China: Franchising In China: An Excellent Business Opportunity But One Not To Take Lightly

Last Updated: 4 January 2018
Article by Kristy Guo

Franchising American restaurants in China was recently in the news amid reports that fast food giant McDonald’s has sold its mainland China and Hong Kong businesses to a consortium between the state-owned Chinese conglomerate Citic and the American private equity giant Carlyle Group for $2.03 billion. Among the key points of the deal was that it gives franchising control to the Citic/Carlyle consortium in the PRC for a period of 20 years. Insider reports of the negotiations that culminated in this deal reported that controlling the future franchising rights was one of the key areas of interest from the consortium. McDonald’s will retain a fifth of the ownership interest in the corporate entity that operates its franchising and operations in the PRC, but this sale represents a large part of new CEO Steve Easterbrook's plans to turn the troubled fast food company around.

It is unsurprising the future franchising rights in China would be such a source of interest for the Citic/Carlyle consortium, as franchising American brands in particular in the PRC has been a very successful business model, particularly as Chinese consumers have enjoyed increased income as the PRC's economy has skyrocketed in growth since the 1980's. As China has developed over the past three decades, many foreign (particularly American) companies have become wildly popular. This is particularly true of American fast food restaurants like Kentucky Fried Chicken or McDonalds. However, it also includes retail establishments, fashion labels and a whole host of other industries. Foreign brands are increasingly popular and will only continue to become more so as Chinese consumers enjoy the fruits of their country's breakneck economic growth in their paychecks. This makes franchising foreign businesses in China a particularly lucrative business opportunity, but an opportunity that needs to be approached with caution by foreign companies, who must tread carefully to ensure they comply fully with China's complicated legal framework relating to offer franchises. In addition, franchising in China can offer some unique challenges that many would be franchisors need to understand clearly before entering the Chinese market by offering franchise opportunities in the PRC.

Legal Requirements to Franchise under PRC Law

There are several sets of regulations and promulgations that set forth the law and regulation controlling franchising in the PRC. Currently, the key regulations on franchising in China are the Regulation on the Administration of Commercial Franchises, the Administrative Measures for the Registration of Commercial Franchises, and the Administrative Measures for Information Disclosure of Commercial Franchises. The first was promulgated by the PRC State Council, while both the second and third regulatory schemes were issued by the Chinese Ministry of Commerce (MOFCOM).

Before this legal regime was put into place by the State Council and the MOFCOM, franchisors were not permitted to franchise directly from another country into China. Instead, foreigners either had to establish entities in China which would carry out the franchising or form joint ventures with Chinese partners who had foreign trading rights. Then, through a series of independent contracts, these entities would be awarded a license to use the franchisor’s trademarks and technology and obtain supplies and other items necessary to carry on business in the country as a franchisee of the foreign business.

With the enactment of this legal regime, foreign franchisors are now permitted to directly franchise from abroad into the PRC. Nevertheless, there are several stringent requirements for potential franchisors looking to offer franchising opportunities within the country must comply with. First, only business entities can offer franchising opportunities. Secondly, the franchisor must have a registered trademark or patent. Finally, and perhaps most importantly, PRC law specify that the franchisor must own at least two franchises itself in the PRC and must have operated those two franchises for at least a year. (Some attorneys and businesspersons in the PRC call this the 2+1 rule). Therefore, in the McDonald’s example, the group that bought the rights to offer franchises in China is legally required to own at least two restaurants within the country in order to comply with PRC law and those restaurants must have been open at least a year before the consortium can offer a franchising opportunity to a Chinese business, for example. Nevertheless, this should not be an issue, as McDonald’s will have a stake in the consortium.

Required Disclosures That Must Be Made to a Franchisee under PRC Law

In addition, PRC law mandates certain disclosures that the franchisor must make to the potential franchises. These disclosures are mandatory and must be made at least 30 days before a franchise agreement can be signed by the franchisee. The required information includes the identity of the franchisor, its related corporate affiliates and shareholders and its business resources as well as copies of the franchisor's financial statements and audit reports for the past two years. The disclosures are also required to include information regarding the franchise, including the expenses of operating a franchise, the prices of any products, services or equipment that will be provided to the franchisee, any training and/or technological support the franchisor will provide, as well as what level of guidance and supervision the franchisor will provide. Significantly, the franchisor is also required to inform the potential franchisee of negative information relating to the franchising opportunity, such as any lawsuits or arbitration proceedings which it has been involved in relating to franchise operations over the past five years as well as the records of any illegal activities committed by the franchisor or any of its legal representatives that have resulted in the imposition of criminal penalties or administrative fines of more than RMB 300,000. Finally, and perhaps most importantly from the potential franchisee's perspective, the franchisor must provide copies of the template franchise agreement and any other required contracts the franchisee will need to sign in order to operate a franchise as well as a model investment budget for a franchise outlet.

Potential Problems Likely to Be Encountered when Offering Franchising Opportunities in China

Both the potential franchisor and franchisee need to be aware of the often-onerous conditions that PRC law places on foreign companies looking to offer franchise opportunities within the PRC. For instance, a franchisor failing to fulfill the disclosure obligations to potential franchisees could face a fine from the Chinese Ministry of Commerce in the amount of up to RMB 50,000. In addition, a franchisee may terminate the franchise agreement if the franchisor provides any false information or conceals information that may affect the performance of the franchise agreement. Further, there are also other potential stumbling blocks for potential franchisors which designate a supplier for products or commodities for their franchisees will be liable to franchisees for the quality (or lack thereof) of the products supplied by those suppliers.

In addition to the problems noted above, the International Franchising Association has noted on this issue that there are some problems that can be encountered by businesses wishing to offer franchise opportunities in the PRC. Chief among these is the issue of trademarks and registering the brand name of the franchisor when first entering the Chinese market. It is also critical not to forget to register the trademark in Chinese as failure to do so could result in some unexpected ordeals. For instance, Starbucks found itself in a lawsuit over the use of the Starbucks name in the PRC when it first entered the Chinese market in 2004 because it had not trademarked the Starbucks name in China quickly enough before entering the market. Other brands have experienced horror stories involving a foreign company's failure to understand local customs and cultures or enlist local partners not only in establishing a local supply chain and local distributors and partners in making the franchisor's franchises successful. For example, Subway has struggled to operate at the same level of success in China because Chinese consumers' taste buds do not run to the cold cut sandwiches that the chain offers. Ensuring that the franchisor understands the local markets in which it will be operating is also crucial, as multiple brands have failed to take off in China due to their failure to study local cultures and whether they will indeed have what it takes to succeed in a city like Urumqi, which is very different than Shanghai or Beijing. Finally, the importance of consistency across franchises cannot be established enough. This comes down to not only ensuring that the employees of all franchises are offered adequate training opportunities as well as an emphasis being placed upon adhering to common uniforms, ways of doing business, etc. A Chicken McNugget in Suzhou has got to be cooked the same way by someone dressed in the same outfit and utilizing the same recipe as someone in Guangzhou, or else McDonald's will have serious issues. This all may seem evident even to the most unexperienced businessperson, but this is often not the case for the Chinese.

Enter the Market with Eyes Wide Open

As the Chinese economy continues to expand at over 6% per year, PRC citizens are seeing their incomes rise rapidly. As a result, many of them are anxious to enjoy the trappings of life in Western countries, including foreign cars, stores and even fast food. As has been demonstrated by the success of this model in the PRC for McDonalds, Kentucky Fried Chicken and other companies, there is a very bright future for franchising foreign brands within the PRC. There is therefore a very bright future in franchising in the PRC, but potential franchisors need to ensure they adhere to the letter of the law in offering franchising operations to Chinese companies. They also need to ensure they have appropriately registered all applicable trademarks and put serious efforts into training employees, finding local partners to work with in each Chinese market they enter, and ensure uniformity across all franchises throughout China. The consequences of not doing so can be quite steep indeed.

February 3, 2017

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