India: The International Hotspot -- Franchising Goes East

The Legal Framework

For international companies and brands looking to franchise into India, a number of legal hurdles exist, in particular relating to the repatriation of payments overseas and a lack of clear policy direction from the authorities.

The Indian rupee is still not fully convertible, and as a result, there are restrictions with respect to transactions in foreign exchange to maintain a balance of payment. The Indian Foreign Exchange Management Act ('FEMA') 1999 and the rules and regulations made under it provide the regime for regulating foreign currency transactions: A key aim is to prevent excessive outflow of foreign exchange from the country. The traditional method for obtaining payments in foreign exchange from an Indian party or franchisee/master franchisee is the technical collaboration route. The advantage of this method is that it has certainty for the franchisor. The technical collaboration route applies where a business-format franchise provides a new technique of doing business that accompanies the sale of products or the provision of services. The advantage of this route is that no governmental consent is required. It is therefore possible for a franchisor to obtain a lump-sum payment from a master franchisee or developer of up to US $2 million and ongoing royalty payments of up to 5% of turnover. It is also possible to have a consultancy services agreement for up to US $1 million per project. For hotel franchises, it is possible to obtain up to 3% of the capital costs of the proposed venture for technical and consultancy services including fees for architects, design, and supervision of 3% of the net turnover as a franchise or marketing fee, and up to 10% of the gross operating profit as a management fee or incentive fee, without the need for governmental consent.

For a payment structure above those limits mentioned, permission of the Project Approval Board of the Foreign Investment Promotion Board has to be sought. But franchisors will find that the consent route is a time-consuming and expensive process. Further, the success of the venture depends upon the attitude of the government toward that particular type of franchise or industry sector. For example, the Indian hotel and tourism industry requires foreign participation, so obtaining consent is relatively easy. In retail, however, it is very difficult, and in the educational sector the content is scrutinized for cultural and political suitability. The advantage for franchisors of having formal consent is one of certainty that the payment terms in the documentation are enforceable against the Indian party.

A third approach, which is becoming increasingly popular, is to structure the franchise agreement so that franchise services are provided by the foreign franchisor/master franchisor for a 'service fee.' Under this route, royalties are not available. The service fee is equivalent to an upfront or initial fee. This approach takes advantage of a loophole in the law. The FEMA (Current Account Transactions) Rules 2000 previously provided that foreign exchange required to purchase a franchise in India required the consent of the Reserve Bank of India ('RBI'). The amendments made in 2006 and 2007 provided that this restriction of requiring prior consent has been removed. This has been interpreted by many to mean that there is no limit on the amount payable (i.e., the upfront fee) for a franchise.

The position is, however, unclear for international franchisors. The RBI has not clarified whether this means that there are no restrictions on payment whatsoever, or whether it will decide at a later date what the limits will be. It is also not certain whether the service fee can be calculated and paid as a percentage of turnover or as a lump sum. Neither FEMA nor RBI has defined 'service fee' nor 'franchise fee' in regulations or circulars. Whilst from one perspective the FEMA regulations do provide a tightly regulated framework, with limits prescribed for most activities, further clarification ' or, indeed, regulation ' would be welcomed in the franchise sector for the purposes of clarity. If the RBI finds over time that there is significant outflow of foreign exchange through the service fee route, then it will no doubt plug the loophole. This uncertainty brings an element of risk.

Obtaining a guarantee from an Indian party is another problem faced by foreign franchisors. Indian banks can freely provide a guarantee of up to US $100,000 for their customers importing international services, beyond which permission of the RBI is required. Franchisors seeking larger guarantees are therefore more likely to face stiff resistance from the potential Indian partner. Indian parties generally dislike the scrutiny they have to undergo when seeking permission for a performance guarantee from the RBI, and the process can often be time consuming.

Trends and Opportunities

In the retail sector, the government faces a strong lobby of independent retailers, especially from traditional 'mom and pop' stores that have insisted upon protection of their interests. On the other hand, attitudes are shifting. The spending habits of Indians, particularly the young middle classes, have changed from buying basic food, groceries, and essential clothing to purchasing high-quality brands. For international brands to be truly embraced, this shift in attitude needs to spread wider and deeper. It is therefore no surprise that a number of the large global supermarkets and multi-brand retailers such as Wal-Mart, Carrefour, Metro, and Tesco are targeting the Indian market and have joined with major Indian companies for the opportunity to establish their stores. In the meantime, due to current restrictions on international, multi-brand retailing, they have entered through the Indian market wholesale cash-and'carry, business which permits international retailers under Indian law.

As a note of caution, the large Indian companies may have already stolen the march on international brands. Companies such as Reliance, TATA, Bharti, ITC, Mahindra Inter-trade, and the Birla Group have already started multi-brand retailing. However, Reliance and TATA, which were planning to establish significant operations, have faced hurdles themselves. Reliance had to shut down many outlets in various states (especially UP, Orrisa, West Bengal) due to local opposition from small businesses. Further, it has been difficult to obtain retail space. As a result, these companies have had to resort to various strategies, including co-opting existing small retailers.

International companies not already in discussions with the major Indian companies will need to consider their India strategy and identify potential partners before it is too late. According to the Economist Intelligence Unit, it is anticipated that Reliance alone will have 20% of the multi-brand retail market by 2011.

The Attractions of Franchising

Despite the above obstacles, the franchise model, with some careful thought and planning, is potentially a very attractive model for international brands seeking to penetrate the Indian markets. A number of British retailers have marketed their brands in India by granting franchises to Indian retailers, including Marks & Spencer, Debenhams, Accessorize, Next, French Connection, Body Shop, Costa caf', and Mothercare. British Home Stores will open stores in Delhi and Mumbai through a franchise agreement to L K Pagarani. French Connection has entered India through the Murjani Group. The Murjani Group is also the franchisee/licensee for brands such as Calvin Klein, La Perla, Gucci, Tommy Hilfiger, and Jimmy Choo.

Despite India's extremely positive economic outlook (in stark contrast to the United States' and the UK's economies), one of the challenges for India is to ease its restrictions, which includes modifying its legal framework, to make foreign investment into India easier. This in turn will permit the growth and development of international franchise businesses. The challenge for international franchisors will be to convince Indian consumers and businesses of the benefits of international franchise businesses.

Graeme Payne is a Senior Solicitor and Lisa Sen is a Solicitor (dual English and Indian qualified) with Field Fisher Waterhouse LLP. Payne lectured at the recent India Fashion Forum held in Mumbai.

India's attraction to European and U.S. franchisors (and all branded marketers) is not only the sheer number of potential Indian consumers, but, more importantly, a growing young affluent population with an increasing demand for quality consumer goods and services. This, in part, has been due to the 8-10% annual growth rate of the Indian economy. Further, there has been significant growth in organized retailing through large shopping malls, with a target of 600 malls by 2010 [source: 'Indian Companies on the Move ' And How,' Sathish Kulkarni, Economic Times, Mumbai, Dec. 21, 2007]. At the recent India Fashion Forum, experts predicted that the Indian retail sector is expected to grow by another US trillion dollars in the next eight years.

Despite the positive economic conditions and the demand for international brands, the Indian legal framework still raises some barriers to international business. The Indian government has the delicate task of balancing what is perceived to be in the interest of local businesses and those of foreign investors.

In the retail sector, for example, until 2005 foreign investors were not allowed to invest directly in India. Even when investment was opened, foreigners were permitted to own a maximum of 51% shareholding in a single-brand retail business after having to obtain government consent. For foreign investors, the only viable options have been to grant a franchise (as with the recent Armani-DLF partnership) or to license a brand to an Indian partner or to be involved in the cash-and-carry wholesale business.

The Legal Framework

For international companies and brands looking to franchise into India, a number of legal hurdles exist, in particular relating to the repatriation of payments overseas and a lack of clear policy direction from the authorities.

The Indian rupee is still not fully convertible, and as a result, there are restrictions with respect to transactions in foreign exchange to maintain a balance of payment. The Indian Foreign Exchange Management Act ('FEMA') 1999 and the rules and regulations made under it provide the regime for regulating foreign currency transactions: A key aim is to prevent excessive outflow of foreign exchange from the country. The traditional method for obtaining payments in foreign exchange from an Indian party or franchisee/master franchisee is the technical collaboration route. The advantage of this method is that it has certainty for the franchisor. The technical collaboration route applies where a business-format franchise provides a new technique of doing business that accompanies the sale of products or the provision of services. The advantage of this route is that no governmental consent is required. It is therefore possible for a franchisor to obtain a lump-sum payment from a master franchisee or developer of up to US $2 million and ongoing royalty payments of up to 5% of turnover. It is also possible to have a consultancy services agreement for up to US $1 million per project. For hotel franchises, it is possible to obtain up to 3% of the capital costs of the proposed venture for technical and consultancy services including fees for architects, design, and supervision of 3% of the net turnover as a franchise or marketing fee, and up to 10% of the gross operating profit as a management fee or incentive fee, without the need for governmental consent.

For a payment structure above those limits mentioned, permission of the Project Approval Board of the Foreign Investment Promotion Board has to be sought. But franchisors will find that the consent route is a time-consuming and expensive process. Further, the success of the venture depends upon the attitude of the government toward that particular type of franchise or industry sector. For example, the Indian hotel and tourism industry requires foreign participation, so obtaining consent is relatively easy. In retail, however, it is very difficult, and in the educational sector the content is scrutinized for cultural and political suitability. The advantage for franchisors of having formal consent is one of certainty that the payment terms in the documentation are enforceable against the Indian party.

A third approach, which is becoming increasingly popular, is to structure the franchise agreement so that franchise services are provided by the foreign franchisor/master franchisor for a 'service fee.' Under this route, royalties are not available. The service fee is equivalent to an upfront or initial fee. This approach takes advantage of a loophole in the law. The FEMA (Current Account Transactions) Rules 2000 previously provided that foreign exchange required to purchase a franchise in India required the consent of the Reserve Bank of India ('RBI'). The amendments made in 2006 and 2007 provided that this restriction of requiring prior consent has been removed. This has been interpreted by many to mean that there is no limit on the amount payable (i.e., the upfront fee) for a franchise.

The position is, however, unclear for international franchisors. The RBI has not clarified whether this means that there are no restrictions on payment whatsoever, or whether it will decide at a later date what the limits will be. It is also not certain whether the service fee can be calculated and paid as a percentage of turnover or as a lump sum. Neither FEMA nor RBI has defined 'service fee' nor 'franchise fee' in regulations or circulars. Whilst from one perspective the FEMA regulations do provide a tightly regulated framework, with limits prescribed for most activities, further clarification ' or, indeed, regulation ' would be welcomed in the franchise sector for the purposes of clarity. If the RBI finds over time that there is significant outflow of foreign exchange through the service fee route, then it will no doubt plug the loophole. This uncertainty brings an element of risk.

Obtaining a guarantee from an Indian party is another problem faced by foreign franchisors. Indian banks can freely provide a guarantee of up to US $100,000 for their customers importing international services, beyond which permission of the RBI is required. Franchisors seeking larger guarantees are therefore more likely to face stiff resistance from the potential Indian partner. Indian parties generally dislike the scrutiny they have to undergo when seeking permission for a performance guarantee from the RBI, and the process can often be time consuming.

Trends and Opportunities

In the retail sector, the government faces a strong lobby of independent retailers, especially from traditional 'mom and pop' stores that have insisted upon protection of their interests. On the other hand, attitudes are shifting. The spending habits of Indians, particularly the young middle classes, have changed from buying basic food, groceries, and essential clothing to purchasing high-quality brands. For international brands to be truly embraced, this shift in attitude needs to spread wider and deeper. It is therefore no surprise that a number of the large global supermarkets and multi-brand retailers such as Wal-Mart, Carrefour, Metro, and Tesco are targeting the Indian market and have joined with major Indian companies for the opportunity to establish their stores. In the meantime, due to current restrictions on international, multi-brand retailing, they have entered through the Indian market wholesale cash-and'carry, business which permits international retailers under Indian law.

As a note of caution, the large Indian companies may have already stolen the march on international brands. Companies such as Reliance, TATA, Bharti, ITC, Mahindra Inter-trade, and the Birla Group have already started multi-brand retailing. However, Reliance and TATA, which were planning to establish significant operations, have faced hurdles themselves. Reliance had to shut down many outlets in various states (especially UP, Orrisa, West Bengal) due to local opposition from small businesses. Further, it has been difficult to obtain retail space. As a result, these companies have had to resort to various strategies, including co-opting existing small retailers.

International companies not already in discussions with the major Indian companies will need to consider their India strategy and identify potential partners before it is too late. According to the Economist Intelligence Unit, it is anticipated that Reliance alone will have 20% of the multi-brand retail market by 2011.

The Attractions of Franchising

Despite the above obstacles, the franchise model, with some careful thought and planning, is potentially a very attractive model for international brands seeking to penetrate the Indian markets. A number of British retailers have marketed their brands in India by granting franchises to Indian retailers, including Marks & Spencer, Debenhams, Accessorize, Next, French Connection, Body Shop, Costa caf', and Mothercare. British Home Stores will open stores in Delhi and Mumbai through a franchise agreement to L K Pagarani. French Connection has entered India through the Murjani Group. The Murjani Group is also the franchisee/licensee for brands such as Calvin Klein, La Perla, Gucci, Tommy Hilfiger, and Jimmy Choo.

Despite India's extremely positive economic outlook (in stark contrast to the United States' and the UK's economies), one of the challenges for India is to ease its restrictions, which includes modifying its legal framework, to make foreign investment into India easier. This in turn will permit the growth and development of international franchise businesses. The challenge for international franchisors will be to convince Indian consumers and businesses of the benefits of international franchise businesses.

Graeme Payne is a Senior Solicitor and Lisa Sen is a Solicitor (dual English and Indian qualified) with Field Fisher Waterhouse LLP. Payne lectured at the recent India Fashion Forum held in Mumbai.