January 13, 2021

Impact of the Pandemic on International Franchising

Kristin Corcoran

Partner, Appleby & Corcoran LLC

With more than 25 years of experience in global franchise law, Kristin Corcoran provide the legal support needed to grow businesses and franchise concepts internationally. She is a partner in the law firm Appleby & Corcoran LLC, found on the web at https://applebycorcoranlaw.com.

PDF with Citations

As the pandemic surged globally in the spring of 2020, many looked to China to determine the likely effect on businesses in other regions.  The initial signs were hopeful—that the pandemic was a storm that could be weathered for a finite period, with the retail sector being hit hard, followed by gradual, steady re-opening.  In March, according to the Harvard Business Review, “only six weeks after the initial outbreak, China appears to be in the early stages of recovery”, noting the resumption of the movement of people and goods. While companies anticipated scrambling to handle the crisis, dealing with shutdowns and addressing employee and consumer concerns around safety, many global chains thought naïvely or perhaps overly optimistically, that this was a problem with a beginning, middle and end, expecting that in six or maybe eight weeks, there would be a return to something approaching normal levels of activity.

International franchising and distribution represented a large part of the market share impacted by COVID-19, and it soon became clear that the governments of various countries needed to stabilize franchised businesses for the sake of the wider economy. Franchising results in significant job creation and provides a pathway to business ownership in many countries, notably South Korea, India, USA, Taiwan, and Brazil.  In countries such as India, Taiwan and South Africa, it was noted that “[b]ecause of the size of their populations, per capita income, urbanization rates and income distribution, emerging markets offer the largest and most dynamic markets for international franchisors.

For those reasons, throughout the spring of 2020, governments passed stimulus plans to help businesses, emphasizing the support of small businesses, many of which were franchises.  Europe, in particular, passed legislation designed to support those displaced by the shutdown of certain industries that were bearing the brunt of the effect of closures due to the pandemic particularly in retail, hospitality and restaurant services.  The government plans were designed to support both employees and employers.  Whether it was a moratorium on evictions in the UK or the Franchising Association of South Africa asking that takeaway and fast food be considered essential services, many governments’ first steps were to stabilize franchise businesses in retail sectors. Some governments offered “top down” business focused solutions, like in the UK, which offered VAT reductions and a number of COVID-19 loans to businesses, as compared to countries like Brazil which focused on “bottom up” programs that were more employee focused.  Both approaches seemingly looked to China for these models, as China employed both a “top-down” and “bottom-up” approach to stabilizing the business sector.

The support did not just come from the government, but from franchisors as well.  Franchisors and franchisees cooperatively considered a reduction of business expenses, maintaining at least part of the revenue stream through online, delivery or other alternative channels, and emergency measures, including royalty waivers and deferrals.  Franchisors and franchisees quickly determined what to communicate to employees and customers to successfully implement changes to their business model.  Global franchisors, faced with franchisees losing significant revenue, were required to make quick decisions to allow for alternative sources of supply, for example, without the usual due diligence and vendor vetting, or let franchisees take the lead to directly source supply within certain parameters, or for a limited period of time.  There was legal risk, of course, when allowing a new vendor, without proper due diligence or a finalized contract, to provide supply to a franchise system.  Quality and pricing may not be scrutinized as they typically would. Not to mention the review of regulatory compliance, such as can be found particularly in food supply, where nutrition and allergen laws are critical for the protection of consumers’ health and safety.  However, when faced with a broken supply chain and potential loss of revenue if not fixed urgently, some brands were willing to take a calculated risk to allow franchisees opportunities to capture at least some percentage of their customary sales revenues. 

As an example of “outside the box thinking”, in Brazil and India, delivery-only outlets have sprung up seemingly overnight. Many franchisors had considered use of these low-rent, high yield locations, but the pandemic accelerated use of this model. While “dark” or “cloud” kitchens can be cost effective, particularly where dine-in is not allowed,  a franchisor may be concerned that a franchisee operating such an outlet for multiple brands will not protect the franchisor’s proprietary information or increase the risk of cross-contamination of allergens or increase food safety risk. Also, franchisors may not have fully considered how to adapt training, operational standards, reporting requirements, or even the royalty structure that would apply to this arrangement.  However, when the alternative is the loss of income and perhaps permanent closure, some franchisors took the leap. For many franchisors, rushing to put a solution in place has led them to adopt a “we’ll fix it later” approach,  suspending certain franchise agreement terms and agreeing to address the myriad legal issues after the crisis abates.

Unfortunately, the pandemic has lasted longer than the original six to eight-week period China saw in early 2020. While other countries in Asia more closely followed the China timeline of shutdown with steady reopening, for most of the world, especially in Europe and the Americas, this has not been the case. As it became clear that the pandemic would rage on through the remainder of 2020, some of the solutions that were designed to carry franchise businesses for a short duration have had unintended consequences for other parts of the economy.  Government actions to protect franchisees from collection efforts, including the payment of rent, led to consequences for others, chiefly suppliers and landlords.    While larger landlords, like those in the UK, may be able to survive without rent payments for a few months, some landlords, like many in Brazil, are smaller owners who are just as vulnerable to the loss of revenue as the small businesses that the government was trying to “save”.

With vaccines on the horizon, is there an end in sight?  If so, will the pandemic have a long-lasting effect on franchising?  Thus far, franchise business models that were adaptable and nimble fared better, especially those that could leverage their digital presence and offer contactless services such as curbside takeaway and delivery.  Some quick service restaurants have seen an increase in revenues during the pandemic, with pizza concepts and other delivery-centric restaurants seeing substantial increases.  Many of those businesses state that those adaptations will remain post-pandemic because they have proven profitable, efficient, and overall improved the business model.

However, permanent closures of many franchise outlets are expected.  Both wellness and hospitality segments were hard hit, as were many restaurant brands.  Some have already sought the intervention of the courts.  Chuck E. Cheese, operating in 16 countries outside the US, has filed for bankruptcy protection, stating “…it also became clear that decisive action would be necessary to address COVID-related financial challenges.”   The Mexican franchisor of the KidZania amusement parks attempted to terminate its contract with a US based franchisee.  In granting an injunction against the termination, the court noted the parties’ discussions had been ongoing in February and March, just as the pandemic began to surge.  The issues in dispute will need to be addressed in the already pending International Chamber of Commerce arbitration.

While much of the focus has been on shoring up existing franchises, what has become of development and growth of existing chains?  Some retailers with company-owned and franchised outlets are assessing and restructuring their business.  In October, Gap announced that it is transferring retail stores in Europe, primarily in the UK, France, Ireland and Italy, to franchisees.  Those that do not transfer will likely close. 

The news is not all bleak.  The Global Entrepreneurship Monitor (GEM) reported the highest number of new business ownership in the UK for the past twenty years. Some of the newly unemployed having decided to take advantage of low interest rates, available properties and skilled unemployed staff to begin new ventures as small business owners.  There is a pathway to success, and GEM concluded that many businesses in a “brave new post-COVID-19 world, will need to increase their capacity to adapt, improving their flexibility, resiliency and responsiveness.” Many emerging franchisors are already poised to accelerate the use of technology to collaborate and communicate among their stakeholders, including franchisees and suppliers.  If they remain flexible in adapting their business model to the changing landscape, meeting the needs of consumers as the crisis subsides, they will not only survive the pandemic but also grow in units and sales. While larger, more established franchisors will also look to adapt, their size and complexity may impede their ability to roll out the changes as quickly as smaller franchise brands.

Turning once more to China as a possible window into what can be expected in other parts of the world, estimates of its recovery from the economic effects of COVID-19 are at about 90% to date.  It is not possible to know if the rest of the world will have the same recovery, although GEM estimates economies could shrink between 5-10%.  What is certain is that there will be no complete return to a pre-COVID world. But smart franchise systems willing to apply the lessons learned may emerge from the pandemic with  new and improved business models ready to meet the needs of post-COVID consumers.