Franchising in the Hotel Sector

I Introduction

Franchising has a long history in the hotel sector and has been used extensively in certain parts of the world since the early 1950s.

It is big business not only in the hotel sector but also in a wide range of other sectors, accounting for some 3 per cent of US GDP – US$674.3 billion of earnings – and 7.6 million direct jobs in the United States alone and some US$300 billion in the European Union. It is a proven and successful way of doing business in the hotel sector but has developed and changed over the years in terms of both its structure and strategic use.

The popularity of franchising in the hotel sector has steadily increased with the inclination for brand owners in the sector to pursue an asset-light strategy. This has meant that many of hotel brands have incorporated franchising as part of their growth strategy, alongside leases and hotel management agreements.

Franchising in the hotel sector is generally more common in North America, Europe and the Middle East, where there is a ready supply of operators who understand the value that a franchise delivers to them, whereas there tends to be a lack of proven operators who understand the value of franchising in Asia. Nevertheless, some brands do use franchising strategically in Asia to good effect.

The advent of franchise specific regulation has done nothing to abate this growth in popularity. This started with the Californian franchise law in 1971, spreading over the ensuing decade throughout the whole of the United States as both federal and state regulators followed suit. The trend then spread into Europe and across much of the globe.

II What is franchising?

Franchising is a business relationship in which the brand owner (the franchisor) grants to another party (the franchisee) the right to use the brand and the operating system that underpins it in exchange for a percentage of the income it generates. The operating system comprises all of the elements necessary to establish the franchisee as the operator of a hotel with the same look, feel, standards and room reservation system as other hotels operated by the franchisor or other franchisees under the same brand. The key issue is consistency of the quality and service delivered by all hotels operating under the brand, regardless of whether it is the brand owner or a third party operating it.

W Hotels are a good example of this drive for consistency. They have their own unique ways of communicating the brand values to guests that are used by all employees across all of their hotels across the globe, franchised or otherwise. They even have a signature scent used in all public areas, and fonts specific to only their brand for any signage, as well as mandatory uniforms that must be used in all W branded properties. W Hotel franchisees are fully trained in the W operating system so that consumers have no idea whether a hotel is operated by the brand owner or a franchisee. Franchisees have full access to the Starwood Preferred Guest programme, a Starwood Hotels loyalty programme and bookings through the W website rather than through third-party aggregation websites. This international loyalty program is immensely effective and therefore valuable, driving both new and repeat business.

III Benefits of franchising

There are a number of key attractions to the franchise model. These can be broken down into what academics call Resource Theory and Agency Theory.

Resource theory refers to capital and management. Access to capital is perhaps the most obvious attraction. John Y Brown, the former president of KFC, has stated that the only way he could access the US$450 million he needed to establish KFC's first 2,700 stores was through franchising. Access to key management expertise and local market knowledge is another key attraction.

Agency theory refers to the access franchising provides to highly skilled and incentivised management. A wealth of research evidences the fact that franchising improves managerial performance by establishing a community of interest that incentivises managers to work hard.

The academics Aliouche and Schlentrich² suggest that franchising offers business an efficient way of increasing its value. This 'value creation' or 'transaction cost theory' is demonstrated by their survey of the US restaurant sector during the 10 years from 1993 to 2002. It suggests that franchised businesses create more value than their non-franchising competitors because they have a higher prospect of creating market value and economic value than non-franchisors and generate on average higher added value than non-franchisors.

Another attraction of franchising is the economies of scale it offers leads to cost savings and more cost-effective increased brand recognition.

IV The development of franchising in the hotel sector

These attractions have led to franchising being used in the hotel sector. It is a dynamic commercial medium and the way it is used in the hotel sector has changed, in myriad subtle ways, over the years and across different geographies.

i North America

Franchising was first used in the hotel sector in the United States during the 1920s, having been used with great success by the Singer sewing machine company and several of the US automobile manufacturers to overcome the challenges presented by the vast size of the domestic market.

One of the earliest hotel franchises is probably Quality Courts United – now Choice Hotels International.

In the 1950s, the Howard Johnson and Holiday Inn brands were launched. The Howard Johnson Motor Lodges brand began as an add-on to an existing ice-cream parlour business. Holiday Inn (now part of IHG), was created by Kemmons Wilson, following a family road trip from Memphis to Washington, DC on which he found that he could not find reasonably priced, clean and comfortable motel rooms where children could stay at no additional charge.

In the 1950s, the franchise chains tended to be more of a cooperative type of arrangement whereby owner members complied with standards and referred business to one another. However, consumer demand for higher standards and consistency led to more formalised structures.

There has been substantial change in hotel franchising in the United States since those early days. These developments have been driven by changes in demographics, the economy, consumer expectations and technology. However, the fact that many hotel chains still use franchising as a key part of their growth strategy shows its value in a global market and evidences the flexibility, durability and sustainability of franchising in the hotel sector.

These early franchise chains introduced quality-based innovations such as wall-to-wall carpeting, daily change of linen, 24-hour desk service, in-room telephones no-smoking rooms, 24-hour-a-day and toll-free reservations.

The advantages franchising offered hotel operators in the days before online travel agencies and hotel aggregator websites, were significant. With these changes in the market, franchising in the sector has itself developed. This was particularly evident when hotel brands became more reliant upon the strength of their reservation systems and loyalty programmes. Hotel brands evolved as a result of, among other things, the price-based segmentation of the market, which in turn lead to a development in the role and responsibilities of franchisors and franchisees as regards creating and delivering that product. The franchisor became responsible for supporting franchisees with an effective reservation system, national advertising to market its benefits and latest programmes, and otherwise delineate and support its formula for success.

More recently, somewhat depending on the brand they choose, franchisees have been able to enjoy a greater or lesser degree of freedom. Some franchisees just want the business plan and a hotel in a box, so that they can build the hotel and operate it according to the system. Others prefer to belong to a system that places an emphasis on consistency.

Some brands, particularly higher-end boutique brands, such as Hotel Indigo, allow the franchisee to customise the property and guest experience, as a key element of the brand is that no two Hotel Indigo properties are alike, but are instead a reflection of their environment. Through their design and amenities, they tell the local story, including with interior design and local foods in the restaurant to mimic the neighbourhood feeling.

Without doubt, technology has had a significant impact upon how consumers decide which hotel to stay in and how operators manage their relationships with consumers. These seem to have caused both franchisors and franchisees to maximise their respective roles to better compete and be more profitable.

ii Europe

Although since the 1960s, many of the major US brands have used franchising in Europe, it is not as common as it is in the States and there are distinct differences in some of the forms it takes. This is partly because there is a large number of independent and often family-run hotels in Europe. Indeed, only approximately 30 per cent of European hotels are 'branded'.

The principal reason for this is that Europe is a heterogeneous market comprising numerous individual markets. As a result, while a brand may be widely recognised in, say, France, it may be relatively unknown in the UK or Germany. Also, it seems that European clientele prefer individuality and local traditions or tastes to a global brand with a homogenous offering. The complex and heterogeneous regulatory environment in Europe also reduces the attraction of pan-continental brands. Nevertheless, brands such as Accor use franchising extensively throughout Europe.

However, this may be set to change according to some commentators, who predict that during 2020–2025 hotel owners in Europe will be more likely to choose franchise deals than hotel management agreements. The firm CBRE predicts more than 50 per cent of all new four-star hotel deals will be operated under franchise agreements as owners seek to retain operational control and maximise returns.

It is thought that this increase in franchising in the sector is likely to be driven by new brands from existing companies as well as new entrants to the hotel industry, including Tribute from Starwood Hotels & Resorts and Curio by Hilton.

Out of all of the European markets, franchises are currently perhaps most commonly used in the UK, where it is estimated that over 39 per cent of hotel rooms are franchised, with Hilton, Wyndham, Accor, InterContinental Group and Choice Hotels all involved in franchising.

European franchising in the sector has tended to develop, at least in part, somewhat differently to the US market, in line with cultural and commercial preferences. 'Limited franchises', where there is less central control than in the usual type of franchise, are not uncommon in Continental Europe. These arrangements give the owner the benefits of being associated with an established brand, but deliver less to the franchisee and have a lighter touch, with fewer and less strict brand guidelines than are found in an ordinary franchise. However, these arrangements offer the franchisor less control over the use its brand and can, therefore, be problematic at times.

iii Asia

In Asia, the lower number of experienced operators interested in taking on a franchise and accepting the disciplines it imposes has meant that many of the larger brands are nervous of entrusting their premium brands to franchisees.

Instead, there generally seems to be a preference for franchising mid and lower-level brands and those that are more focused on customising the property and guest experience, and in which a key element of the brand is that no two hotels under the brand are alike, but are instead a reflection of their environment. As in Europe, we are beginning to see indigenous hotel brands adopt the limited franchise approach. This is particularly for value-driven brands.

V Current global trends in franchising

Nowadays, many franchisors tend to focus globally on providing the resources, particularly information, that owners need to succeed. They provide data to help members compete and be more profitable. Franchisees have more freedom to customise their hotels within the segment while leveraging the resources available to them as an owner. Understanding and knowing how to leverage these available resources from best-in-class revenue management tools to a world-class loyalty programme is pivotal to success and it is this that franchisors focus on delivering.

Franchisors are now investing heavily in technology, while going 'asset-light', and focusing on helping franchisees to optimise their return on their investment while maintaining quality and consistency within their brand.

This tends to mean that franchisors deliver high-quality data, such as consumer insights, research and data, to help the franchisees manage their yield in a market where pricing varies depending upon the day of week, time of year, length of stay of the guest and affiliation or status when booking a reservation, and so on. Many franchisors also use this data to support franchisees establishing well-positioned and well-run hotels.

Franchisees are generally attracted to a brand that offers them a successful business model and helps them increase RevPAR using resources such as a loyalty programme and a range of digital and other channels that help them generate bookings for their hotel.

Consumers today want more, and the onus is on both franchisees and franchisors as a team to deliver more than just a hotel. They want accommodation that is part of a multi-functional mixed-use concept, a property in a place or location people want to visit with services, restaurants and activities they enjoy.

The use of franchising in the hotel sector differs markedly from region to region. For example, Europe has a markedly different hotel market to the United States where brand is king, some 70 per cent of hotels in the United States are 'branded' and there is a strong, embedded and regulated franchise system.

VI The strategic use of franchising

Franchising is a versatile, effective and road-tested route to both domestic and international growth in the sector. It offers a range of exciting strategic possibilities to hotel businesses looking to expand internationally, but its full potential is often not appreciated. To some it is an obvious and ready-made way of internationalising their businesses; others associate it with hamburgers and pizzas, and discount it as an option, fearing that it will compromise their brand. It is suggested that both groups have become too focused on the label they put on the international structure they adopt at the cost of objectively analysing the substance of a particular structure and how it can support and promote their business objectives. When considering how to develop an international hotel business structure involving third parties, it is perhaps best to forget the form and focus on the substantive needs of the business and how they can best be met. It is essential that any existing prejudices or misunderstandings about the term do not deflect a hotel business from developing an appropriate structure or misdirect its legal advisers as to how a particular legal structure will be regulated. How a structure is labelled will have no bearing on whether it is regulated by franchise rules or other regulations.

Whatever type of franchising a hotel business uses, it will have the following four common features. To a greater or lesser extent they all involve:

1. profit sharing;
2. investment by a third party;
3. a divestiture of some degree of operational control; and
4. risk sharing.

The precise details of the structure used will determine the exact risk profiles of the relationship between the franchisor and the franchisee.

Many hotel businesses, such as Accor, have successfully developed a strategy of operating both company-owned outlets and franchised outlets.

This combined approach ensures that the franchisor has continual access to the operational realities of its format and is able to review and develop it on an ongoing basis. Corporate outlets generally yield higher profits for the brand owner than franchised outlets. However, the more rapid rate of growth and need for lower investment per unit gives rise to a 'multiplier effect', which leads to a higher return investment, greater market share and ultimately higher gross earnings for the brand owner.

VII The different types of franchising structures

i Unit franchising

This is the most basic form of franchising. The franchisor directly grants the franchisee a right to open and operate a single hotel.

ii Master franchising

In this relationship the franchisor grants to another party, described as a master franchisee (or sometimes a sub-franchisor), the right to open and operate one or more hotels itself, and to sub-franchise to independent third parties, described as 'sub-franchisees', to open and operate hotels within a specified or exclusive territory.

iii Development agreements

In this relationship, the franchisor grants exclusive rights to a party described as the 'developer' to develop a territory by opening a number of hotels itself. Developers must have substantial capital and managerial resources and are usually experienced operators.

iv Subordinated equity agreements

Companies are increasingly finding that their longer-term, international strategic aims are not always met by vanilla franchising. Their commercial aims require more sophisticated, hybrid structures, often involving taking equity in the corporate vehicle that the franchisee has created to develop the brand in the territory. There is a wide range of such subordinated equity structures available, the appropriateness of which will depend upon the franchisor's commercial priorities, their longer-term market-entry strategy, the franchisor's shareholders' ultimate exit strategy, tax planning and so on.

Joint ventures are sometimes used to try to add further flexibility to traditional franchising structures, but more often than not these result in a head-on clash between the control dynamics present in a traditional shareholders' agreement and the brand owner's need to have unfettered control of the brand. Subordinated equity agreements enable the parties to circumvent these inherent tensions and equity interests to become a part of the brand owner's overall strategy.

In many jurisdictions, these can have a substantial impact on the regulatory and tax issues that the franchisor has to deal with. As a result, subordinated equity arrangements tend to be tailored to each market, while at the same time not compromising the integral homogeneity of the overall international structure.

Subordinated equity structures are sometimes used in conjunction with other 'extra-franchise' structures, such as hotel management agreements of various types.

v 'Manchising'

The granting of a franchise to an owner who then contracts the brand owner to operate the branded hotel on its behalf is referred to as a Manchise. It offers the franchisor a further income stream, allied to, but distinct from, that which it receives by way of the franchise agreement.

VIII How does franchising differ from hotel management agreements?

In essence, franchises are generally taken by owner-operators who want access to a brand, business format and reservation platform that will drive RevPAR and so enhance profitability.

Hotel management agreements are generally taken by hotel owners who do not have operational expertise.

However, it is not a binary matter as franchise agreements can be combined with hotel management agreements to produce the Manchise hybrid structure, which involves the owner taking on a franchise but then contracting the brand owner to operate the hotel under the franchised brand. The Manchise agreements come in differing shapes and sizes. Some are long-term relationships, while others are effectively used as a start-up mechanism so that once the hotel has been up and running with a full staff for say five years or so, the manager exits the relationship leaving the staff and managerial infrastructure in place.

So, the key point is that franchises are one part of the hotel brand's commercial arsenal, which can be deployed as and when the appropriate market opportunity presents itself.

The key commercial imperative with franchising is that association with the brand will improve the performance of the potential franchisee's asset. A franchise can deliver significant benefits, including a higher likelihood of success, brand awareness, increased access to financing and access to centralised reservation and other systems. It delivers a 'hotel in a box' to the franchisee, and so is a very effective way of leveraging an asset's success of an established brand and business format without losing full control of the asset.

From the brand owner's perspective, a franchise can be a very efficient way of growing the hotel network – particularly internationally – without the need for significant capital or operating management.

Some franchisees contract with a non-branded management company, which manages the day-to-day operations under the franchisor's brand. These non-branded management companies can offer both the brand owner and its franchisees crucial local market knowledge.

Management agreements generate more revenue per hotel for the brand owner. However, the cost associated with managing hotels, particularly on an international basis, is an awkward fit with the rationalised, lean model that in the present economic environment is preferred by brand owners.

However, there are still many instances when management agreements are preferable to franchises. For example, flagship hotels, new and emerging brands and hotels in emerging markets are more likely to flourish under the tighter brand controls offered by a management agreement

Asymmetry in the exchange of information between the franchisor and its franchisees can present a challenge. The franchisor, therefore, often employs 'mystery shoppers', guest surveys and other embedded control devices to ensure adherence to brand standards by franchisees. The reservation system and EPOS system are particularly useful in this regard.

IX What are the usual commercial terms of a franchise?

Franchise agreements tend to be for a period of between 10 to 20 years, with the right to extend for a further term – sometimes by mutual consent.

The franchisee is licensed the use of a brand and a business format with access to centralised marketing, advertising and reservation services. Management and operation of the hotel remains the obligation of the owner.

Although overall management of the hotel remains with the franchisee, it is required to adhere to the brand owner's 'brand standards' and participate in both group marketing and advertising and the group's central reservation system. Where the hotel is being constructed or renovated, the franchisee will have to obtain the brand owner's approval for the relevant plans and specifications.

The hotel will need to open on a specified date, possibly with an opening ceremony. During the term of the relationship, the franchisee will need to maintain records and accounts and provide the franchisor with full access to them. The franchisee will be required to comply with all applicable legal requirements and indemnify the franchisor against any claims.

The brand owner will typically provide the franchisee with training in the operation of the hotel in accordance with the 'system' and access to the 'manual', which will be updated on an ongoing basis. Sometimes the brand owner will provide pre-opening services to the franchisee. The franchisor will also provide the franchisee with access to its marketing, advertising and reservations system as well as a variety of technical services.

As regards the financial arrangements in a franchise agreement, the typical fee structure involves an upfront fee, which is often linked to the size of the hotel. There is an ongoing fee – sometimes described as royalty fees – which is typically between 3 per cent and 5 per cent of room revenue. In addition to this there is an advertising or marketing contribution – again usually based on room revenue. This fee is usually paid into a group advertising or marketing fund and is usually somewhere between 2 per cent to 4 per cent of room revenue. Reservation fees are sometimes charged separately as a distinct contribution towards the cost of the franchisor's reservation or loyalty systems.

It is extremely unusual for there to be any post-term restriction on a franchisee, due to the size of the investment they have made in the bricks and mortar of the hotel.

X Regulatory issues arising from a franchise

i Entering into the franchise relationship

Hotel brand owners who intend to use franchising as part of their business need to understand that this will mean that they must comply with franchise regulations in certain markets.

Franchising is regulated in some countries by specific franchise laws. These can be categorised as competition law regulations, foreign trade or investment regulations and core franchise regulations. Competition law regulations seek to prevent the restriction of trade. They are concerned with issues such as the tying in of peripheral or unconnected goods, price maintenance, exclusivity and so on. The EU (in the form of Article 101 of the Treaty on the Functioning of the European Union and the Vertical Restraints Block Exemption), Japan³ and Venezuela⁴ are examples of countries that regulate franchising in this manner.

Developing markets such as China, Indonesia, Kazakhstan, Korea, Moldova, Russia, Ukraine, Belarus, Barbados and Vietnam use foreign trade and investment regulations to protect their economies and often have political and social aims, such as the creation and distribution of wealth. Core franchise regulations are concerned with the way that franchises are sold particularly the creation of what might be called pre-contractual hygiene. They do this by a variety of means including mandating pre-contractual disclosure and the terms of the in-term relationship between the franchisor and its franchisees. More developed franchise markets such as the United States, Australia, Canada, Brazil, Taiwan, Mexico, France, Spain, Italy, Belgium and Sweden tend to take this approach. Some countries have adopted a hybrid approach to the regulation of franchising. For example, the South African Consumer Protection Act 2009 is a cross between competition law regulations and core franchise regulations, while both Malaysia and China have a mixture of foreign trade and investment franchise laws and core franchise regulations. Some countries, such as Croatia, define franchise agreements but do not regulate them.⁵

XI The definition of franchising in regulations

Whether or not a hotel brand owner is technically a franchisor and, therefore, has to comply with franchise specific regulations in a particular market, will depend upon the definition of franchising in those regulations.

Unfortunately, there is no universal definition of a franchise. Even in the United States, home of modern franchising, there is no single definition used by regulators. The Federal Trade Commission (FTC) and the 15 states that have their own franchise laws all have different definitions of the term 'franchising'.

However, there are two basic approaches used by the US legislators and these have had a significant impact upon many of those jurisdictions that have adopted franchise-specific regulations.

i The us prescribed marketing plan or system approach

The 'prescribed marketing plan or system approach'⁶ to defining a franchise is most prevalent in the US states. Other states take a broader approach and refer to a 'community of interest' in the marketing of goods or services.⁷ Even within these two general categories, there are noteworthy differences.

The prescribed marketing plan or system approach raises the issues of 'control and assistance', and the use of the franchisor's brand. These are dealt with in differing ways by the various statutes and the FTC.

The state of California's franchise legislation was the United States' first franchise law when it was introduced in 1970.⁸ It adopts the 'prescribed marketing plan or system approach' and defines a 'franchise' as a contract or agreement, either express or implied, whether oral or written, between two or more persons by which:

1. a franchisee is granted the right to engage in the business of offering, selling or distributing goods or services under a marketing plan or system prescribed in substantial part by a franchisor;
2. the operation of the franchisee's business pursuant to such a plan or system is substantially associated with the franchisor's trademark, service mark, trade name, logo type, advertising or other commercial symbol designating the franchisor or its affiliate; and
3. the franchisee is required to pay, directly or indirectly, a franchisee fee.

This fairly general definition is typical of those to be found in many other US state franchise laws.

The Amended FTC Franchise Rule requires the franchisor to exert control over the franchisee's method of operation or to provide significant assistance in the franchisee's method of operation.

The FTC definition is a broad one and provides that the franchisee must operate under the franchisor's brand – either by selling goods, commodities or services bearing the brand or operating under the brand and selling goods, commodities or services meeting the franchisor's quality standards.

There is little substantive difference between the FTC Rule and the various state approaches.

ii The US community of interest approach

The community-of-interest approach is used in states such as Wisconsin⁹ and New Jersey.¹⁰ It defines a 'franchise' as an agreement between two or more persons in which:

1. the franchisee is granted the right to engage in the business of offering or distributing goods or services using the franchisor's trade name or marks;
2. the franchisor and franchisee share a community of interest in the marketing of the goods or services; and
3. the franchisee pays a franchise fee.

'Community of interest' generally means a continuing financial interest between the parties in the operation of the franchisee's business or the resale of the franchisor's products. Since most commercial relationships involve some type of continuing financial interest, this definition is potentially broader in application than most 'marketing plan' definitions.

The 1987 Ziegler decision by the Wisconsin Supreme Court¹¹ lists factors that should be considered in determining whether a community of interest exists under the dealership law.¹²

iii Definitions used outside the US

The key characteristic of the prescribed marketing plan or system definition is that the business must be 'substantially associated' with the franchisor's trademark, trade name or other commercial symbols to qualify as a franchise. There is often an element of control to be exercised by the franchisor as well.

A classic example of this is the definition used by the state of Alberta in Canada.¹³ Australia also takes a very comprehensive approach, but only by sacrificing succinctness.

Certain jurisdictions stipulate that the franchisor should assist the franchisee in running the business. In Korea, the franchisor is required to 'support, educate and control' the franchisee in the ways of its business.¹⁴

In Malaysia, the definition of franchising includes a responsibility on the franchisor to 'provide assistance to the franchisee to operate his business, including help with the provision or supply of materials, services, training, marketing, business or technology'.¹⁵ This is an interesting addition to a market plan definition and acknowledges the fact that most franchisees will need assistance to start up the business. Interestingly, the more detailed definition used in Australia is not as comprehensive in this area.

No countries have adopted a 'pure' community of interest approach, probably because the definitions based on it are broader and lack the detail or accuracy of some of the lengthier marketing plan definitions.

However, many definitions contain certain elements of it mixed in with those of a prescribed system approach.

Italy has a definition of franchising that covers intellectual property rights, commercial assistance and fees very concisely.¹⁶ It does not deal with control by the franchisor. It merely describes the business aspect as a 'franchising network' and is therefore not detailed enough to give an accurate description of what a franchise entails. The Romanian version is equally succinct and requires the parties to 'continually cooperate' and be 'financially independent' from each other.¹⁷ It requires the parties to be named as franchisor and franchisee; however, is silent on intellectual property rights, which is far from ideal.

Spanish law¹⁸ offers a very broad definition that relates entirely to the rights granted by the franchisor and, apparently, the use of the words 'franchisor' and 'franchisee'. It defines a franchise as an activity that 'is carried out by virtue of an agreement or contract by which a company, known as the franchisor, grants to another, known as a franchisee, the rights to exploit its own system of commercialisation of products or services'. Although this can still be classified as a marketing plan or prescribed system approach, it is so broad that it is almost meaningless. Describing the business as a 'system of commercialisation products or services' does not adequately describe the IP rights exploited by the franchisee and there is no mention of a fee. Furthermore, if a strict interpretation is used, the definition will not catch any arrangement where the terms 'franchisor' or 'franchisee' are not used by the parties.

The Brazilian franchise law defines a franchise as:

[A] system whereby a franchisor licenses to the franchisee the right to use a trademark or patent, along with the right to distribute products or services on an exclusive or semi-exclusive basis and, possibly, also the right to use technology related to the establishment and management of a business or operating system developed or used by the franchisor, in exchange for direct or indirect compensation, without, however, being characterised as an employment relationship.¹⁹

Although this has something in common with the community of interest approach, the interchangeability of the brand and a patent is an interesting and unique concept that differentiates it from most other definitions, but draws some comparisons with the interchangeability in the Indonesian system. There are also elements of the prescribed plan approach, as the franchisor's 'operating system' must be used.

XII Piloting the hotel concept

China and Vietnam prohibit franchising until the concept has been piloted in the local market. In China there is a requirement that the franchisor establish and operate two company-owned units for more than one year before granting franchises to third parties.²⁰ Although the original regulation required that this pilot had to be in China, this requirement has been modified mirroring the debate in Italy, so that the pilot can be anywhere.

Article 2 of the Vietnamese Commercial Law of 2001 requires that franchisors must hold a Vietnamese business licence²¹ and that the franchise system has been in operation for at least a year before a franchise can be granted. The Vietnamese master franchisee of a foreign brand is required to have operated the franchise business for 12 months or more prior to granting sub-franchises to unit franchisees.²²

XIII Pre-contractual disclosure

Pre-contractual disclosure is the most common form of franchise-specific regulation and all those countries that require this are heavily influenced by the US Uniform Disclosure Document (US UFDD).

The pre-contractual laws often comprise some or all of the following; a duty not to misrepresent facts, an obligation to disclose relevant information to potential franchisees, an extra-contractual obligation to disclose relevant information to potential franchisees, an extra-contractual obligation of confidentiality, an obligation to enter into the franchise agreement once negotiations have passed a certain point and a right to withdraw from the contract within a limited time period. Each country takes a different approach to each of these issues, resulting in a lack of any homogeneous approach.

XIV Timing of disclosure

Pre-contractual disclosure must usually be given between 10 and 21 days prior to the execution of the franchise agreement. Malaysia, Taiwan and Brazil require disclosure at least 10 days prior to the execution of a franchise agreement. Korea requires only five days, while the Canadian provinces and territories all require 14 days, Mexico 30 days, China 20 days and Vietnam 15 days.

i Cooling-off period

A number of countries such as Malaysia, Mexico and Taiwan require a cooling-off period during which the franchisee can withdraw from the relationship without penalty. These range from a 30-day cooling-off period in Mexico²³ to five days in Taiwan.²⁴

ii Contents

Following the lead of the US UFDD, most countries that require pre-contractual disclosure require the same sort of information to be disclosed to the potential franchisees, although the details tend to vary. The information generally required to be disclosed is discussed below.

XV Basic details of the franchisor

Every country with franchise-specific disclosure legislation requires the franchisor to give some basic details about its business. The amount of detail that has to be disclosed varies from rudimentary information about the franchisor (such as in Indonesia or Japan), to more detailed information about the franchisor's business experience, its history of development and information about the business experience of the main people involved on the franchisor's side such as its directors and manager. Not surprisingly, the countries with pure franchise regulations such as Canada and Malaysia require a franchisor to provide more franchise-specific information than others.

i Description of the franchise and of the market

Almost all disclosure countries require the franchisor to give a short description of the franchise in question. In addition, some countries such as France, Brazil and Vietnam also require the franchisor to provide details of the territory or the market where the franchise is supposed to operate.

ii Financial information about the franchisor

Most disclosure countries require the franchisor to provide the prospective franchisee with balance sheets and financial statements for the past two years with the exception of Japan, Mexico and Taiwan.

iii Details of the franchise network

Most disclosure countries require the franchisor to give details about the franchise network, including providing the prospective franchisee with names and addresses of existing franchisees and information about franchisees who left the franchise network. The period that needs to be covered varies from 12 months before the franchise agreement is signed (in Brazil) to three years in the case of Canada.

iv Litigation details

Details concerning litigation that has to be provided can be divided into franchise-related litigation and general civil or criminal litigation regarding the franchisor and its directors or managers involved in the sale of the franchise.

v Initial fee, initial investment and continuing fees

Most disclosure laws require the disclosure of fees and other payments that have to be made in accordance with the agreement as separate disclosure items. They all require disclosure of the amount of initial fees and ongoing fees that are payable to the franchisor. Japan and Taiwan also explicitly require the franchisor to specify under which circumstances the initial fee is repayable to the franchisee. Many, but not all, countries require disclosure of the details of the initial investment that the franchisee will have to make.

vi Earning claims

With the exception of the United States, Canadian and Japanese franchise legislation, no other disclosure legislation requires the franchisor to disclose details of any earning claims made by the franchisor. In Canada and Japan it is optional for the franchisor to make such claims in the disclosure document. The only condition is that if earning claims are made, they have to have a reasonable basis. Franchisors in Canada are also required to include the material assumptions underlying the preparation and presentation of the earnings claim and they have to indicate the place where the prospective franchisee would be able to inspect substantiating documents.

vii Restrictions on the franchisee

Most franchise disclosure laws require that the franchisor discloses details of any restrictions on the franchisee during the ongoing relationship. Some countries list the restrictive covenants that have to be disclosed separately (e.g., Canada or Malaysia), while others simply refer to 'the general obligations of the franchisee' (e.g., Indonesia) or 'conditions or limitations on the franchisee's business' (e.g., Korea).

viii Descriptions of the obligations that the parties owe towards one another

Although there is a primary focus on information that has to be provided about the obligations of the franchisee, the obligations of the franchisor, in particular with regard to training and assistance during the pre-opening, but also regarding continuing support during the ongoing franchise relationship, have to be disclosed to prospective franchisees.

ix Purchase ties and personal involvement of franchisee

If the franchisee is required to purchase certain goods or services from the franchisor, then this generally has to be disclosed, even though it might not be specifically mentioned in the disclosure law, but would fall under the broad heading 'obligations of the franchisee'. The Canadian franchise legislation even goes a step further in that a franchisor not only has to disclose whether the franchisee has to purchase certain goods exclusively from it, but also any rebates from its suppliers on products that are sold on to the franchisee this way. In addition, any details about the franchisee's personal involvement have to be given, if required under the franchise agreement (as in Brazil, Canada, Malaysia and Vietnam, where this is a separate disclosure item).

x Term, termination, renewal

All countries with franchise regulations, other than Brazil and China, require that the term of the agreement, its termination provisions and a possible renewal are disclosed.

xi Details about franchisor's IP rights

Brazil, China, Indonesia, Malaysia, Mexico, Taiwan and Venezuela require disclosure of IP-related items.

xii Details of financing arrangements offered by the franchisor

Japan, Malaysia, Canada and Indonesia require the franchisor to disclose details about any financial arrangement offered to the prospective franchisee. In addition, a franchisor is also required in Japan to disclose whether it is prepared to provide financial assistance to a franchisee that finds itself in a difficult financial position.

xiii Exclusivity

Most disclosure countries require the franchisor to specifically disclose whether the franchise granted is exclusive or non-exclusive and whether the franchisor retains the right to operate corporate units in the territory granted (as in Japan).

ix Consequences of non-compliance

Failure to comply with the disclosure regulations generally results in the franchisee being able to reject the agreement so long as it does so within a reasonable period of entering into the agreement. Fines are also imposed in some jurisdictions. For example, in Malaysia, violations of the disclosure law are punishable by the imposition of a fine. The court can also declare a franchise void, order refunds of all payments from the franchisee, and prohibit the franchisor from entering into new agreements.²⁵

Jurisdictions with antitrust regulations take a slightly different approach to failure to properly disclose. In Japan, for example, failure to provide necessary disclosure amounts to the unfair trade practice of deceptive customer inducement, and can result in the Japanese Fair Trade Commission issuing a cease-and-desist order or the franchisee obtaining an injunction in the courts.²⁶

XVI Registration requirements

Some jurisdictions require the franchisor to register relevant details and documentation with a government agency. In developing markets this seems to be to enable the government to monitor franchisors doing business in the market, while in more developed economies (such as the United States and Spain) it is to ensure transparency and maintain a certain level of quality.

For example, franchisors who sell franchises in China need to file relevant information with the competent commercial authority. If a franchisor wants to sell franchises in just one province, the information has to be filed at the local office of the MOFCOM of that province. For cross-province franchising the application has to be filed with MOFCOM itself.

An application has to be made within 15 days of the execution of the franchise agreement and has to contain the following:

1. basic information about the franchise system;
2. information about all the franchisees within China;
3. the market plan of the franchisor;
4. a copy of the business licence or any other qualification certificate of the franchisor;
5. a copy of the registration certificate for the registered trademark, patent and other operational resources concerning the franchising activities;
6. a document issued by the commercial authority at city level certifying that the franchisor owns at least two directly operated outlets that have been in operation for more than one year. For the directly operated outlets located outside China, the notarised and authenticated certificate of incorporation must be provided by the franchisor;
7. a sample franchise contract;
8. the index of the franchising operation manual;
9. if the products or services that are franchised are subject to the approval of relevant authorities, the relevant approval documents shall be provided by the franchisor;
10. a statement for the authenticity and the veracity of the filed information affixed with the signature of the franchisor's legal representative and the franchisor's corporate seal; and
11. information regarding the execution, rescission, renewal and modification of franchise contracts within the proceeding year. This information has to be updated by 31 March every year.²⁷

Russian law requires that franchise agreements are registered at the register of commercial concessions, which is maintained by the tax authorities. Failure to register it means that it is not valid as against third parties.²⁸ In addition to information about the franchisor and franchisee, three copies of the agreement have to be filed. Termination of a franchise agreement prior to its expiration must be registered by the franchisor.²⁹

Regulation of the ongoing franchise relationship

The ongoing franchisor–franchisee relationship is often regulated by antitrust, unfair competition and consumer law. A duty of good faith also impacts upon franchising in civil law jurisdictions, although not in common law jurisdictions, which take a very different approach to the concept of good faith. For example, whereas German and French law take a loose approach based upon the Roman law concept of bona fides, English law takes a far more literal approach to contracts, using a variety of legal tools to ensure fairness on the relationship.

A number of countries insist that a franchise agreement contains certain standard clauses. There is a wide variety of approaches and no general trend or pattern can be identified other than a general desire for comprehensiveness. Failure to include these terms often makes the agreement invalid or terminable at the option of the franchisee.

In Indonesia, for example, a franchise agreement must contain the following clauses:

1. the name, address and domicile of the company of each party;
2. the name and position of each party authorised to sign the agreement;
3. the name and type of right over intellectual property, invention or a unique business characteristic, for example, a management system, a selling or display method or a distribution method that constitutes a special characteristic that is the object of a franchise;
4. the rights and obligations of each party and the aid and facility given to a franchisee;
5. the marketing area;
6. the period of the agreement and the method of and the requirements for the extension of the agreement;
7. the method for settling a dispute;
8. mutually agreed basic provisions that may result in the termination or expiration of an agreement;
9. compensation in the event of agreement termination;
10. the procedure for the payment of compensation;
11. the use of domestically produced goods or materials produced and supplied by small-scale enterprises; and
12. nurturing guidance and training for franchises.³⁰

Some jurisdictions impose certain requirements concerning dispute resolution. For example, the Korean franchise law also provides for a dispute resolution mechanism and establishes a Franchise Transaction Dispute Mediation Committee.³¹

XVII Does regulation have a significant impact on hotel franchising?

There is, and has always been, a good deal of debate about the need for, desirability of and impact of regulation on franchising.

The strength of franchising in the world's most heavily regulated jurisdiction (the United States) somewhat undermines the suggestion that regulation per se has a significant and adverse impact upon franchising.

Clearly, bad regulation will have a negative impact on franchising, but that does not mean that good regulation cannot have a positive impact upon franchising. Indeed, the lack of good regulation can have an adverse impact on franchising.

This exotic cocktail of laws further strengthens the technical barrier to cross-EU expansion.

XVIII Conclusion

Franchising is a useful part of the hotel brand owner's strategic toolbox. It can offer a convincing answer to a number of the questions that they face when growing the brand into new or under developed markets.

When seeking to use franchising in this way, it is important to have a full understanding of the challenges that will be presented by the legal systems of each target market. These challenges must be anticipated and taken into account not only in the drafting of the standard documentation but also in the way in which the rollout is planned, budgeted and implemented.