FRANCHISORS AND FRANCHISEES: UNDERSTANDING COMPLIANCE RISKS

FRANCHISORS AND FRANCHISEES: UNDERSTANDING COMPLIANCE RISKS

Franchisors and Franchisees: Understanding Compliance Risks

What do KFC, Liberty Tax Service, Fatburger, and Orkin have in common? In addition to storefronts on main streets across America, each of these well-known companies operates franchises in foreign markets. While franchising traces its roots to the Middle Ages, the business practice did not begin to take hold in the United States until the late 19th century 1. Today, companies at all levels of economic activity rely on franchising to increase their operating footprint. As a result, brands that have become household names continue to grow in popularity and demand domestically and internationally without incurring the considerable investment of time and money that businesses traditionally associate with expanding their company-owned network. Establishing a franchise requires that the franchisor and, more often, the franchisee interact with a broad range of entities and individuals. Much red tape is involved. Locations, operating licenses, and permits must be secured. The business entity has to be registered. Utilities have to be established. There are government inspections to be endured. But something far more sinister often lurks behind the scenes: Officials who are attracted to key government positions out of a perception that U.S.-based companies have deep pockets and a strong desire to compete aggressively on the world stage and who are willing to solicit bribes to smooth the process. For these reasons, as more companies seek to expand their foreign-based franchise network, we believe that the frequency of bribery and corruption undoubtedly will increase. THE INHERENT COMPLIANCE RISK IN THE FRANCHISOR/FRANCHISEE RELATIONSHIP The International Franchise Association defines a franchise as an agreement or license between two parties that allows the franchisee to market a product or service and the methods of the franchisor. In return, the agreement creates an obligation by the franchisee to pay the franchisor fees for those rights. In addition, the agreement obliges the franchisor to provide rights and support to franchisees 2. Therefore, franchising creates a principal-agent problem in that the franchisor (the principal) and franchisee (agent) may not always align 3. By franchising the business, the franchisor removes from the franchisor entity much of the risk that is associated with launching a new store in a foreign market and transfers that risk to the franchisee. In practical terms, securing locations, equipment, permits, licenses, and establishing vendor relationships often falls to the franchisee instead of the franchisor. As an example of issues that can arise, a franchisee may choose to bribe a government official responsible for issuing a health and safety license that they need to open their location rather than bear the expense of remaining closed. The existence of compliance-related risk is not contingent upon the size of the franchise. While well-known international brands such as McDonalds and Subway operate large overseas franchise systems and consequently face considerable exposure to the actions of their franchisees, including risk associated with bribery and corruption, even a franchisor with a single franchised location can generate compliance risk. 1 http://www.franchise-chat.com/resources/where_it_all_began_the_evolution_of_franchising.htm 2 http://www.franchise.org//franchiseesecondary.aspx?id=52625 3 http://ir.ydu.edu.tw/retrieve/105/7-157-183.pdf STEELE CIS 01

INCREASED REGULATORY ACTIVITY ON THE HORIZON While U.S. and foreign law enforcement authorities routinely examine the role of third parties in bribery and corruption schemes, to date there is no public record of Anti-Bribery and Anti-Corruption (ABAC) enforcement involving a franchisor and its franchisees. The absence of ABAC action in this realm does not signal a lack of interest or willingness by regulators to pursue franchisors or their franchisees in cases of suspected wrongdoing. In fact, within the compliance community, there is growing recognition that the control that a franchisor typically exerts over a franchisee, coupled with the benefits that bribery or corruption can bring to both parties, makes it only a question of time before U.S. regulators or their foreign counterparts initiate an ABAC-related investigation of a franchise system. With increased cooperation between global regulators, assuming that U.S. regulators announce the first franchise-related investigation, law enforcement authorities in Canada, the UK, and Brazil will likely pay close attention to the outcome. While ABAC regulators have yet to apply vicarious liability where the franchisor is held liable for the actions of the franchisee prosecutors in criminal matters and plaintiffs and defendants in civil actions involving franchisors do so routinely, especially in labor-related disputes 4. Given its remit, there is no reason for the U.S. Department of Justice, in particular, not to apply the concept. 4 http://www.law360.com/articles/613307/nlrb-joint-employer-redefinition-threatens-franchises 02 Franchisors and Franchisees: Understanding Compliance Risks

RISK-BASED DUE DILIGENCE: AN OVERVIEW Faced with the apparently inevitable threat of investigations of international franchise systems, what can franchisors do to minimize their exposure to bribery and corruption? A risk-based due diligence program is a methodical and systematic process that companies use to examine their third parties. In this case, the third parties are the franchisees and their likely propensity to engage in activity that may violate ABAC-related regulations. Franchisors in a country or region at high risk for corruption may find it appropriate to increase the level of scrutiny to franchisees that are under a master franchise. A master franchise is defined as a franchising contract in which the master franchisor (the owner of the brand name) hands over the control of the franchising activities in a specified territory to a person or entity called the master franchisee. Master franchising is a method that most franchise systems have employed. Regulators encourage companies to employ risk-based due diligence as it provides companies with the intelligence they need to allocate compliance resources to third parties that present the greatest compliance risk. Moreover, regulators consistently warn companies against applying a one-size-fits-all approach to third-party compliance 5. A third-party risk model is based on a number of factors, including analysis of the third party s location, how much business it generates, and the extent of its interactions with government officials. In addition to centralizing the analysis to compliance risk in a single model, it also helps the multinational quantify their appetite for risk. Consequently, the development and application of a risk model to assess franchisee compliance risk can help provide the franchisor with a credible and defensible approach to franchisee compliance. 5 A Resource Guide to the U.S. Foreign Corrupt Practices Act (By the Criminal Division of the U.S. Department of Justice and the Enforcement Division of the U.S. Securities and Exchange Commission), November 2012 STEELE CIS 03

FRANCHISEE DUE DILIGENCE: A TIERED APPROACH Depending on the results of the risk model and the franchisee s inherent compliance risk, three levels of third-party due diligence could exist. One: Vetting a low-risk franchisee involves conducting a Global Database Check (GDC), which includes a search of sanctions, embargo and watch lists, and databases of politically exposed persons. Two: An Open Source Investigation (OSI) applies to franchisees that present a moderate risk. It involves an analysis of online media, including business journals, websites, industry publications, mainstream and local media, and other publicly available sources in English and local languages. Three: Vetting high-risk franchisees requires conducting Enhanced Due Diligence (EDD). An EDD is the most in depth form of due diligence. It typically includes a site visit, a review of public records, identification and analysis of business partners and, where appropriate, interviews to determine the entity s reputation. While the availability of records vary by country, a knowledgeable professional services firm will know from experience which documents they typically can retrieve in each market. Implementing a risk-based approach to franchisee due diligence requires a methodical approach. Similar to the processes that exist to select and manage routine franchisee operations, relevant data may reside in multiple areas of the company. Not surprisingly, embarking on a compliance effort and embedding it within the franchisor s operating model takes time. However, it is never too late to start. As this article shows, regulatory enforcement involving franchise systems could appear at any time. AUTOMATING FRANCHISEE ABAC COMPLIANCE Conducting the initial due diligence of a prospective franchisee is only the first step in a comprehensive risk management program. Periodically, franchisors must conduct ongoing analysis of their franchisees and their commitments to complying with ABAC regulations. To minimize the burden this commitment generates, multinationals often employ a third-party compliance solution that allows the company to centralize critical data in one platform and streamline the onboarding and renewal processes for new and existing third parties, including franchisees. Such an approach removes subjectivity, ensures consistency, increases transparency, delivers a robust audit trail, and fosters confidence within the franchisor regarding their ability to withstand regulatory scrutiny. CONCLUSION The principal/agent relationship is in many respects similar to the multinational/third party relationship that regulators routinely target for evidence of activity that violates ABAC regulations. With the potential threat of regulatory enforcement involving franchisors and their franchisees, adopting a risk-based approach and embedding it within the franchisor s business model can play a critical role in ensuring ABAC compliance or obtaining a non-prosecution agreement or declination in the event of franchisee misconduct. Implementing an ABAC-focused franchisee compliance will require a thoughtful, structured approach. Time is of the essence as more countries join the fight against corruption by enacting laws that apply beyond their borders. While franchising allows companies to expand around the globe, by doing so they cannot avoid the scrutiny of law enforcement agencies at home and abroad. 04 Franchisors and Franchisees: Understanding Compliance Risks

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ABOUT STEELE CIS STEELE Compliance and Investigation Services (CIS) is a global business advisory and compliance intelligence firm offering comprehensive third-party due diligence solutions that help organizations comply with regulatory requirements and align with best practices. With more than 26 years of experience, STEELE CIS provides Fortune 1000 companies and mid-sized businesses with pragmatic solutions, including Regulatory Due Diligence, Third-Party Program Advisory Services, Program Management Services, and Compliance Analytics and Benchmarking Services. With engagements in more than 190 countries, STEELE CIS delivers local and regional expertise with on-the-ground resources. Interested in learning how STEELE provides clients with a credible and defensible FCPA compliance program? Call us at +1 (415) 692-5000, email us at info@steelecis.com, or visit www.steelecis.com. STEELE CIS Worldwide Headquarters One Sansome Street Suite 3500 San Francisco, CA 94104 USA +1 (415) 692-5000 info@steelecis.com www.steelecis.com 2015 STEELE CIS, Inc. CIS-2031504