International Law

Franchising as a Corporate Form

Image via Wikipedia

One of the interesting facets of franchising, generally not recognized, is its value as a different corporate form.

Consider the recent problems that Deloitte Touche is having because of the Parmalat fraud.

From the Judicial Opinion, which refused summary judgment, is some background on the Parmalat lawsuit.

"In the early 1990s, Parmalat, an Italian dairy conglomerate known for its long shelf life milk, pursued an aggressive growth strategy financed largely by debt. Its expansion into South America, however, turned out to be ill-advised, and it began to lose hundreds of millions of dollars there.

The company needed constant infusions of cash to cover these 14 losses, service its massive debt, and hide the personal diversion of funds by Parmalat chief executive officer Calisto Tanzi and his family. But cash could be obtained only so long as Parmalat appeared to be a sound investment.

To this end, insiders at Parmalat and Grant Thornton S.p.A. ("GT-Italy") concocted a scheme involving misleading transactions and off-shore entities that created the appearance of financial health. One such transaction, for example, involved a fictitious sale of 300,000 tons of powdered milk to Cuba for $620 million.

Loans obtained on the basis of this transaction were used to service debt and obtain more loans. In short, Parmalat and its confederates were operating something akin to a Ponzi scheme."

Lawrence Cunningham, writing at Concurring Opinions, describes the particular problem, one of the correct corporate form.

"The argument is that Deloitte Italy acted as an agent of Deloitte Central and/or Deloitte US acting as principal.

The Deloitte defendants, acknowledging securities law violations by Deloitte Italy, first deny the existence of any principal-agent relationship between Deloitte Central and Deloitte Italy and second deny that Deloitte US controls Deloitte Central.

A principal-agent relationship arises from agreement that the agent will act for the principal under the latter's control.

Authority can be actual, apparent or implied; control, which is essential, is evaluated according to all surrounding circumstances.

Deloitte Central denies giving Deloitte Italy any agency authority or exercising any control over it. But the proffered evidence raises material fact questions about these assertions."

The particular corporate form, giving Deloitte US and Deloitte Central, problems is the known as a Swiss Verein.

"The Verein can also be used as a legal form for a busines organization consisting of a number of independent offices, each of which has limited liability vis-à-vis the others.

The form is often used by multinational professional firms. One advantage to the Verein structure is that because control of the firm is decentralized, offices are only bound by regulators in their country.

For instance, non-US offices of accounting firms in a Verein structure are not bound by Securities and Exchange Commission subpoenae from the United States.

Since the assets and earnings of a Swiss Verein are controlled by the member firms, Swiss Verein borrowers should provide a lender with guarantees from member firms or backup Letters of Credit."

Basically, the members of the international network all share a like desire to maintain standards, in this case professional accounting standards, under a common brand, which is in part regulated by local laws and customs.

Operational control of any member of the network by another can be evidence of a principal/agent role, which defeats the intent to keep member liabilities and assets distinct.

The proper corporate form for this is a franchise system, with the franchisor setting standards but not exerting operational control over any of the members is what is needed.

Currently, the Deloitte solution is typical naive legalisms - constantly repeating that each member is a distinct entity.  This is largely window dressing - these business networks need to have centralized standards and an independent mediation/arbitration process to resolve if those standards have been met.  The independence is required, otherwise operational control will pierce the franchisor/franchisee veil.

Full post as published by Misleading Advertising Law on February 03, 2009 (boomark / email).