China Further Streamlines its Franchise Regime

With China starts to re-position itself from the “world’s factory” to one of the world’s largest consumer markets, international franchisors and branded retailers are moving in the country quickly to grasp the opportunities offered by the expanding middle-class consumer base. As of end of 2010, franchise has created more than 8 million jobs across China and remains robust in growth this year.

In the past, Chinese law requires a foreign franchisor must operate at least two self-owned stores within China for more than one year before they can franchise their brands or services to local Chinese franchisees. In practice, this means that foreign franchisors will have to set up a retail company in China for one year before they can legally start to franchise. The situation improved in 2007 after a new franchise regulation made it possible for a foreign franchisor to satisfy the “two stores, one year” requirement if it has operated two self-owned stores in its home country or other markets. This liberated China’s retail sector and contributed to the later blooming of franchise in China.

Nowadays, foreign franchisors normally have two options to structure their franchising activities in China. One is to enter into franchise contracts with Chinese franchisees directly from offshore. The other is to set up a foreign invested enterprise (“FIE”) in China, e.g. a joint venture or a wholly foreign owned enterprise (“WFOE”), and to enter into franchising contracts through this FIE.

There are advantages to both models. By establishing an FIE, companies gain direct operational experience in China. However, doing so by means of a WFOE requires considerable knowledge and experience of Chinese operational conditions. Whilst a JV allows a foreign investor to leverage off its Chinese partner’s experience and pre-existing supply and distribution channels, a JV requires a lot of attention to partnering issues, and conflicts are not infrequent. Establishment of a WFOE or JV is not as administratively complex as it used to be, but a JV requires protracted negotiations. For these reasons, many franchisors now look to the off-shore model. This, however, does carry risks as well, namely the attenuated control over operations due to the fact that the franchisor remains off-shore. A lot of effort must therefore be dedicated to remaining on top of operating conditions in China, and in monitoring the behaviour and performance of the franchisee.

Recently, the Ministry of Commerce published two new draft franchise regulations for public comments. These drafts are available from the Ministry’s website.

The draft regulations reinforce the filling requirement - a franchisor must make a filing with the Ministry of Commerce or its provincial level branches within 15 days following the execution of the initial franchise agreement with a Chinese franchisee. In addition, the franchisor are also required to update the filing authority annually on the status of any franchise agreements processed by it in the preceding year.

To reflect the fast development of e-commerce in China, the draft regulations exempt on-line retailers and long-distance education providers from the requirement to prove their physical shops or premises. The draft regulations also provide clearer guidance for hotel management company to determine their qualification under the “two stores, one year” requirement.

On disclosure requirement, the draft regulations remain to request that at least 30 days prior to concluding a franchise contract, the franchisor must disclose to its franchisees the basic particulars of the franchisor, franchise fees, prices and conditions under which products, services and equipment will be supplied to the franchisee, support and guidance by the franchisor, investment budget, franchisor's financial and accounting reports, etc. However, the draft regulations appear to no longer oblige the franchisor to bear joint and several liabilities with its local franchisees for customer claims and damages.

Another welcomed development for foreign franchisors is that the draft regulations clearly require an intended franchisee to keep confidential of the business secret it received in its negotiations with the foreign franchisor and make compensation in case of its breaches, regardless whether a franchise agreement is eventually signed or not. This is good news to many foreign franchisors who had suffered from bad-faith potential franchisees, whose intention is to steal business secret from the franchisor instead of negotiating for a franchise agreement.

An interesting development is that the new draft regulations require the franchisor to submit trademark or patent certificates issued by the Chinese authorities. As a practical matter, this means that an offshore franchisor who has only registered its marks and brands in its home country cannot qualify to carry out franchise business in China without having registered their IP rights in China. It is therefore advisory for retailers and brand owners, prior to enter into the Chinese market, to take a proactive approach to seek IP registrations in China. This will not only help to satisfy the franchise requirement, but also enable franchisors to enjoy broader IP protection under local law.