Article by Fiona Wallwork and Katrina Hammon
Despite the current economic climate we see a growing interest in Australian franchisors expanding into the People's Republic of China.
As a result of the introduction of the new regulations and changing consumer attitudes, franchising has experienced rapid growth in China. The fast food / refreshment and retail systems are considered to have the greatest potential in this market.
However, China is not an easy market to crack. Franchisors must be mindful of the complex regulatory environment. Foreign franchisors need to be aware of the extent of information that must be submitted to demonstrate that the franchisor's system is credible, the complex online filing requirements and translation costs.
It is our experience that those foreign franchisors who are seriously committed to the Chinese market will eventually make it, despite what may first appear to be insurmountable regulatory impediments – patience is a virtue.
Current regulatory regime
Franchising in China has come a long way since KFC entered the market in 1987. McDonald's followed suit in 1990. Both systems operated through joint ventures with stores being company-owned or managed. Initially operating in China through the traditional franchise format was not possible due to regulatory and commercial reasons. The development of franchise-specific regulation has been a work in progress, interim franchise regulation was first introduced in 1997 and only applied to domestic invested franchisors, and further interim regulation was introduced in 2005. A decade after the first interim regulation the current Commercial Franchise Administration Regulations were adopted by the State Council and took effect from 1 May 2007 (Regulations).
The Regulations are applicable to "all franchise activities within the People's Republic of China". The Regulations are applicable to foreign franchisors and their franchisees conducting business in China.
For foreign franchisors the regulations have lessened the burden of approval requirements and brought China's franchise regulation in line with other markets with franchise-specific legislation. However a number of complexities remain.
The Regulations are prescriptive and do not explicitly contemplate Western business formats such as master franchise, area developer and sub-master franchise arrangements. In our experience, a flexible and often creative approach to compliance with the Regulations requirements is required.
There continues to be some uncertainty concerning compliance requirements. However, we have seen an improvement over the last 12 months, and some of the perceived uncertainties have now been clarified by China's Ministry of Commerce. Greater certainty will further fuel significant growth and developments of the Chinese franchise sector.
Summary of key compliance requirements
Qualifications of franchisor
The Regulations set out the requirements that a franchisor must satisfy in order to operate and grant franchises in China. Amongst other things a franchisor must:
- be registered as a trading company (individuals and other entities may not be a franchisor)
- have a mature business model and be able to provide franchisees with continuous operational guidance, technical support, training and other services
- have "directly operated" itself (or its subsidiary) at least two stores which have been in operation for more than one year (Two Store Rule). With adequate evidence it may be possible to satisfy the Two Store Rule where stores are operated by an affiliate of the franchisor as opposed to a subsidiary
- own or be licensed to use the registered trade mark, company mark, patent, know-how and other intellectual property, and
- have a sufficiently developed management system to support franchisees.
Registration and online filing
Franchisors must file certain information and copies of franchise documents within 30 days of signing any franchise agreement. This includes a foreign franchisor executing a master franchise agreement and a foreign master franchisee executing a sub-franchise agreement.
The online filing procedure can only be conducted online. To complete online filing and register with the Ministry of Commerce (MOFCOM) a franchisor must obtain an online access key from MOFCOM. To obtain the online access key a franchisor must complete an application and submit extensive supporting documents in order to establish that the franchisor's system is credible and it is authorised to grant franchise rights in China. The documents include evidence that the franchisor meets the Two Store Rule. Documents that need to be submitted include:
- certificates of incorporation and business name registration
- certificates of registered trade mark or alternatively filing receipts for pending trade mark applications
- documents that can certify the franchisor meets the Two Store Rule requirement
- letters of authorisation to use the intellectual property and other documents or information required by MOFCOM from time to time.
A franchisor who does not meet the qualifications to operate in China but grants franchises is at risk of having the income generated by such franchises confiscated by the authorities.
The Regulations require that a disclosure document be issued to a franchisee at least 30 days prior to signing a franchise agreement.
The disclosure document must contain detailed information which is prescribed in the Regulations some of which is similar to the Code requirements in Australia.
The Regulations require disclosure of the specific costs for a franchisee to commence operation in China. It may be possible to specify the costs based on Australian franchisee start-up costs provided effective disclaimers are used. Due to the Regulations not specifically contemplating a franchisor granting master franchise rights a Franchisor must disclose the franchisee level start-up costs even though the rights that are being granted are master franchise rights.
Audited financial statements must be provided to prospective franchisees as part of the disclosure requirements. It may be possible to satisfy this requirement without the need to have the franchisor's accounts audited, this depends on what substitute information the franchisor is able to provide and is particularly relevant for Australian Franchisors that have accounts audited as a consolidated group.
Franchise agreements must be in writing and must have a minimum term of 3 years unless the franchisee agrees to a lesser term. Franchise agreements must contain a number of obligatory clauses, including a mandatory cooling-off period, however the period is not defined in the Regulations. The franchisee may unilaterally terminate the franchise agreement within the stipulated cooling off period, without compensation being payable to the franchisor.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.