A Master Franchisor on a Budget: Exploring the Unspoken "Exemption" Under the Korean Franchise Law in Master Franchising
The following article was originally published on June 7, 2017, and first appeared in the April 2017 edition of "Value Chain," the Monthly Magazine of the Korea Business Leaders Alliance. It was written by Terry Kim and Sun Chang of Lee & Ko.
Suppose that you own a franchise business. It can be of any type. Let us say that your franchise business offers Kansas City spareribs in ways that are truly unique. Through careful planning, development, and hard work, you developed “Kansas City BBQ” into a franchise business that is widely-known and enjoyed by your patrons of all ages. After many years of successfully operating your franchise business, you believe that time has come to look beyond your borders and introduce “Kansas City BBQ” abroad so BBQ enthusiasts from around world can experience the authentic taste of Kansas City spareribs.
You decide that Korea is an attractive market. Since you are cost-conscious, at this point in your thought process, you might ask yourself the question: what would be the most aggressive franchise arrangement for introducing “Kansas City BBQ” to Korea that is both legally compliant and inexpensive?
Franchise Arrangement of Choice: Master Franchising
Franchisors seeking to expand their franchise businesses internationally often struggle with this fundamental question. There are several franchise arrangements that our hypothetical franchisor of “Kansas City BBQ” could choose from, such as direct - unit franchising, area development, or master franchising. Although the decision in choosing the right franchise arrangement will depend on manifold factors, for international expansion, master franchising is arguably the most popular franchise arrangement.
In master franchising, a franchisor – the “master franchisor” – grants a franchisee – the “master franchisee” – the right to develop a franchise business within an assigned territory by granting sub-franchisees the right to establish and operate sub-franchised units. The master franchisee assumes the role of the franchisor and carries out the functions of operating company - owned units, selling sub-franchised units, and supporting (e.g., training, logistical support, and marketing) the sub-franchisees in the assigned territory.
Conceptually, the franchisor maintains contractual privity only with the master franchisee by entering into a master franchise agreement, which typically grants the master franchisee the right to operate its company -owned units and the power to sublicense to sub-franchisees that establish and operate sub-franchised units. The master franchisee executes a sub-franchise agreement through which the master franchisee, in its capacity as the franchisor in the assigned territory, grants the sub-franchisees the right to establish and operate sub-franchised units.
Master franchising offers many advantages, and an exhaustive discussion is beyond the scope of this article. However, what makes master franchising so attractive is that it allows the franchisor to shift most of the responsibilities of selling sub-franchised units and supporting the sub-franchisees in the assigned territory to the master franchisee. This shift minimizes the nancial and non- financial burdens for the franchisor.
Furthermore, by leveraging the local knowledge and expertise of the master franchisee, master franchising presents an opportunity for the franchisor, such as our hypothetical franchisor of “Kansas City BBQ,” to achieve rapid expansion while minimizing investment while simultaneously increasing the probability of success in the local market.
Implementation: Limited Value of Registering a Franchise Disclosure Document
In Korea, franchise transactions are governed primarily by the Fair Transactions in Franchise Business Act (“Franchise Act”) and its Enforcement Decree. Before a franchisor, including a master franchisor, can offer and sell its franchise business in Korea, the Franchise Act obligates the franchisor to register its franchise disclosure document (“FDD”) with the Korean Fair Trade Commission (“KFTC”) and provide the registered FDD to the prospective franchisees. The FDD is a written document describing extensive information about the franchisor and the franchise organization. And the intent behind the requirement for providing the FDD is to give the prospective franchisee sufficient information to make an informed decision about purchasing a franchise.
In master franchising, there are two levels of transaction. The first-level transaction involves the master franchisor granting the master franchisee the right to operate its company-owned units, and more importantly, the right to recruit sub- franchisees in the assigned territory. The second-level transaction entails the master franchisee – in its capacity as the franchisor in the assigned territory – granting the sub-franchisees the right to establish and operate sub-franchised units. Thus, in principle, both the master franchisor and the master franchisee must each register its own FDD.
The problem facing our hypothetical franchisor of “Kansas City BBQ” in implementing master franchising comes into view. As the master franchisor, our hypothetical franchisor seeks one master franchisee, who ideally has been selected carefully to develop the franchise business and support the sub-franchisees in ways that uphold the uniformity and value of the franchise business in Korea. To offer and sell the franchise business to the master franchisee, our hypothetical franchisor must register and deliver its registered FDD to the master franchisee. However, once our hypothetical franchisor enters into a master franchise relationship with the master franchisee, the FDD no longer has any significant value because no further master franchisee will be recruited in Korea. In addition, the FDD used in entering into the master franchise relationship becomes of limited value to the master franchisee, who must register its own FDD to engage in the second-level transaction in master franchising – that is, to grant sub-franchisees the right to establish and operate sub-franchised units.
It is understandable then that a master franchisor, when seeking to implement master franchising in Korea, would want to search for ways to avoid registering its FDD. This desire could be especially pronounced because registering an FDD is a lengthy and costly process; it can take anywhere from two and three months to complete the registration and can cost between $40,000 and $50,000 in legal and administrative fees. Is there a way for our hypothetical franchisor of “Kansas City BBQ” to offer and sell its franchise business in Korea without registering its FDD?
De Facto Exemption: Separating the Rights in Master Franchising
The Franchise Act provides two statutorily-stipulated exemptions. To be eligible, a franchisor (or a master franchisor) must satisfy one of the following two requirements:
1) Franchisor receives less than KRW 1 million (approx. $900) in franchise fees during a six-month period from the date of receiving the first payment of franchise fees from the franchisee; or
2) Franchisor has less than four franchisees worldwide and earned less than KRW 50 million (approx. $48,000) in worldwide sales in the previous fiscal year.
The exemptions under the Franchise Act are intended to apply to small franchisors and are rarely applicable to foreign franchisors, who are introducing their franchise businesses to Korea. However, a de facto exemption could be found in the way the Franchise Act defines the critical term, “franchisor.”
Specifically, the Franchise Act defines a “franchisor” as a business entity that “grants the right to operate franchised unit to a franchisee.” The corollary of this definition could be that if a business entity does not grant the right to operate a franchised unit, then the business entity is not a “franchisor,” and therefore, does not fall within the purview of the Franchise Act. In master franchising, a master franchisor grants a master franchisee the right to operate its company-owned units and the right to recruit sub-franchisees to establish and operate sub-franchised units in an assigned territory. If the master franchisor withholds the right to operate company-owned units while granting only the right to recruit sub-franchisees to the master franchisee, then it is possible to interpret the Franchise Act to mean that such a master franchisor is not a “franchisor” as that term is de ned under the Franchise Act, and consequently, not subject to the registration and disclosure obligations of the Franchise Act.
The KFTC has released no formal guidelines or statements on whether a de facto exemption exists in the context master franchising. However, it appears that the KFTC shares the view that if a master franchisor grants only the right to recruit sub-franchisees to a master franchisee, then the Franchise Act does not govern the first-level transaction between the master franchisor and the master franchisee in master franchising. Thus, the master franchisor can offer and sell its franchise business to the master franchisee immediately without registering and disclosing its FDD to the master franchisee.
It is important to note that the de facto exemption does not absolve a master franchisee of its own obligations to register and disclose its FDD to the sub-franchisees. In master franchising, the master franchisee grants the sub-franchisees the right to establish and operate sub-franchised units, and therefore, the master franchisee falls squarely within the definition of a “franchisor” as defined under the Franchise Act. Before the master franchisee can offer and sell the franchise business to the sub-franchisees, therefore, the master franchisee must register its FDD.
Let us return for the nal time to our hypothetical franchisor of “Kansas City BBQ.” To take advantage of the de facto exemption, our hypothetical franchisor can consider structuring a master franchising arrangement by granting the right to recruit sub-franchisees but not the right to operate any company-owned units to the master franchisee. Should our hypothetical franchisor desire for the master franchisee to operate its “company-owned units,” then the master franchisee could do so by “recruiting” its wholly-owned subsidiary as a sub-franchisee.
Under this master franchising arrangement, only the master franchisee will need to register its FDD. Meanwhile, our hypothetical franchisor would have achieved its goals of introducing “Kansas City BBQ” in Korea using master franchising as the vehicle in a legally compliant and inexpensive way.
Cautionary Warning: Seek Local Counsel Advice
It bears repeating that the KFTC has not formally acknowledged the de facto exemption in master franchising. More importantly, the Korean courts have yet to review whether any exemption, other than the two statutorily-stipulated exemptions, can be interpreted to exist under the Franchise Act. Given the legal uncertainties surrounding the de facto exemption, and further, the knowledge that the registration and disclosure obligations constitute important cornerstones of the Korean franchise regulatory regime, it is highly advisable to seek local counsel advice before structuring your master franchising arrangement to take advantage of the de facto exemption under the Franchise Act.
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