It has become clear that this approach is certainly not the case in current-day compliance. Following on from the obvious cases where the vendor knew, or ought to have known, that a bribe was being paid and was complicit in that activity, the current practice is more that the vendor is required to take steps to ensure that the distributors or resellers are in strict compliance with the FCPA, whether they are technically bound by the law or not, even if they trade in their own name.
Third party compliance programmes have now been developed specifically to manage the third party (i.e. the distributor). They have been designed to look at:
- how the distributor is selected
- the backgrounds and integrity of the distributor
- specialised training for the distributor
- enhanced contract provisions
- special on-going certifications of compliance
- audits and reviews.
All of the above have become very normal in the distributor/reseller relationship. This is the case despite the buy–sell association of the vendor–distributor/reseller relationship.
A major reason that these controls and compliance programmes have been put in place is because of the FCPA and related legislation and the extended reach back to the vendor based on the actions of the distributor; however, the main reason is ethics and integrity. The reputational effect of a partner being involved in illegal conduct almost always impacts the vendor, irrespective of whether there is an issue or not. The “taint” of the allegation and potential judgement is enough to affect the vendor in some way.
The press have a very strong ability to attach the allegation or judgement against the “brand” (the most famous company). We have seen this happen in the supply-chain area as well when independent actions of contract manufacturers in China have impacted vendors simply due to their association.
How have franchisors reacted?
Interestingly, many franchisor companies remain of the view that because they operate a franchise, which by its nature is an independent relationship with the franchisee a separate company which has no ability to contractually affect the franchisor by its actions, they will have no involvement in the compliance of the franchisees. This is despite the fact that we have seen instances where franchisors have been deemed responsible for the acts of their independent franchisors.
Recently, 7-Eleven was investigated in what was allegedly the largest criminal immigrant employment investigation ever conducted by the United States Department of Justice (DOJ) and Department of Homeland Security. The allegations of human trafficking involved franchisees giving 50 illegal immigrants identities stolen from United States citizens, including from children and deceased people. These illegal immigrants then worked up to 100 hours a week in 7-Eleven stores, but were paid for only a fraction of that time and were forced to live in sub-standard housing owned by the operators of the convenience stores. The allegations suggest that the franchisor was also involved because it not only failed to detect the scheme, but apparently processed the payroll and sent the wages to the employers for distribution.
The 7-Eleven case and others in the franchising area clearly demonstrate that the brand of a franchisor is the biggest asset to protect. The public are not going to think about the contractual clauses of a franchise agreement or break down the responsibilities to recognise that a franchisor may not have been involved.
Can franchisors be responsible under the FCPA?
There are no reported FCPA enforcement actions regarding franchisors; however, it would seem that the FCPA could apply and the acts of overseas franchisees. It is clear that the FCPA can be violated when a franchisor obtains an improper business advantage. A bribe being paid by a franchisee in another country is clearly going to benefit the franchisor in the United States – either the reputation of the franchisor will increase as the result of a bribe being paid or there will be an increase in profits flowing back to the franchisor.
It is argued that there is no difference between a franchisor–franchisee relationship and the vendor–distributor relationship that has been the subject of almost every DOJ and Securities and Exchange Commission (SEC) investigation in the last five years. In fact, in a franchisor–franchisee relationship, the position is even worse because the branding of the franchisee is often the same as the franchisor (which is the very concept of a franchise). Franchise relationships are very well controlled by contract and in practice. The way in which a franchise operates is strictly controlled by the franchisor and it is in their financial interest for their franchisees to be successful businesses. Both upfront payments and royalty payments from franchisees raise the potential of a books and records violation for a franchisor.
There are many factors considered by the DOJ and SEC to determine the precise role of the franchisor and the relationship between the franchisor and their contracting party (either a direct franchisee, an area developer or a master franchisee). Some considerations might include the methods of payment between the franchisor and its contracting party and whether or not there are intermediate parties. Because an FCPA violation is not a strict liability offence, franchisors would be quick to argue that they did not have the requisite corrupt intent due to lack of knowledge that the corruption was happening by a franchisee and that they had absolutely no knowledge and no ability to know that the act was happening. Accordingly, they would argue that they cannot be held liable, and any intent attributed to the master franchisee or sub-franchisee should not be imputed to them. This is certainly the same argument that the distributors and resellers ran in the early cases – an argument that has periodically been watered down. The relevant questions then became:
- What steps did you take to minimise the risk of corruption down the chain?
- What training did you give these local companies to help them understand international laws?
- What steps did you take to ensure that the franchisees actually knew, understood and acted in accordance with local and international laws?
- What steps did you take to validate the franchisees’ contractual requirements to follow the local laws? Did you ever check, audit, review or discuss this with them?
- Did you ever question the business practices of an applicant franchisee, irrespective of how they came to you as an applicant? Did you validate their business practices? Did you do any due diligence on the ground before giving them the right to manage your logo and your business locally and be the face of your brand?
Understanding the franchisor corruption risks
Risks in their own business
There are different types of franchise relationships and each one of them has different FCPA risks, meaning that they require different types of risk management. Some cases would necessitate a detailed and “heavy” compliance programme; others a smaller, less-controlled one. Regardless, what is clear is that a franchisor’s anti-corruption compliance programme should always include due diligence into a franchisee upon appointment and throughout the terms of the relationship. Hiding behind a contract is clearly not an answer anymore.
Some risks in the franchise area – the risks of the franchisor itself and its own business – are no different to the risks of any other company. They have employees, often internationally. They are conducting business in overseas markets and would be covered by the FCPA and local corruption laws. In many cases, these franchisors may engage third parties to help them in certain markets. These third parties might be agents, intermediaries or companies to help with the regulatory approvals needed in certain countries or states to operate a franchise. This might involve government lobbying or other engagement with government officials. They will no doubt include various suppliers, marketing support, public-relations support and other third parties that engage with government. For these risks, similar anti-corruption programmes would apply to those of any large company working in international markets.
However, where the risks do differ, and where many franchisees are simply “not getting it”, is when it comes to the actual franchisees who operate their businesses in local markets according to their franchise arrangements and agreements. There is a dispute over how much “compliance” the franchisor is responsible for in these relationships and to what level the franchisor can push this responsibility to the franchisee and absolve itself from liability.
Risks of their franchisee businesses
There is a range of international franchising arrangements, with varying degrees of control exercised by the franchisor. The greater the franchisor’s involvement in, and control over, the activities of its franchisees, the more likely it is that the authorities will determine the franchisor had the requisite “knowledge” of the improper conduct and corrupt intent. However, with greater control comes greater ability to deter and prevent questionable behaviour by a franchisee.
At a minimum, in every market in which it operates a franchisor must:
- have a process by which they consider a new applicant for a franchise
- have the applicant complete a questionnaire detailing their compliance history, their experience in the local markets, their legal history and their professional backgrounds
- conduct a detailed due diligence on the proposed applicant which reviews the questionnaire and compares that to a due diligence background check
- conduct a background integrity analysis which includes, at a minimum:
- detailed screening of all international watchlists, sanctions lists and lists of known companies engaged in non-compliant practices
- consideration of the backgrounds of the executives of the company and how they are connected to local regulatory authorities, local government, ministries or other semi-government bodies that have jurisdiction over the proposed franchise
- media analysis
- litigation searches
- corporate governance reviews
- reputation analysis
- a local site visit to verify their offices.
This should be done for every existing franchisee as part of their application to become a franchise. The costs of this review can be embedded into the cost of application for the franchise or, if successful, rebated back through a reduction in the initial franchise fee (which is generally payable upon contract). In most cases, the costs of the due diligence will be a very small percentage of the fees payable by a franchisee in the acquisition phase.
It should be noted that the above due diligence with detailed background screening should be carried out not just for new applicants but also retrospectively for all existing franchisees. This is likely to be a significant task and might need to be done over several years. In addition, a risk review can be completed to rate the risks of the existing franchisees into higher and lower risk areas. It might be the case that the due diligence process can be simplified in certain countries where risks are lower.
It should also be noted that due diligence and background checks do not simply consist of reviewing someone against a watchlist. This is totally inadequate and any company that thinks assessing someone who is their direct franchisee against a watchlist or compliance database service (which are primarily created for money-laundering purposes and international terrorism) is totally missing the point of due diligence. The sort of due diligence identified above cannot be obtained wholly from a database.
More detailed due diligence in certain situations
In addition to the above (which can be classified as the most basic form of due diligence and background check, routinely done by almost every vendor that has distributors and resellers globally), different models of franchises may require additional levels of due diligence due to their additional risk implications.
The direct-unit or single-unit franchising model, the oldest and arguably most commonly used model in the United States, is where a franchisor sells one of its units at a time and has direct involvement with the franchisee. There is no third party involved in the operations between the franchisor and franchisee. It is the franchisor’s responsibility to provide training, marketing, supplies and other support to the franchisee rather than outsourcing these tasks. In this model, the franchisor has a direct relationship with the international franchisee and tends to have more control over the operations of its franchise and a greater return on the franchise profits. In addition to the basic due diligence outlined above, the franchisor should also closely review their own businesses as they would likely be providing more localised support using local third parties.
Under the direct-unit model, the franchisor is at the most risk for direct liability of the acts of the franchisee. Because of the level of control the franchisor has over the franchisee, it would be easy for the DOJ and SEC to find a link between the two entities and determine the corrupt intent of the foreign franchisee to the franchisor. It would also be clear that any illegal payment made by the franchisee would benefit the domestic business.
Due to the higher level of control and therefore direct responsibility and potential liability, the franchisee should put in place additional controls, which include:
- direct training in compliance methods and in anti-corruption controls
- ensuring the franchisee pushes this training down to their own staff and that the training is effective (typically achieved through conducting audits)
- ensuring that the franchisee has an anti-corruption compliance programme which includes a risk-assessment procedure to identify risk areas and a strong reporting procedure to investigate alleged misconduct.
A multi-unit franchising model is where a franchisor employs an area developer who operates or controls multiple local franchises in a specified region. This method is likely to produce faster growth. Area developers are sophisticated businesspersons with a good knowledge of the particular territory in which the franchisor is interested. The area developer bears some of the financial burden by paying some of the expenditures or expenses for the local franchisee’s needs.
In this model the franchisor has a go-between in the area developer and therefore has slightly less control over the franchisee. The area developer engages with the local government and new franchisees and is directly representing the franchisor’s interest in that country. It is therefore with the area developer that the major risks lie.
The company needs to focus its compliance around the area developer and it is essential that there is a strong compliance programme specifically for the area developer. The franchisor should make sure that the area developer has all of the requirements that a direct-unit franchisor has, but with additional obligations. At the very least, these additional obligations should include:
- specialised contractual provisions that require representations and warranties from directors, officers and employees engaged with any form of government
- audits of the compliance programme annually conducted by independent experts in compliance that are reviewing not only that the compliance programme exists but that it works
- interviews with the area developer to test their awareness of the compliance programme
- evidence that the area developer has a third party compliance programme in place and that due diligence has been completed on all third parties
- evidence that the controls identified above for direct-unit franchisees have been put in place for any franchises that the area developer enters into directly (i.e. sub-franchises)
- visibility into audit committee meetings (or other appropriate committee meetings) that discuss compliance
- transparency into investigations and the conduct and result of those investigations.
In a master franchising model, a contract exists between a franchisor and a master franchisee in a particular area that then contracts with third-party sub-franchisees within a specified territory. Frequently the domestic franchisor will have no contractual relationship with the sub-franchisees. The master franchisee effectively acts as the franchisor in the local market and will recruit, research, train and provide other support in the local area on behalf of the franchisor.
Due to the direct relationship and control between the franchisor and master franchisee, it is not difficult to find a nexus of involvement with the United States. However, because there is no direct contractual relationship between the domestic franchisor and sub-franchisees, this area of FCPA exposure is less clear.
In this situation, the proposed due diligence on the master franchisee should be similar to the due diligence identified above on the area developer. In addition, the master franchisee should be demanded by contract to conduct due diligence (as suggested above for a direct franchisee) on any sub-franchisee. The due diligence results should be all made available to the franchisor and checked via audits and transparency. The franchisor should have the right to veto any franchisees where the due diligence picks up potential red flags.
Area-representative franchising uses an area representative (or independent contractor) to market, supervise and carry out other roles in the local market on behalf of the franchisor. While the local area representative by contract would expressly assume its own legal responsibility for its actions, it is clear under the FCPA that the franchisor would be held liable for its actions. The franchisor is likely paying the area representative fees for services and recovery of costs. There is no doubt that the services provided by an area representative are extremely high risk and the franchisor should not rely on the contractual provisions that attempt to absolve them of liability. The sort of due diligence in this case should be the same as any other agent, intermediary, contractor that the franchisor appoints in a local market. It should include the additional obligations of both direct-unit or single-unit franchising and multi-unit franchising.
Importantly, as the area representative is acting as a contractor and is no doubt being paid by the franchisor for services and reimbursement of fees, they should also have additional transactional due diligence conducted on them (which would not be generally applicable in other due diligence). For example, they should also have:
- detailed scrutiny of all invoices submitted
- assessment of all underlying expenses which are claimed for reimbursement
- close review of all gifts, travel and entertainment spends when being claimed back as an expense from the franchisor, with a pre-approval system put in place where relevant
- validation of all service fees and fees of third parties that the area representative engages and why they have been incurred.
A joint venture franchising model is where the franchisor forms a separate entity in a local community to develop its franchisees there, and the franchisor is a shareholder of the franchise.
If the franchisor is the sole or majority shareholder the legal exposure is greater, and they should treat this entity as a subsidiary which is subject to the usual stringent compliance programmes. The same position would apply if the joint venture company was majority owned.
If the franchisor holds a minority interest, they should take steps to implement into the joint venture company the same level of compliance that would be expected by a company in that jurisdiction and have the same level of controls, at the very minimum.
The level upon which compliance should be implemented is complex and will depend on many factors, such as whether they have board seats or board control, if they are a member of the audit committee or whether there are management people in place seconded by the franchisor. The compliance proposed for the joint venture will need to be considered closely.
Franchisors need realise that in the new compliance environment hiding behind contractual provisions and hoping to fight it out in the courts of public opinion will not work. They need to have a comprehensive compliance programme for their own business and ensure that they include detailed due diligence in the selection and approval of their franchisees, master franchisees, area developers, area representatives and sub-franchisees.
It is essential that they take some ownership of compliance as the DOJ and SEC clearly expect franchisors to take on responsibility for compliance (at varying levels) over the third parties that they engage, including franchisees.