China’s New Commercial Franchise Regulation: Setting up Shop in China

May 2007

This CS Alert addresses how the new Commercial Franchise Regulations issued by China’s State Council and effective as of 1 May 2007 (“New Regulations”) may affect foreign entities engaged in franchise operations in China. The New Regulations provide foreign entities easier access to the China market by (i) reducing the requirements for qualifying as a franchisor to engage in franchising in China, (ii) mandating increased disclosure to franchisees in an effort to combat fraud and (iii) allowing greater autonomy to the franchising parties to contract material terms and conditions.

Background
A franchise is a contractual relationship in which a franchisee: (i) utilizes the business resources of the franchisor (e.g., trademark, distribution network, business model), (ii) operates under a uniform operating system that applies equally to other franchisees and (iii) pays a franchising fee to the franchisor. A franchise structure is common in a variety of industries, such as retail, hospitality, food and beverage, leisure, beauty and travel.

According to the Chinese government, the New Regulations standardize commercial franchising operations, enhance the orderly development of commercial franchising, reduce “chaotic market conditions” and promote order in the franchising industry.1 The New Regulations also move China towards fulfilling corresponding WTO-related commitments. Additionally, easing entry into China’s franchising industry provides an alternative to the restrictive regime that still governs direct sales,2 while strictly prohibiting pyramid sales under the guise of franchising.

Qualifying as a Franchisor
Equal Treatment for Foreign and Domestic Franchisors
The New Regulations apply equally to both foreign and domestic-invested franchisors doing business in China and, ostensibly, even off-shore franchisors engaged in franchising in China; the New Regulations eliminate the dual track regimes that formerly governed franchisors based on the nationality of the registered capital. In order for a franchisor to qualify to engage in franchising in China an entity must:

(i)    Be a corporation;

(ii)   Have a mature management system sufficient to support franchisees with operational guidance, technical support and business training;

(iii)  Directly operate at least two retail outlets for more than one year.

Previously, the governing regulations required that the two retail outlets had to be within China, implying the franchisor had to be Chinese (either foreign-invested or domestic-invested). However, the New Regulations are now silent in reference to the “within China” requirement, implying that the two retail outlets may be based outside of China. This creates the possibility for the franchisor to be a foreign company, and engaged in franchising with Chinese franchisees.

Commentators note that such an interpretation is consistent with China’s WTO commitments. It remains to be seen how local approval authorities will interpret this requirement. In addition, it remains to be seen whether the reference to “directly operate” includes businesses which are only operated (but not owned) by the franchisor.

Pre-approval No Longer Required
Under the New Regulations, franchisors need only register with the provincial government (or the Ministry of Commerce if the franchisor intends to engage in inter-provincial operations),reducing the transaction costs corresponding to establishing a franchisor in China.

Under the previous regulatory regime, franchisors needed to seek approval and obtain a franchise license prior to being able to commence franchise operations. The registration process still requires that the franchisor submit various documents and materials to the relevant authorities, including a marketing plan, a standard franchise agreement, an operating manual and certification that the franchise agreement complies with Chinese law.

Disclosures
Fraud in the franchise industry is not uncommon, including wildly exaggerated claims regarding returns on investment or promises of franchisor-led support that will be delivered to franchisees. Such claims have led eager or naïve franchisees to make considerable investment and pay frontloaded fees to franchisors, only to be disappointed by lackluster returns or to find that the franchisor disappeared, leaving little hope for a just resolution. Such fraud has been due, in part, to the lack of a strong regulatory framework addressing fraud in the franchise industry.

The New Regulations seek to prevent such scenarios by significantly increasing franchisors’ obligation to disclose information to franchisees. The New Regulations provide that:

(i)    Information provided to the franchisee must be accurate, comprehensive, free of omissions and updated if changes occur which materially impact the accuracy of the information;

(ii)  The franchisee can unilaterally terminate the franchise agreement and seek indemnification from the franchisor;

(iii)  The franchisor must provide the franchisee with sufficient information to make an accurate investment decision prior to execution of the franchise contract. Such information should include an outline of the franchisor’s preceding two year’s financial accounts and a basic description of the franchisor’s material know-how, patents and operations;

(iv)  The franchisee may not divulge or permit others to use the trade secrets of the franchisor;

(v)   The franchisor must set out in writing franchise fees, promotional fees and advertising fees that the franchisee will be obligated to pay to the franchisor. In addition, the franchisor must specify what services and support the franchisor will provide to the franchisee in exchange for such fees, including the method of delivering such support. Failure to provide accurate information or failure to utilize the fees for its stated purpose may subject the franchisor to fines; and

(vi)  The franchisor cannot engage in misleading advertising (e.g., misleading claims regarding return on investment). To further ensure compliance, the New Regulations specifically provide that both legal persons and individuals have the right to report violations to the authorities, who must timely respond to such reports.

Franchisors must plan ahead to determine how to protect legitimate interests in protecting sensitive or confidential information while still fulfilling all disclosure obligations. Nevertheless, serious and legitimate franchisors will welcome these increased obligations because such obligations will discourage fly-by-night franchisors seeking to take advantage of the unwitting with get-rich-quick schemes. This will provide a clearer path for legitimate franchisors to develop
commercial success for both the franchisor and corresponding franchisees.

Greater Autonomy
The New Regulations provide greater autonomy to the franchising parties to contract material terms and conditions of the franchise agreement. The prior regime controlling foreign-invested franchising imposed greater control over such terms and conditions. In particular the New Regulations:

(i)    Provide a default term of three years for franchise contracts, but allow the franchising parties to agree otherwise. Previously, franchise agreements were mandated at three years in length;

(ii)   Allow for the franchisee to unilaterally rescind the franchise contract within a coolingoff period. Importantly, the length of the cooling-off period can be decided by the parties, as opposed to being imposed by the New Regulations;

(iii)  Allow the parties to specify who bears product liability arising from franchise-related products and services. Previously the franchisor and franchisee were jointly and severally liable for damages incurred by consumers due to substandard products or services;

(iv)  Eliminate the requirement that the franchise fee must be “reasonable and fair,” reducing the likelihood of government intervention in this regard; and

(v)   Expressly establish the franchisor’s right to approve the transfer of the franchise license or change of a franchise location.

These changes should give rise to greater autonomy between the franchising parties to tailor contracts to the unique circumstances arising from each transaction and each industry.

Conclusion
The New Regulations governing franchising in China, although needing some clarification, are a significant improvement for franchisors that want to operate in the China market. The greater disclosures required by the New Regulations and the autonomy given to the parties should reduce fraud and lead to better business decisions by franchisees. Such changes will likely result in additional foreign entities entering the market and increase the delivery of better products and services to the Chinese consumer.

©2012 All content of this article is the property and copyright of China Solutions Inc and may not be reproduced in any format without prior express written permission. The content of this article is intended to provide a general guide to the subject matter and should not be treated as a substitute for specific advice concerning individual situations. Readers should seek legal advice before taking any action with respect to the matters discussed herein.

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