China: Going Global: The Current Landscape Of Franchising In China

Last Updated: 31 July 2018
Article by IPO Pang Xingpu

Co-authored by Sofie Gleditsch*

Franchising in China emerged in the late 1980s, with American fast-food chain KFC paving the way. Soon after, several other multinational companies entered and expanded into the Chinese market. In 1997, China issued its first regulation directed at providing guidance on franchising. However, foreign direct franchising remained of limited reach due to a lack of specific provisions governing it. As it then were, foreign companies were required to seek approval from China's Ministry of Commerce ('MOFCOM') before registration of its franchise.

Today's landscape paints a different picture. As part of China's accession into the World Trade Organization, new regulation and measures were enacted and with it the abolishment of the requirement to seek pre-approval from MOFCOM. Although franchisors are not required to obtain pre-approval from MOFCOM before carrying out franchising projects, the law does require franchisors to file with MOFCOM prior to franchising.

LEGAL REQUIREMENTS AND APPLICATION PROCESS

Franchising in China is regulated by the Regulation on the Administration of Commercial Franchises ('Regulation'), the Administrative Measures for the Registration of Commercial Franchises and the Administrative Measures for Information Disclosure of Commercial Franchises.

According to the Regulation, to successfully franchise into China, the prospective franchisor must be a business, not an individual. Secondly, the business must have a registered patent or trademark in China. Thirdly, the franchisor must demonstrate that it has a mature business model. To do that, the franchisor must show proof that it, or "a directly operated outlet" of the franchisor, has operated at least two franchise units for at least one year. This is often referred to as the "2+1 rule".

The MOFCOM released the revised Administrative Rules on Commercial Franchise Filing ("the Rules") on December 12, 2011 and the Rules entered into effect on February 1, 2012. The revised rules provided certain improvements and clarifications on franchise filing, but it fails to address the "2+1 rule" with sufficient clarity.

One of the on-going uncertainties in relation to the "2+1 rule" is that the franchise regulations do not indicate how the MOFCOM will determine ownership and what types of "directly operated outlets" will satisfy the requirements of the "2+1 rule." The Draft Filing Rules released in April 2011 for public comment proposed provisions to clarify the rule. However, all these proposed provisions were removed from the final Revised Franchise Filing Rules. It remains unclear the intention of removal of such provisions, and whether future regulations or rules will clarify these issues.

Due to such uncertainties, the MOFCOM exercises discretion in its application of the "2+1 rule." Fortunately, the MOFCOM has provided some guidance on the interpretation of "directly operated outlets." Outlets directly operated by a related company of the franchisor qualifies as "directly operated outlets" of the franchisor under the "2+1 rule" when the following two conditions are met.

  1. The related company refers only to the parent company, or a wholly owned enterprise, of the franchisor, or a company in which the franchisor owns a controlling interest;
  2. The directly operated outlets of the related company engages in the same type of business as the franchisor, and conduct business under the same brand as the franchisor.

Under such circumstances, the franchisor shall submit the following documentation to satisfy the "2+1 rule."

  1. Proof of the relationship between the related company and the franchisor in terms of ownership;
  2. Proof that such relationship has been in existence for at least one year.

As shown by our recent experience with a franchisor, a mere overlap of shareholders between two companies does not satisfy the relationship requirements according to the MOFCOM.

The MOFCOM rejected the company's filing for its failure to comply with the "2+1 rule." The franchisor is a newly established entity, and thus does not own any franchise units that have operated for at least one year. The franchisor claimed another company to be a "related company" of the franchisor based on an overlap of shareholders between the two companies, and that company owns two directly operated units for at least one year. However, according to the MOFCOM, that company does not qualify as a "related company" of the franchisor for purposes of the "2+1 rule," because the "related company" under the "2+1 rule" refers only to the parent company, or a wholly owned enterprise, of the franchisor, or a company in which the franchisor owns a controlling interest.

In practice the MOFCOM has relaxed the requirements of the "2+1 rule", in the sense that units operated by certain related companies of the franchisor qualify as "directly operated outlets" of the franchisor (assuming the aforementioned two conditions are met). Further, Chinese courts generally agree that a franchisor may demonstrate a mature system without complying with the "2+1 rule," which in practice means that the franchise agreement will be valid (assuming non-compliance with the "2+1 rule" is properly disclosed). However, registration with the MOFCOM will be problematic.

Additionally, when  all of the legal criteria are met, the franchisor must file an application to the MOFCOM to register its franchise within 15 days of signing a franchise agreement. The documents necessary for submission are outlined in Art. 8 of the Regulation. The franchisor must also disclose information to the franchisee about itself and its franchise at least 30 days before a franchise agreement is signed. The required information to be disclosed includes, but is not limited to, the following: the franchisor's business resources; financial statements and audit reports from the past two years; services provided, such as training and operating systems; and any litigation and arbitration proceedings involving the franchisor related to the franchise. Although Chinese law does not stipulate that franchise agreements be written in Chinese, the franchisor must submit those agreements in Chinese in addition to English versions, because the MOFCOM will likely reject the entire application if the franchisor does not provide a Chinese version of the agreements. all

Although the Rules require a franchisor to record with the MOFCOM, failure to record or file does not render a franchise agreement invalid. Further, failure to make the record filing does not preclude the franchisor from operating franchises in China. However, such failure may incur fines by the MOFCOM. According to the Rules, if a franchisor fails to file with the MOFCOM, the MOFCOM shall order the franchisor to file within a specified time limit and impose a fine of not less than RMB10,000 but not more than RMB50,000. If the franchisor fails to file within the specified time limit, the MOFCOM shall impose a fine of not less than RMB50,000 but not more than RMB100,000.

THE CHALLENGES

As franchisors enter the Chinese market, of crucial concern is infringement or misuse of intellectual property. China operates a first-to-register trademark system. As such, any person can register a foreign trademark so long as the trademark is not illegal and has not been previously registered with the China Trademark Office. A number of notable cases, including Apple v Shenzhen Proview and Starbucks Corp. v Shanghai Xingbake Cafe Corp., demonstrate the issue of so-called 'trademark squatters'. In the former case, a Chinese court held that Proview registered the trademark 'iPad' in China before Apple did, despite Apple having created the brand's value. Consequently, Apple paid $60m to settle the dispute. To avoid falling into the trap of trademark squatters, potential franchisors must ensure their IP is protected under Chinese law. Franchise agreements should contain specific clauses regarding IP use.

Some academics and journalists argue global firms who made large chunks of their profits from franchising overseas are in retreat. Many franchisors are facing domestic competition, as support and demand for local franchises grows. For example, Uber recently sold its Chinese operations to domestic rival Didi Chuxing. Without a proper understanding and catering to local customs, franchisors may face difficulties appealing to consumers. In addition, different regions or provinces may have different preferences. As a solution, franchisors may consider making alterations to, for example, menu items. KFC's China executives understood that Chinese consumers prefer an abundance of flavors, and so decided to expand their menu to enhance success. Similarly, Nestle appointed country managers who may deem certain products proposed by the head office to not suit local consumers. Finding a strong local partner can be crucial to ensuring success in China, as local companies may have a deeper understanding of local consumer needs.

LOOKING FORWARD

Although global trends show a decline in multinational companies franchising overseas in sectors offering food, beverage or retail services, there is an abundance of opportunity within other expanding sectors. In early 2017, the Government of Shanghai promoted the opinion that foreign companies should invest, through franchising, in areas of energy, infrastructure and environmental protection. Furthermore, during a press conference in 2017, MOFCOM announced its plan to revise current regulation to streamline the filing process. This suggests a further opening of the Chinese franchising industry for foreign companies.

*Sofie Gleditsch is a law student at King's College London.

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.

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