China: The New Chinese Franchise Regulation: Worth the Wait?

Last Updated: 6 December 2004
Article by Lee J. Plave and Tao Xu
This article is part of a series: Click New China Franchise Regulation To Be Effective February 1 for the previous article.

Originally published December 3, 2004

Introduction

We have been waiting for three years for the Chinese Government to issue new regulations on franchising. We knew they were inevitable, in light of the manifest inadequacy of the only current regulatory treatment, a set of rules promulgated in 1997. Perhaps more important, we knew that China’s commitments, made in order to move toward membership in the World Trade Organization, would require a new and more carefully developed regime. The several sets of proposals which were leaked over the years were all flawed, in one fashion or another.

Despite the anticipation, the release of draft rules by the Ministry of Commerce (the "MOFCOM") last week (with the first translations appearing in the West earlier this week) came as something of a surprise. They were drafted as an "emergency response" in order to meet the WTO’s requirement that restrictions on franchising by foreign investors be lifted by December 11. The drafters seem to have lacked confidence that the full-fledged Commercial Franchise Regulation would be adopted in time, and the resultant Provisional Measures on the Regulation of Foreign Invested Enterprises Engaging in Commercial Franchising Business (Draft) (the "Measures") have the earmarks of a somewhat hasty operation. Because the translation which was circulated in America this week was inadequate, here’s what we’ve learned from our own translation and, more importantly, from our discussions this week with those in China who are knowledgeable about the drafting process.

Background

The Measures are heavily based on the 1997 Interim Measures on Administration of Commercial Franchise Operations (the "Interim Measures"). The Interim Measures were promulgated by the Ministry of Domestic Trade, which only had jurisdiction over domestic trade. Although there are some serious questions as to whether the Interim Measures apply to foreign franchisors, it has remained until now the only legal framework in China for franchising.

Now, with the imminent adoption of the Measures, it appears that there will be, at least for the immediate future, a parallel regulatory scheme, with the Measures applying to foreign franchisors and the Interim Measures still being applied to domestic franchisors. This dichotomy raises concerns, as there are important differences between the Interim and the Measures. As just one example, the Interim Measures require disclosure to be provided at least 10 days before the execution of a Franchise Agreement, while the Measures require disclosure at least 20 days in advance. While that difference is not particularly troubling, the fact that these and other differences exist at all may well be inconsistent with China’s commitment to the World Trade Organization to treat foreign and domestic businesses on an equal footing.

The regulatory structure in China is made somewhat more complicated by the fact that the Interim Measures and the Measures have, until now, been widely expected to be replaced by formal legislation – tentatively entitled the "Commercial Franchise Regulation" (the "Regulation" in this report) – which remains pending before the State Council of the People’s Republic of China. As of now, it is uncertain whether and when the Regulation will be adopted, whether it will apply to foreign franchisors, and whether the Regulation will be substantively consistent with the terms in the draft Measures, the Interim Measures, or both. If the Regulation is adopted and applicable to foreign franchisors, then presumably it will override the current Interim Measures and the Measures, since they are both only "departmental" rules.

For the present, we must deal with these Measures. Here’s what you need to know:

Coverage

General
By its terms, the Measures apply to franchisors offering franchises in the so-called "service industries" (which the Measures suggest include businesses operating in the fields of retailing, food services, lodging, and rental services, as well as "cultural and sports"). It is unclear whether this term is meant to suggest a different treatment for foreign franchisors in other "non-service" industries, such as the distribution of goods.

Foreign-Invested Entities
The Measures only apply to foreign-invested entities ("FIE") franchising in China. No mention is made of foreign franchisors offering franchises directly to Chinese parties without setting up a Chinese FIE to be the franchisor. Franchisors should note, however, that it is quite possible that direct "off-shore" franchising by a foreign franchisor will be deemed illegal under the Measures for the Administration of Foreign Investment in the Commercial Sector, which was promulgated by MOFCOM earlier this year. That regulation explicitly states that to offer franchises in China, a foreign investor must set up an FIE in China.

Subfranchising
The Measures do not address the critical issue of master licensing, or subfranchising, which leaves unanswered many questions. Among these, for example, are whether it is the master franchisee or the foreign franchisor that is obliged to make disclosure to the subfranchisees, and what obligation a franchisor may have to a subfranchisor which is itself an FIE.

Disclosure

General
Structurally, the disclosure obligations imposed by the Measures are not excessively onerous, with a few notable exceptions. The Measures will require a franchisor to provide a prospective franchisee with a written disclosure document and a copy of the franchise agreement at least 20 days before signing a franchise agreement. The disclosure document must include basic information such as the franchisor’s name and business address, the number and location of the existing outlets, the estimated investment for an outlet, information on the franchisor’s trademark, copyrights and patents, franchise fees and royalties due under the franchise agreement, the franchisor’s litigation history, information about training, sources of products and supplies, and some background information on the franchisor’s principal officers.

Breadth and Vagueness
While the structure of the proposed disclosure obligations is relatively clear, there is more uncertainty as to the nature and extent of some of the required disclosures. Most of these concerns have to do with the breadth of the requirements, which are vaguely worded (in both the translation and in the original Mandarin text) and which therefore leave uncertain a franchisor’s disclosure obligations. Additionally, there are some provisions that appear to impose unduly onerous burdens on franchisors that cannot be justified by any corresponding benefits to prospective franchisees.

Among these, most troubling of the disclosure obligations is the proposal that franchisors must disclose "operational results" of existing franchisees. In the U.S. and other jurisdictions, authorities have reconsidered this proposal and stepped back from mandated earnings claims requirements. While the intent underlying this requirement is not clear, the Measures appear to require franchisors to provide information that few, if any, franchisors actually possess - "operational results" – in any sufficiently meaningful fashion so that the franchisors, in turn, can make that information useful to a prospective franchisee. And, of course, if a franchisor has no or few franchisees in China, or has incomplete or unclear results, any such information on "operational results" could actually be grossly misleading to a prospective franchisee.

An example of how a vague clause leaves a franchisor’s disclosure obligations unclear is the litigation disclosure. The Measures would require a franchisor to disclose "any disputes and unresolved litigations [in] which the franchisor is involved." While seemingly straightforward, the requirement is ambiguous and potentially quite burdensome. The use of the conjunction "and" suggests that the language is intended to refer to "disputes" that have not yet resulted in actual litigation. That, of course, could include any number of disagreements that arise between contracting parties in the normal course of business and that are resolved, also in the normal course of business. Compounding the problem is the absence of any time limitations with respect to the required disclosure as well as to the requirement to disclose "background information" with respect to the franchisor’s principal officers.

Existing Franchisees
The Measures also require franchisors to make disclosures to existing franchisees, among other things about "any development and improvement of the business model, operational technique and management system." While it may well be appropriate as a matter of good business practice for a franchisor to keep its franchisee informed, it is unusual in the context of what is largely a pre-sale disclosure set of requirements.

Franchisor-Franchisee "Relationship" Issues

General
The Measures also impose requirements as to the franchisor-franchisee relationship. Some are helpful, e.g., that a franchisee not transfer its business without the franchisor’s approval. Some only modestly infringe on a franchisor’s freedom, e.g., the Measures require that the term of a franchise agreement generally cannot be less than 3 years. In general, the Measures accord the parties the freedom to contract and act in accordance with the terms of their agreement, e.g., the franchisor may terminate according to the franchise agreement, without any statutory standards. Moreover, parties are free to agree by contract as to their dispute resolution provisions. These provisions show welcome evidence of the Chinese government’s support for the sanctity of contract.

Concerns
However, some serious concerns arise when the Measures seek to impose requirements that are unrelated to the terms of the franchise agreement itself. For example, a franchisor would be liable for the products supplied by its designated suppliers. The Measures require that the franchise agreement include provisions addressing the issue of consumer complaints. These reflect the Chinese government’s laudatory intention to protect consumers, but it is unrealistic for a franchisor to be responsible for the products provided by outside suppliers, especially where the franchisee may have selected the local supplier from among those approved, and where the franchisor is unlikely to be a party to the supply contract. (Franchisors that would otherwise prefer simply to sell products directly to their franchisees might be stymied by a provision generally preventing the franchisor from being the sole source of a product unless the item is proprietary in nature, although U.S. franchisors are familiar with such antitrust concerns.)

Compared to the Past: Better or Worse?

The Measures make some very sensible changes compared to the Interim Measures. For example, the Measures add provisions protecting a franchisor’s intellectual property rights. The Measures also mandate that a franchise agreement should include provisions on confidentiality, and provide that a prospective franchisee is prohibited from disclosing any confidential information gained from the written disclosure document, even if a franchise agreement is not executed or before a franchise agreement is executed. The Measures also abandon the distinction in the Interim Measure between "direct franchise" and "regional franchise" (a combination of area development and subfranchising). The earlier provisions, insisting that a franchisor is only allowed to franchise if it "has good operational results for more than one year" were also dropped, and while the Measures provide more details than the Interim Measures, they are not as detailed and definitive as one would like on how to discharge the disclosure obligations.

Compared to the previously circulated drafts of the Regulation, the Measures also make some welcome changes. For example, the Measures do not require a franchisor to have a certain number of company-owned outlets and be profitable before offering franchises, nor do they require that the franchise agreement be in Chinese. In short, we have made substantial progress.

Approval Process

The Measures mandate application to various government agencies – some local and in some cases directly to the MOFCOM – for approval before an FIE franchisor can offer franchises in China. The application must be made to whichever government agency has the authority to approve the establishment of the FIE in the first instance. To gain approval, an FIE must submit supporting documents, including an application, relevant board resolutions, business licenses, modified bylaws, materials on the FIE’s trademark, copyright and patent, a copy of the sample franchise agreement, and a copy of the written disclosure document.

The few countries that have established such application and approval systems have typically limited the process to a determination of whether the requisite documents were filed in the required fashion. The Measures, however, go further and seek to prescribe the qualifications of the parties, and thus allow the government agency to make a judgment as to whether they should enter into a contractual relationship with one another. For example, the franchisor must demonstrate that it is "equipped with the ability" to undertake certain actions in furtherance of the franchise relationship. Conversely, the franchisee must demonstrate that it possesses adequate capital and "other qualities corresponding to the needs of the franchise business." These qualification standards are unusual and, we believe, inappropriately trump judgments best made by the private parties.

The Measures also require the franchisor to file "information on the franchise agreements executed in the previous year" every January to the approving agency. The Measures leave unclear what kind of "information" will be required.

A Major Question

The Measures have no provisions addressing the consequences of violations, just as the Interim Measures did not. That probably reflects the Chinese government’s determination that special penalties or causes of actions are not necessary, and that existing remedies and penalties in the general legal framework are sufficient. However, it remains unclear what impact there will be due to placing ordinary obligations – such as requiring a franchisor to comply with the terms of the franchise agreement – in the Measures. For example, it is uncertain whether this implies that in addition to any private right of action, a franchisor accused of violating the franchise agreement might also be subject to state action as well. And it is not yet clear whether the Chinese courts – which are not bound by a "department" rule, such as the Measures, that is issued by a ministry – will follow or ignore these guidelines.

Conclusion

No one should expect significant changes to be made in the Draft. The secrecy of the process, the necessity of rapid action, and the extremely short period of time provided for comment, all make it clear that what you see is almost certainly what you are going to get.

So what do we see? A largely tolerable, if obviously flawed, set of requirements. Some unwise and ill-considered provisions, alongside an otherwise quite manageable litany of obligations. Much work remains to be done by franchisors and their counsel, but there is a sense of relief that we are at last dealing with an official, and at least nominally "final," document.

But if we step back from the text and the imperfect translation, we can glimpse a larger reality: this legislation may be that rare example of a law which franchisors do not oppose, but actively seek.
Franchisors have historically taken the position that the only legal conditions needed for franchising to thrive are a recognition of the sanctity of contract and protection of intellectual property. China may prove to be the exception to that rule.

The Chinese market is so huge that no franchisor can afford to ignore it. The uncertainties of the Chinese legal system, and the questions hovering over the legal status of the new marketing technique called franchising, have led multinational franchisors to reconsider the historic opposition to franchising.

For almost two decades we have heard the arguments made in socialist and post-socialist societies, "It doesn’t make any difference that we have not had any real abuses necessary to ‘justify’ a law. What matters is that franchising will never be a fully accepted way of doing business until we have a law addressing it." For almost two decades we have scoffed at that simplistic approach. We are not scoffing any longer.

This article is intended to provide information on recent legal developments. It should not be construed as legal advice or legal opinion on specific facts. Pursuant to applicable Rules of Professional Conduct, it may constitute advertising.

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This article is part of a series: Click New China Franchise Regulation To Be Effective February 1 for the previous article.
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