be permitted to translate the manuals to the local language, and, if so, under what conditions).

Country-specific changes to the Franchise Agreement may be required in certain jurisdictions as well. The scope and degree of country-specific changes will vary from jurisdiction to jurisdiction, but it is critical to have local counsel experienced in franchising review the relevant documents and provide input on required and suggested legal and business changes in order to ensure that the agreements are generally enforceable and that none of the terms of the agreements violate public policy or other statutes or regulations in the country. Local counsel should also provide advice on other matters, including franchise relationship issues (e.g., if franchisors are required to pay terminated franchisees “indemnities” or other amounts), tax issues implicated by franchise relationships in the country, and issues relating to industry-specific regulation and licensing in the country.

Franchise Disclosure and Registration

The state of franchise regulation outside the U.S. seems to be in constant flux. Jurisdictions that previously did not have franchise regulations continue to implement regulations that require franchisors to provide franchise disclosure and, in some cases, register the franchise offering, before offering and selling franchises. Additionally, countries that already have franchise regulations on the books often modify their regulations in ways that impact franchising activities in those countries. For example, South Africa recently enacted a franchise disclosure law which became effective in April 2010. Also, within the past two years, South Korea made significant changes to its existing franchise law.

Approximately 18 countries outside of the U.S. currently have some form of franchise regulation. Those countries include: Australia, Belgium, Brazil, Canada (currently, only in the provinces of Alberta, Ontario and PEI, but New Brunswick and Manitoba have recently enacted new disclosure laws that are not yet effective -- New Brunswick published regulations for its Franchises Act in June 2010, and the law is expected to come into force in early 2011), China, France, Indonesia, Italy, Japan, South Korea, Malaysia, Mexico, Romania, South Africa, Spain, Sweden, Taiwan and Vietnam.

In many cases, these laws require franchisors to prepare entirely new franchise disclosure documents (FDD) that may differ significantly in form and substance from the franchisor’s U.S. FDD. At a minimum, the U.S. FDD will have to be supplemented with a “wrap-around” addendum to address the country-specific disclosure requirements, although this approach is not permissible in a number of countries. Some of these laws also require filing/registration of the franchise disclosure document before franchise offers can be made or the franchisor can accept any money from prospects or sign an agreement relating to the franchise. Countries with filing/registration requirements include Malaysia, South Korea, Spain and Vietnam. Additionally, these disclosure laws typically require the franchisor to provide the franchisee with a disclosure review period or a cooling-off period before or after the franchise agreement is signed or money is paid to the franchisor, and these cooling-off periods can be significant (e.g., the 30 business day period in Mexico).

The above is intended to be a general overview of some of the issues franchisors must be mindful of before beginning discussions with prospective franchisees outside of the U.S. Franchisors must take into account these and other issues before expanding internationally in order to avoid pitfalls and ensure enforceability of their franchise agreements.