INTRODUCTION

Franchising offers a foreign manufacturer or retailer an entry into the PRC consumer market without some of the difficulties associated with direct investment in a retail venture in the PRC. Some franchise operators in the PRC include Giordano, Benetton, Crocodile and Bossini and the French retailer Printemps is reportedly franchising its name and mark to a Hong Kong retailer in respect of a store which will be established in Shanghai.

The following are some advantages, commercial and legal, to franchising in the PRC:-

  • permits the franchisor a relatively low cost entry into the PRC and fast expansion;
  • lends a consistent image to the products;
  • avoids the more difficult approval process required for retail joint ventures. Although the Foreign Investment in Retailing Provisions ("Retail Provisions") promulgated in 1992 sanction foreign participation in the retail sector in the PRC through retail joint ventures established with a PRC party, this requires approval by the State Council and the Ministry of Internal Trade. Such approval is still relatively difficult to obtain;
  • avoids geographical constraints. The Retail Provisions allow retail joint ventures to be set up in only 11 cities and zones in the PRC, i.e. Beijing, Tianjing, Shanghai, Guangzhou, Dalian, Qingdao and the five special economic zones. These restrictions do not apply to franchising arrangements;
  • avoids the 30% import limitation applicable to retail joint ventures. Under the Retail Provisions, retail joint ventures can import only up to 30% of the goods which it sells. This import limit does not apply to the product supply arrangement between franchisor and franchisee.

STRUCTURING A FRANCHISE

The manner in which a franchise is structured largely is dictated by various factors such as the degree of control which the franchisor wishes to exercise over the franchisee, the capability of the franchisee, the available resources and the degree of market penetration which the franchisor or franchisee may have in the PRC market. The following are just a few ways in which a franchise arrangement may be structured:-

(A) A simple trade mark licence. By this, the franchise arrangement is simply a licence by the franchisor granted to the franchisee allowing the use of trade marks, trade names, service marks and get up subject to certain quality control standards being complied with. The franchisor may also provide some marketing material and a supply of products. In return, the franchisor earns certain royalties from the license and payment for the products supplied to the franchisee.

The advantage here is that with franchise arrangements that comprise no more than a simple trade mark licence, approval of such licence probably will not be required. Although the PRC Regulations on the Administration of Technology Import Contracts ("Technology Import Regulations) stipulate that a licence in respect of industrial property rights must be approved by the Ministry of Foreign Trade and Economic Cooperation ("MOFTEC"), MOFTEC has maintained that a simple trade mark licence will notrequire to be approved in order to be valid. However, the licence will still be required to be registered with the PRC Trade Mark Office and the local Bureau of Administration of Industry and Commerce.

The main disadvantage of a simple licence arrangement is that the franchisor has little control over how the franchise is run and quality control.

(B) A franchising agreement allowing the franchisor greater control over the franchisee. This arrangement would comprise a licence granted by the franchisor to the franchisee to utilise the franchisor's marks, names etc. In addition, the franchisor may provide patents and manufacturing know-how, marketing materials, tied products, management training, shop fitting and decoration design, marketing and service schemes and consultancy services. The franchisee may be required to permit the franchisor to inspect the premises and products and provide the franchisor with reports and updates. The franchisor may also have some control over the selection of raw material sources, employees and pricing.

The advantage to such a fuller franchise arrangement is that the franchisor has a greater degree of control over the way the franchise is operated and the quality and consistency of the product.

The disadvantage is that the provision of industrial property such as patents, and know-how and technical services such as management, service and marketing strategies, may bring the agreement under the regulation of the Technology Import Regulations. Such regulation may be disadvantageous to the franchisor in certain respects discussed in further detail under the heading "Relevant Legislation" below.

(C) The establishment of the franchisee by the franchisor. This can take two forms. The first is where the franchisor may already have an existing manufacturing venture (either wholly owned by the franchisor or a joint venture with a PRC party). Under PRC law, this PRC foreign investment enterprise will be a PRC legal entity and it may in turn enter into a domestic joint venture with another PRC party to run the franchise. Theoretically, if the articles of association of the foreign investment enterprise allows it to invest in related businesses, it may invest in other PRC enterprises without further approval and to use its retained earnings or registered capital to do so. However, this method is not usual and in the light of the recent promulgation of the Foreign Investment Guidelines (see "Relevant Legislation" below) in June 1995 which re-asserts central government control over certain types of foreign investment activities in the PRC including retailing and wholesale, the views of PRC counsel should be sought as to the continued viability of this method.

A variation on this structure is where the franchisor establishes a joint venture with the sole purpose that it be the franchisee. This will allow the franchisor a greater degree of control over the franchisee than if the franchisee was an independent third party. At the same time, the franchisor will involve in the franchise arrangement a PRC partner who will be helpful in areas of obtaining the relevant approvals, the sourcing of materials and financing. The joint venture may also avail itself of favourable tax treatment given to foreign investment enterprises. However, the disadvantage is that such joint venture may be regarded as a retail joint venture under the Retail Provisions if its sole purpose is to retail to the PRC market. Therefore, in addition to MOFTEC approval, it may require approval from the State Council and the Ministry of Internal Trade, which may be difficult to obtain. The joint venture will also be subject to regulation under the Retail Provisions with regard to the 30% limit on its sales of imports.

(D) Sub-franchisement. This refers to the situation where the franchisor is itself a franchisee under a master franchise. For instance, a foreign franchisor may itself be a franchisee of the master franchisor with rights to the PRC market and may sub-franchise to PRC parties or to its PRC joint venture. This is the method used, for example, in the Pierre Cardin franchise and the Yoshinoya franchise (a Japanese restaurant chain) in the PRC. One disadvantage is that the franchisee must sub-license the necessary marks to the sub-franchisee. However, sub-licences of marks may not be recognised under PRC law and it may be necessary for the master franchisor and the sub-franchisee to separately enter into a licence agreement which should be registered with the PRC Trade Mark Office.

RELEVANT LEGISLATION

There is no legislation specifically applicable to franchising in the PRC. However, the following legislation will be relevant to a franchise arrangement:-

(A) The Interim Provisions on the Guidelines of the Direction of Foreign Investment ("Foreign Investment Guidelines"), which were issued recently in June 1995 and established new approval procedures for foreign investment activities. Of note is that retail and wholesale activities fall into a category of restricted activities requiring approval from the central and local authorities; otherwise, the venture concerned is liable to be revoked. Arguably, a franchise should not be regarded as giving rise to participation in "investment" or retail activities by the foreign franchisor; the franchise arrangement will be a licence/sale rather than an investment arrangement between the parties and it is generally the PRC franchisee who is retailing. However, the franchisor should note the possible impact of the Foreign Investment Guidelines on franchise arrangements which involve the establishment of a joint venture franchisee. It is also unclear whether the supply of tied products by the franchisor to the franchisee will be regarded as wholesale activities. As the Foreign Investment Guidelines are largely untested, it remains to be seen how these will be interpreted in respect of franchises;

(B) The Technology Import Regulations, which will be applicable where the franchise agreement provides for the provision of industrial property, know-how and technical services to the franchisee. The Technology Import Regulations set out a list of provisions required and prohibited in a technology import contract. The main points to note from the Technology Import Regulations are that:-

- the franchisor must provide a guarantee that it is the "lawful owner" of the technology (nb. the difficulties this may present to sub-franchises), that the technology is "complete, correct and effective" and that the technology is capable of accomplishing the technical targets specified in the contract;

- the technology import contract must permit the franchisee to retain the licensed technology after the contract terminates and the contract is subject to a maximum term of ten years. This requirement has caused significant problems to potential franchisors;

- there are certain terms which are prohibited. The general thrust of the prohibitions is that the restricted clauses in the franchising agreement must not be beyond the scope of what is reasonable to protect the technology. The sort of contractual restrictions that are prohibited include, for instance, the "tieing" provisions requiring the franchisee to buy unrelated equipment or materials and provisions which unreasonably restrict the franchisee's access to domestic or overseas markets;

(C) The Patent Law and Trade Mark Law, which provides for a registration system for marks, patents, utility models and designs;

(D) The Copyright Law, which grants protection to technical drawings, databases and computer software;

(E) The Anti-Unfair Competition Law, which provides a limited degree of protection for unregistered marks, names, style and trade secrets. The law is also relevant in that the franchisor should be wary of attaching unreasonable conditions to the sale of goods and services to the franchisee; for instance, a franchisee buying a key product cannot be compelled to buy another product "against its will";

(F) The Foreign Trade Law, which governs the capacity of a PRC franchisee to contract with foreign investors and the PRC franchisee's import rights;

(G) The Foreign Economic Contract Law, which governs the validity of contracts between a PRC franchisee and a foreign franchisor and requires certain provisions to be included in the contract. The Foreign Economic Contract Law also stipulates that the contract will not be valid until the requisite approvals are obtained;

(H) The Joint Venture Law, which will be applicable where the establishment of a joint venture franchisee is being considered;

(I) The Product Quality Law, which renders a producer or seller liable for sub-standard and fake goods. The franchisor should note that his product specification should conform to PRC industry standards for that product and the product must match with standards listed on the packaging. The law also has certain provisions with regard to the labelling of the product, which should state the product's name, manufacturer and instructions in Chinese. The franchisor should place the onus of complying with the law upon the franchisee if the franchisee will be the producer of the product, and the PRC franchisee may give a warranty and indemnity to the franchisor with regard to claims arising in this respect;

(J) The Consumer Law, which regulates the provision of accurate information with regard to the product. Again, the onus should be placed upon the franchisee to comply with the law.

DOCUMENTATION

1 Letter of intent. Although not required by law, a simple pre-contract letter of intent will be useful since this may contain a binding confidentiality clause in respect of know-how passed to the franchisee candidate in the course of the negotiation of the definitive agreements. See comments in paragraph 2(j) below.

2  Franchise agreement. This should include the following main terms 
   (if applicable):-

   (A)  scope of the franchise, i.e. the territory and the products 
        and marks covered by the franchise;

   (B)  whether on an exclusive or non-exclusive basis;

   (C)  duration of the franchise (nb. note the ten year maximum 
        limit stipulated under the Technology Import Regulations);

   (D)  tieing clauses requiring the franchisee to buy materials or 
        products from the franchisor;

   (E)  pricing, fees and royalties and their basis of calculation;

   (F)  reporting requirements of the franchisee;

   (G)  financial or management systems to be established by the 
        franchisee;

   (H)  training to be provided by the franchisor;

   (I)  permission to the franchisor to inspect the franchisees' 
        premises or products;

   (J)  confidentiality clause with regard to know-how being passed 
        to the franchisee. This is important because although the 
        Anti-Unfair Competition Law provides some protection for 
        "trade secrets", the owner must have taken steps to safeguard 
        these before he can avail himself of such protection, which 
        usually would mean including in the relevant agreement a 
        specific confidentiality clause;

   (K)  an indemnification by the franchisee in favour of the 
        franchisor in respect of losses or claims suffered by the 
        franchisor as a result of the franchisee's operation of the 
        franchise and related third party claims;

   (L)  governing law. Although there is no requirement that a 
        franchise agreement must be governed by PRC law, 
        nevertheless, if the agreement comes before the review of the 
        approval authorities, they may require that the governing law 
        be PRC law.

3 Licensing contract. Provisions with regard to the licensing of marks, know-how and the provision of technical services may be included in the main franchise agreement or in a separate intellectual property licence contract. From a commercial perspective, it may be advisable to separate the arrangements into two documents so that the fee arrangements may be more easily differentiated (e.g.a franchise service/product supply fee under the franchise agreement and a royalty fee in respect of the licence agreement). From a legal perspective, technology import contracts will be subject to the regulation of the Technology Import Regulations and the approval of MOFTEC. It may be advisable therefore to separate the technology import aspects into a separate document which will be subject to review and approval by MOFTEC. The other terms governing the franchise arrangement in the franchise agreement may thus be removed from the review and approval process. However, where the technology import consists of no more than a trade mark licence, given MOFTEC's dispensation that this will not require approval, it may be unnecessary to deal with this in a separate document.

However the technology and intellectual property provisions are documented, this should address certain basic issues with regard to the definition of the intellectual property being licensed, restrictions on the use of the intellectual property (for instance, this should be conditional upon certain quality control standards stipulated by the franchisor being satisfied and the franchisor should be permitted to supervise or review the franchisee's adherence to these standards), confidentiality clauses and provisions dealing with infringement claims.

4 Joint venture contract. This will be required where a joint venture is part of the franchise arrangement.

APPROVAL AND RECORDAL REQUIREMENTS

1 The approval for registration of the marks for the relevant goods and services with the PRC Trade Mark Office. This generally takes between eighteen months to two years. Registration of marks in the PRC is particularly recommended and at the earliest possible stage, since the PRC operates a first to file system. Note that currently in the PRC, it is not possible to register a service mark for the specific category of retail services (unlike in Hong Kong, where this is possible), and it may be necessary to register the service mark against a closely related category, for instance, "business administration" and "cost analysis" services, although it is uncertain whether this will work to protect against use of the mark in retail services.

2 The approval for registration of the relevant trading names as enterprise names at the national and local level with the State Administration of Industry and Commerce or its local Bureau under the Enterprise Names Registration Regulations. This is additional protection which prevents other enterprises in the PRC from registering their businesses using the names which the franchisor wishes to protect. Note however that currently the enterprise name registration system has been suspended at the national level and is undergoing review (due to an apparent conflict of this system with the 1994 Companies Law) and while it is still possible to register a name of the local level, it is possible to do so only with a name in the Chinese language.

3 The registration of the trade mark licence with the PRC Trade Mark Office and the local Bureau of Administration of Industry and Commerce within three months of the date of the licence.

4 The approval by and filing of the technology and intellectual property import agreement with MOFTEC.

PRACTICAL DIFFICULTIES

It is difficult to generalise the difficulties which a foreign franchisor may encounter with regard to franchising, or for that matter, other sorts of transactions in the PRC. However, the following concerns have been generally recurring problem areas:-

1 Payment of royalties and fees in hard currency. A franchisor should not expect a high level of fee revenue in hard currency until the Renminbi becomes more effectively convertible. Placing a demanding hard currency requirement on the franchisee may not always be constructive - generally the franchisee's revenue is in Renminbi and therefore in order to balance its hard currency payment obligations to the franchisor, the franchisee's ability to import tied supplies from the franchisor to comply with agreed quality control standards may be impaired. Or else, the price of the products may be raised to accommodate the import requirements of the franchisee.

2  Imports. The main concerns to bear in mind here are:

   (A)  the tariffs barriers levied on imports;

   (B)  importing by the franchisee may also cause difficulties in 
        the balancing of its hard currency flows and may raise the 
        price of the product;

   (C)  the franchisee may not have direct import rights and may be 
        required to import through a foreign trade corporation. The 
        commissions charged by the foreign trade corporation may 
        again raise the price of the products.

These concerns mean that, insofar as is possible, the franchisor should investigate channels of local sourcing in the PRC. However, the trade off may be in quality control.

3 Capacity of the PRC franchisee to contract with a foreign party or to retail. Care should be taken to examine the scope of the PRC franchisee's business capacity in its business registration licence - this should include the capacity of the PRC party to contract with a foreign party and to conduct retailing operations. Where the PRC franchisee does not have a general capacity to contract with foreign parties, a specific authorisation to enter into the franchise and licensing agreements must be obtained or the PRC franchisee must contract through a foreign trade corporation who will sign the agreement on behalf of the PRC franchisee.

Linklaters & Paines
November 1995

FURTHER INFORMATION on the above may be obtained via Linklaters & Paines Hong Kong office or via any of the other nine Linklaters & Paines offices world-wide, located in Singapore, Tokyo, London, Brussels, Paris, Frankfurt, New York, Washington D.C. and Moscow. Contact details for the various L&P offices worldwide are available via the Linklaters & Paines corporate listing c/o Business Monitor Online - http://www.businessmonitor.co.uk