China: Franchising in China: A guide to the landscape

Last Updated: 8 November 2011
Article by Richard Wageman

China presents foreign franchisors with many options and opportunities. The combination of continued interest in foreign products and a growing desire among Chinese consumers for quality products, consistency in products/services and foreign brands has led many foreign franchisors to rush into the Chinese market, desperate to secure a place. yet, even as opportunity beckons, considerable challenges remain to entering the Chinese market without adequate knowledge of its changing conditions.

On 1 May 2007, the State Council of the People's Republic of China (PRC) brought into effect the regulations on The Administration of Commercial Franchise (Franchise Regulations). Although the 2007 franchise regulations were generally well received by the franchise business sector, there were business and legal issues that they did not address fully. This created some uncertainty for franchisors wishing to establish a presence in China. Four years on, this situation has not changed signifcantly. neither the China State Council nor the Ministry of Commerce have issued supplemental regulations or policy statements to clarify the areas of uncertainty. Regardless of these legal uncertainties and the inherent challenges of operating a business in China, international franchisors are realising that if they delay moving into China, they are leaving the market wide open to local competitors.

KEY FRANCHISE REGULATIONS

The franchise regulations defne important franchise parties and activities. some of the key defnitions are as follows:

  • The franchise regulations provide that the regulations are applicable to all 'franchise activities' that take place 'within the territory of the People's Republic of China'. This provision clearly intends to cover not only domestic franchisors and franchisees, but also foreign franchisors intending to conduct business in China.
  • The term 'franchise business' (hereinafter 'franchise') is defned as 'an enterprise that owns the operational resources such as registered trademarks, a company logo, patents and know-how (hereinafter referred to as 'franchisor'), and by means of contract, licenses another business operator (hereinafter referred to as 'franchisee') to use such operational resources owned by the franchisor, and the franchisee conducts its business activities under a uniform business system and pays franchise fees to the franchisor in accordance with the contractual stipulations'.

As noted above, the terms franchisor and franchisee are defned in the franchise regulations, but not with a great degree of specificity. however, what constitutes a franchisor and a franchisee can be effectively derived from the text of the full franchise regulations, as follows:

FRANCHISOR

A franchisor:

  • must be an enterprise or other economic organisation incorporated by law
  • must own operational resources such as registered trademarks and patents, the company logo, know-how and operational models, all of which rights the franchisor may authorise others to use
  • must have the ability to provide franchisees with long-term business guidance, technical support and training services.

This means the franchisor must be a legal enterprise with an operation system, intellectual property and an established support structure.

FRANCHISEE

No unit or individual other than enterprises referred to in the preceding paragraph (referring to the defnition of franchisor) may conduct franchise activities as a franchisee in china.

This very general reference along with the other references to franchisee in the franchise regulations basically state that a franchisee does not require any special qualifcations or skills unless the franchisee wants to conduct franchise activities such as granting sub- franchises. In such case the franchisee must be established as a corporate entity.

THE '2+1 RULE'

One of the most controversial and debated franchise issues in the franchise regulations is the so-called '2+1 rule' – the requirement that a franchisor cannot offer franchises until it can establish that it has owned and operated two franchise units for at least one year.

Although the franchise regulations do not state specifcally whether the units must be located in China or whether these units may be located outside of China, most franchise experts are taking the position that a foreign franchisor can satisfy the legal requirement by operating two directly owned units located anywhere in the world. This position is supported by oral statements made by offcials within the ministry of commerce franchise department and the China Chainstore and Franchise Association.

One of the ongoing uncertainties in relation to the 2+1 rule is that the 2007 franchise regulations do not indicate how the Ministry of Commerce will determine ownership and what types of 'directly operated outlets' will satisfy the requirements of the 2+1 rule. This situation has recently been clarifed to some extent by draft franchise regulations (Draft Regulations) the Ministry of Commerce released in April 2011 for public comment. such draft regulations provide that:

  • a franchisor can rely upon the units of a company that is under the same corporate ownership as the franchisor
  • franchisors that engage in non-store activities, such as online education companies, do not need to satisfy the 2+1 rule requirements
  • a hotel directly managed by a hotel management franchisor would be considered as a directly owned and operated unit by the franchisor.

It is uncertain whether such provisions will be included in additional franchise regulations when issued, or indeed whether additional regulations will be issued at all.

FRANCHISOR ACTIVITIES PRIOR TO 1 MAY 2007

Prior to 1 may 2007, Chinese law did not allow for cross-border franchising or franchising in any form. In response to these restrictions, some international franchisors used a combination of cross-border licensing, service and supply agreements to conduct what may be described as quasi-franchise business activities in China.

The franchise regulations provided that such franchisors did not need to comply with the provisions of the 2+1 rule and would be permitted to continue operations in china as franchisors, provided that they fled notice of their business operation with the Ministry of Commerce by 1 May 2008 and complied with all other provisions of the franchise regulations. According to the Ministry of Commerce, very few franchisors ultimately took advantage of this exemption. In many cases, such franchisors did not register as franchisors, but continued to operate as licensors.

Under the draft regulations, franchisors that did not take advantage of the exemption made available in 2007/2008 may have a second chance to regularise their activities in china. The draft regulations provide, without qualifcation, that if a franchisor was operating in china prior to 1 may 2007, it will not need to satisfy the 2+1 rule. This type of provision, if brought into law, will be welcomed by many international franchisors that have been operating franchises in other parts of the world for many years but do not actually own or operate any units.

LEGAL ENTITY SET-UP

Under the franchise regulations, a franchisor must be an enterprise or other economic organisation. Therefore, if an international franchisor wants to conduct franchise activities in china other than by way of a cross-border franchise agreement, it must establish a legal entity in China. In this regard the foreign franchisor must set up a foreign Invested enterprise in china that can be either a wholly foreign-owned enterprise or a joint venture. As a new legal entity in China, it will need to satisfy all of the franchisor flings requirements set out in the franchise regulations, including the requirements of the 2+1 rule, before it can commence franchise activities in the country.

'To date, the Ministry of Commerce has not been very aggressive with franchisors, but this situation will undoubtedly change.'

FILINGS

In April 2007, the Ministry of Commerce, in accordance with the provisions of the franchise regulations, issued administrative rules to detail procedures for the registration of franchisors who commence franchise business activities in China (Administrative Rules on Commercial Franchise Filing) and for information disclosure (Administration Rules on Commercial Franchise Information Disclosure).

In accordance with the franchise fling rules, a franchisor is required to fle as a franchisor with the appropriate commercial authority of the ministry of commerce within 15 days of the signing of the initial franchise contract in China.

The location of the commercial authority depends on the extent of the franchisor's proposed franchise activity.

To process the franchisor fling, the franchisor must frstly fle pdf copies of the following documentation online with the commercial authority, and secondly submit the original copies of such documents after the Ministry of Commerce has accepted the documents fled online. The documents that must be submitted are as follows:

  • basic information concerning the franchise system
  • a duplicate copy of the franchisor's business license or of its enterprise registration (fling) certifcate
  • a sample of the franchise contract
  • the table of contents of the franchise operation manual
  • the locations of franchise outlets in china
  • the franchisor's marketing plan
  • intellectual property fling certifcates
  • a written undertaking and relevant substantiating materials showing that the franchisor meets the requirements set forth in the regulations
  • evidence that the franchisor has fully complied with the 2+1 rule
  • details/certificates concerning approval for services or products – if required
  • the franchisor's written 'undertaking'(specifed form)
  • other documents and materials as stipulated by the competent commercial authority of the state council.

Within ten days of receiving the documents and materials from the franchisor, the Ministry of Commerce will record the fling and notify the franchisor. If the documents are incomplete, the ministry of commerce will require that the appropriate documents are fled within seven days of notifcation. After the franchisor has fled the documents and the documentation is accepted by the Ministry of Commerce, the Ministry of Commerce will publish the franchisor's fling information on its website.

Franchisors that fail to register in a timely manner can face penalties. franchisors found to be in breach of the franchise regulations will normally be given a certain period of time to rectify the problem, but if the franchisor fails to make the fling or the fling is not accepted, the franchisor can incur fnes from rmB 100,000 to rmB 500,000 and face public announcements concerning such violations.

The franchise regulations also require franchisors to fle notice of all major changes to their original fling details within 30 days of such changes taking place, and to fle an annual update before the end of march each year.

CONTRACT BETWEEN THE FRANCHISOR AND FRANCHISEE

The franchise regulations provide that the franchise contract must include the following provisions:

  • basic information of the franchisor and the franchisee
  • description of the franchise and the term of the franchise
  • types, amounts and payment methods of the franchise fees
  • specifc contents and provision methods of the operational guidance, technical support, business training and other services
  • quality and standards requirements, as well as guarantee measures, for the products or services offered by the franchised business
  • promotion and advertisement of the products or services offered by the franchised business
  • arrangements for the protection of consumer rights/interests and understating of liability for compensation in the franchising activities
  • amendments, rescission and termination of the franchise contract
  • liability for breach of contract
  • methods of dispute resolution
  • a rescission right during a specifed period after the franchise contract is signed
  • other matters as agreed upon by the franchisor and the franchisee.

In addition, the initial term of the franchise agreement cannot be less than three years, unless explicitly agreed to by the franchisee.

FRANCHISE DISCLOSURE AND RESCISSION RIGHTS

The franchise regulations provide that a franchisor shall establish a well-organised information disclosure system by providing various information and documentation to prospective franchisees in the form of a written franchise disclosure statement at least 30 days prior to the date the formal franchise contract is executed.

The following information must be included in the disclosure statement:

  • franchisor details
  • overview of the franchisor's commercial activities
  • basic information concerning franchise flings
  • product supply information – affliate
  • fnancial history of the franchisor – basic (fve years)
  • intellectual property details
  • franchise fee details
  • details concerning products/services/ equipment supplied by the franchisor
  • details concerning franchisor supervision/ guidance of franchise
  • investment details for franchise
  • fnancial statement information – two years
  • franchisor litigation/arbitration – material
  • material illegal activities – franchisor/legal representative
  • franchise contract details.

The franchise regulations also provide that the franchisee shall have the right to rescind the franchise contract during a reasonable period of time after the franchise contract is signed, without penalty or damages payable to the franchisor. so what is a reasonable time period to allow the franchisee to rescind the franchise contract? most franchisors settle upon a time period of 7 to 14 days, but as neither the ministry of commerce nor the chinese courts have provided clear guidance on this issue, the time period used by a franchisor may be challenged by the authorities and franchisees if a complaint is lodged by a franchisee and the relevant authority decides the rescission period is not reasonable.

PENALTIES

If a franchisor breaches the provisions of the franchise regulations, the ministry of commerce has the discretion to take action against the franchisor as follows:

  • levy a fine against the franchisor
  • instruct the franchisor to rectify the breach
  • issue a public announcement concerning the franchisor's breach of the regulations and the penalty levied
  • request the China Administration of Industry and Commerce cancel the franchisor's business license if such franchisor is located in china
  • cancel the franchisor's fling with the ministry of commerce.

To date, the Ministry of Commerce has not been very aggressive with franchisors, but this situation will undoubtedly change as franchisees start to experience problems with their franchisors and fle complaints with the Ministry.

CONCLUSION

Establishing a franchise system in China can be a time-consuming, expensive and diffcult process, regardless of the products or services offered by the franchisor. However if a franchisor carefully considers all issues before it enters china, links up with the right chinese commercial or equity partners and is prepared to accept a long-term approach to develop its franchise system, then China can be a rewarding experience.

© DLA Piper

This publication is intended as a general overview and discussion of the subjects dealt with. It is not intended to be, and should not used as, a substitute for taking legal advice in any specific situation. DLA Piper Australia will accept no responsibility for any actions taken or not taken on the basis of this publication.


DLA Piper Australia is part of DLA Piper, a global law firm, operating through various separate and distinct legal entities. For further information, please refer to www.dlapiper.com

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