Distribution of Luxury Goods in China
A luxury goods company will usually establish an FICE to directly distribute/sell its goods in China. Various distribution models are available for it to choose from, such as wholesale (including counters), retail (including online retail) and the ability to authorise third parties to operate franchises. An FICE can also engage in import and/or export of products connected to its business scope, as well as related ancillary services.
1. Wholesale and commission agent
1.1 Wholesale/retail distributors
1.1.1 Local retail distributor
A business model consists of using one or several wholesale distributors or directly dealing with local retailers. The FICE will either (i) conclude first a distribution agreement with the wholesale distributors which will build a local retail network with retailers under its control and supervision, or (ii) conclude distribution agreements directly with retailers.
1.1.2 Distribution agreement
The content of a distribution agreement is subject to the negotiation of the parties. With the exception of the anti-monopoly regulations, there are no specific regulations in China on distribution. In particular, there is no regulation, restriction or limitation on selective distribution or distribution networks. There are also no mandatory regulations or practices which require compensation of the distributor when the distribution agreement expires.
1.2.1 Local practice
The FICE will solicit leased counters located in department stores and will share the profits with the department store.
Under such a model, the FICE and the department store conclude a consignment contract (sometimes referred to as a “joint operation contract”). Pursuant to a consignment contract, the FICE is responsible for deciding the retail price and providing the goods to be sold in the department store. The department store is responsible for providing property management services, collecting proceeds from sale of goods, issuing invoices and resolving customer complaints regarding defective goods. From a legal perspective, the retailer is the department store. It is industry practice that the department store provides a standard form contract with standardised terms and conditions applicable to all counter lessees in the department store. On very rare occasions the department store may agree to accept certain amendments or supplementary terms to such a contract, subject to the attractiveness and market penetration of the luxury goods company among Chinese customers and whether such company matches the standards of the department store.
1.2.2 Location, area and decoration of counter
The FICE must conduct fitting out activities in compliance with the uniform decoration requirements of the department store. This is applicable to all counter lessees in the department store.
1.2.3 Consignment term
There is no mandatory requirement for the length of the consignment term. It normally varies from half a year to three years, based on the respective business plans and subject to final negotiation between the department store and the FICE.
1.2.4 Commission fee, service charge and miscellaneous fee
The calculation method of the commission to be charged by the department store varies on a case-by-case basis. The following are the most commonly used methods in China.
(a) Fixed commission rate
The department store is entitled to a commission fee of an agreed percentage of the retail price for any retail sales. For branded perfumes and cosmetics for example, this rate tends to range between 20% and 30%.
(b) Guaranteed return
The department store is guaranteed a pre-agreed minimum commission fee.
For any retail sales less than or equivalent to a pre agreed target monthly retail sales amount (“Monthly Base Sales”), the department store will receive the guaranteed commission fee.
For any part of the retail sales over and above the Monthly Base Sales, the department will receive a commission fee of an agreed percentage of the retail price. This commission fee is calculated on a lower percentage than the one which is usually negotiated when no minimum guaranteed commission is agreed.
(c) Base rent or fixed commission rate
The department store is entitled to a commission fee of an agreed percentage of the total monthly retail sales, or to an agreed monthly rent, whichever is higher. This practice applies more frequently to large surfaces (normally over 100 square meters) in department stores.
1.2.5 Service charge and miscellaneous fee
The department store provides a uniform property management service to all counter lessees, such as utility supplies, security guards and patrols and a cleaning service. The FICE pays service charges for the aforesaid services at a fixed rate on a monthly basis or alternatively based on an agreed percentage of the turnovers made on retail sales.
1.2.6 Counter staff
The FICE is responsible for recruiting staff either by itself or through an employment agent. The staff must adhere to the internal rules or regulations imposed by the department store.
1.2.7 Termination of consignment
The department store usually retains the right to re-arrange on a regular basis the location of the counters. In certain department stores, the general practice is that if the monthly retail sales of a branded good rank among the lowest three or five in that store in three consecutive months (or alternatively three times in half a year), the department store shall have the right to unilaterally terminate the consignment contract with the luxury goods company.
2.1 Retail licence application and establishment of branches
To legally operate a retail business activity, an FICE must first make sure that its business scope includes retail activity as defined in its business licence (reference is made to Chapter 1 paragraph 3 above).
The FICE may either apply to include retail in its business scope upon its establishment or later upon extension of its business scope. For such application, the FICE must provide the original of one lease agreement (or one purchase agreement) of the commercial premise that it has entered into. In general, for any retail stores the FICE intends to open, a branch must be established and registered at the address of the retail store. The principle is “one retail store, one registered branch”. The establishment of such a “retail branch” requires prior approval from the authorities at the location of the FICE.
2.2 Lease of retail premises
The operation of a retail store requires the lease or purchase of commercial premises. The purpose of the commercial premises must specifically be for retail. The law gives the landlord and tenant plenty of flexibility to arrange their contractual relationship.
It should however be noted that some local authorities, such as Shanghai Municipal ity, impose the use of a standard commercial lease contract template which restricts the parties’ chosen contract format. The registration of the lease contract with the real estate bureau is usually a necessary and prior step required by the approval authority to approve the establishment of a company or a branch at that location.
These commercial lease contract templates usually contain a section named “supplementary provisions” where the parties can freely amend the content of the contract and/or add any additional provisions. Furthermore, for premium buildings, landlords often have agreed and pre-registered their own lease template with the real estate bureau. All landlords experienced in handling commercial leases usually prefer to use their own commercial lease templates and only certain terms and conditions are negotiable. Needless to say, the final outcome of such negotiations depends on the market position of the given scheme and the attractiveness of the contemplated tenant’s brand.
3. Online retail
By law, FICEs are permitted to apply to include “online retail” in their business scope and to engage in online retail. However, according to the current practice of MOFCOM and its local branches, FICEs stand little chance of actually obtaining such business scope to conduct online retail.
Nevertheless, in practice, some FICEs with retail rights engage in online retail activities without obtaining a business scope encompassing online retail. It is noted that AIC could legitimately challenge and stop such online commercial activity at any time.
In such cases, the FICE hosts its own website for online retail after applying for a not-for-profit internet content provider (“ICP”) certificate. The FICE files records of its activities with the local telecommunications administrative authorities at provincial level, under the direct control of the Ministry of Industry and Information Technology, as a not-for-profit internet content service provider. Note that the local telecommunications administrative authority normally will not check if the business scope of the FICE includes online retail or not when dealing with applications for filing.
4.1 General regime
According to Chinese law, franchising means conducting business whereby a company, through execution of contracts, allows an operator to use registered trademarks, patents, know-how or any other business resource owned by such company; such operator undertakes business operations under the unified business model in accordance with the provisions of the contract and pays franchising fees to the company.
4.2 Qualification of the franchisor
The franchisor must have at least two directly owned stores which have been in operation for more than one year. Other requirements are possessing a mature business model and being capable of providing continued operational guidance, technical support, business training and other services to the franchisee.
4.3 Overseas franchisor
The reference in the regulations to the franchisor having two directly owned stores does not specify where such stores need to be located. In the preceding, now defunct regulations, the franchisor was specifically required to own and directly operate two stores within China. As such direct reference to China has now been removed, the foreign franchisor having two directly owned stores overseas is also able to franchise in China without having to first establish a legal entity within China.
4.4 Disclosure of information
Chinese law requires that the franchisor discloses significant information in writing to the franchisee at least thirty days prior to the signing of the franchise contract, including but not limited to (i) basic information about the registered trademark, patent, know-how and business model of the franchisor and (ii) specific contents, methods and implementation plans for continuously providing management guidance, technical support, business training and other services to the franchisee.
4.5 Franchise contract registration
The franchisor must register the franchise contract and other required information with the Chinese authorities within fifteen days of the execution date of the first franchise contract in China. If the franchisor is an overseas entity, the competent authority is MOFCOM. If the franchisor is a Chinese entity (including FICE), the competent authority is COFCOM at provincial level.
The franchisor also needs to report to the registration authorities any information regarding the conclusion, termination, renewal and/or modification of its franchise contracts during the previous year, prior to 31 March of each year.
4.6. Withdrawal of franchise
As the requirements for engagement in franchise activity in China are quite stringent and trade secrets may be disclosed when training the franchisees, foreign investors in the luxury goods industry do not usually favour the establishment of franchises. On the contrary, quite a lot of foreign investors try to withdraw any existing franchise rights, such as by acquiring part or all of the franchisees’ equity interest, in order to make more profits, control the quality of services and protect its reputation and IP rights in a more efficient manner.
Emmanuel Meril, avocat associé