Franchising Procedures Clarify and Disappoint

Year of Operating Two PRC Outlets

The most negative effect of the Procedures is that foreign franchisors not already active in the PRC will need to make substantial investments of cash and other resources for at least one year before they can receive any franchise fees from the PRC. This results from the combination of the Procedures51 new requirements with the PRC51s 2004 prohibition against direct franchising from offshore.⁴

The Procedures do not expressly repeat the prohibition against direct franchising from offshore, but several sections of the Procedures implicitly confirm this, and MOFCOM personnel have verbally given the same confirmation. It is possible that the strong reaction of foreign franchisors to this prohibition may lead MOFCOM to develop exemptions.

A foreign company may authorize its controlled FIEs (i) to operate PRC outlets and (ii) eventually to engage in PRC franchising. An FIE is only permitted to grant franchises to other PRC companies after directly operating at least two shops in the PRC for at least one year. This requirement is also met if an FIE51s subsidiary(ies) or “share-control company(ies)”⁵ have directly operated the two shops for one year. The FIE-franchisor (or its subsidiary(ies) or share-control company(ies)) must then continue to own at least two directly operated shops, according to verbal explanations by MOFCOM personnel.

Although the 2-shop 1-year requirement appears on the face of the Procedures to apply to each PRC sub-franchisor before it may engage in sub-franchising, verbal comments by MOFCOM personnel indicate that sub-franchisors might not be required to satisfy this requirement if the franchisor has done so and continues to do so. The implications of the above are that (a) an FIE receiving a grant of rights from its controlling foreign investor is not deemed to be a franchisee, (b) the agreements and relationship between them are not deemed to constitute franchising, and (c) the FIE51s eventual franchising is not deemed to constitute sub-franchising.

Grandfathering

An FIE that was already engaging in franchising before the Procedures51 effective date is required to file a report of past franchising activities and, if it wishes to continue, is required to submit the same applications and related materials as other FIE applicants (Article 36).

If a foreign company was already engaging in franchising from offshore directly to PRC franchisees before such transactions were prohibited, verbal comments by MOFCOM personnel indicate that the validity of its contracts will not be challenged if they were valid at the time they were created. This is a common approach to implementing new PRC legislation, and it does not prevent problems from arising if pre-existing contracts are not fully compliant with pre-existing requirements.

Definition of Franchising & Sub-franchising

“Commercial franchising” is defined as “franchisor, by entering into a contract, authorizing a franchisee to use operating resources such as trademark, trade name and operation model that the franchisor has the right to authorize another party to use; and the franchisee, in accordance with the contract, conducting operating activities under a uniform operating system and paying franchise fees to the franchisor” (Article 2). “Sub-franchising” is defined in a manner suggesting that a sub-franchisor must always receive exclusive sub-franchising rights within a certain region (Article 4).

Some FIEs and foreign companies may wish to explore whether their operations can be structured to avoid classification as commercial franchising under the Procedures. The most important element causing a transaction to constitute franchising appears to be a grant of rights in a business operating model or system. A grant of trade name rights appears to be the second most important element. Mere licensing of a trademark, as is expressly governed by other PRC legislation, should not be regarded as franchising even if accompanied by quality controls and/or certain types of technical assistance. Some companies may be able to argue that their franchising is not “commercial”, although this argument will be difficult in view of the vague breadth of this phrase.⁶

Qualifications

Only an enterprise or other economic organization is qualified to be a franchisor (Article 7) or a franchisee (Article 8). Individual business operators are included within the interpretation of “other economic organization”, according to verbal comments from MOFCOM personnel. A related issue addressed in some jurisdictions but not addressed by the Procedures is how to balance the interest of some franchisors, in having an experienced lead owner/manager of the franchisee, against the interests of the owner/manager51s heirs in the event of his or her death.

Other qualifications of a franchisee are “to have commensurate funds, fixed premises and personnel, etc”(Article 8). The more numerous other qualifications of a franchisor include owning “operating resources such as trademark, trade name and operation model, that the franchisor has the right to permit others to use” and “to be capable of providing long-term operational guidance and training services to franchisees” (Article 7). Disqualification as a franchisor results from any record of fraud “by way of franchising”; a record of any other fraud is likely to have the same result, in light of the requirement to have a “good reputation” (Article 7).

Rights of Franchisor

A franchisor51s rights, in addition to other rights validly created by contract, are as follows (Article 9):

• to carry out supervision of the franchisee51s operating activities in accordance with the contract (but only “in order to ensure the uniformity of the franchise system and consistency of product and service quality”);

• to terminate a franchisee51s franchise status in accordance with the contract (but only “against a franchisee that violates the provisions of the franchise contract, infringes the franchisor51s lawful rights and interests or destroys the franchise system”); and

• to collect franchise fees and a security deposit in accordance with the contract.

The corresponding obligations of a franchisee include maintaining the uniformity of the franchise system, accepting the franchisor51s guidance and supervision, preserving the franchisor51s commercial secrets, and not transferring the franchise right without permission (Article 12).

Obligations of Franchisor

A franchisor51s obligations, in addition to those validly created by contract, are as follows:⁷

• to disclose information in a timely manner;

• to provide “business symbol(s) representing the franchise system”, and operation manual(s); and

• to provide the guidance, training and other services on sales, business or technology that are necessary for the launch and development of franchising.

The corresponding rights of a franchisee include receiving authorized operating resources, training and guidance, timely delivery of goods, and “unified”⁸ promotional support (Article 11).

Goods & Services

Goods supply related to the franchise is restricted, and dangerous, under the Procedures. The most dangerous provision is that the “franchisor shall bear liability to guarantee the goods quality of its designated suppliers” (Article 10). Franchisors are also likely to be liable for the quality of any goods that they supply themselves, whether self-manufactured or resold, although the Procedures do not expressly require this. For services supplied by the franchisor or its designated suppliers, equivalent liability should be expected, although services are not mentioned in the Procedures51 provisions on liability. To minimize their exposure in this area, franchisors should consider relying on detailed quality standards and controls rather than designating suppliers.

If, despite this liability, the franchisor desires to provide goods supply, additional qualifications are required: that the franchisor “shall have a stable supply system that can guarantee the quality of goods, and shall be able to provide related services” (Article 7). In any case, the franchisor must not “forcefully require” the franchisee to accept goods supply from the franchisor or its designated suppliers (except for monopoly goods, or where necessary to ensure goods quality) (Article 10). These provisions on goods also appear to apply to services.

Fees

“Franchise fees” are defined to include a “join-in” fee (one-time fee for acquiring the franchise right), “usage” fees (periodic fees “in accordance with certain standards or ratios”), and “other contractually agreed fees” (relating to goods supply or services provided by the franchisor) (Article 14). Security deposits must be refunded to the franchisee upon expiration of the contract, making it important to distinguish clearly between such deposits and “join-in” or other fees.

Disclosures & Confidentiality

Timely disclosure is an obligation not only of the franchisor but also of the franchisee, both before signing a franchise contract and during its effectiveness, although only the franchisor is expressly stated to be liable for the consequences of inadequate disclosure (Articles 17 and 19). The only clear deadline is for the franchisor to disclose basic information in writing, and the franchise contract text, 20 days before “formal signing” of the franchise contract.⁹ The scope of required disclosure will in general not surprise franchisors, although the specified items are frequently vague and sometimes open-ended.¹⁰ Notable items to be disclosed include (Article 19):

• tax returns and audited financial reports,

• number of years conducting franchising,

• the proportion of the total number of franchisees taken up by franchisees terminating franchise contracts,

• litigation involving the franchisor in the previous five years,

• trademark registrations, licences and (apparently regardless of timing) litigation,

• full details of goods, training and guidance, and

• details of key responsible persons of the franchisor, including any criminal punishment, and any personal liability for bankruptcy of an enterprise.

Confidentiality obligations reach all persons receiving franchisor disclosures (Article 22), and continue to bind franchisees and their employees after the termination of the franchise contract (Article 21). Government officials have a duty of confidentiality as to information disclosed to them.¹¹

Advertising

The Procedures51 advertising provisions overlap somewhat with disclosure, while being vague on the allocation of responsibility between the franchisor and franchisee. Truthfulness in advertising must extend to “indirect inclusion” of information, and any performance claim must be “clear and precise” in referencing its “relevant region and time” (Article 24).

Advertising is prohibited from imitating not only another person51s trademarks but also “other identification symbols” and “general appearance or wording of advertisements” (Article 25). This demonstrates a welcome governmental recognition that protectable interests can arise more broadly than in the traditional PRC intellectual property categories of patents, trademarks and commercial secrets.

Intellectual Property

A useful protection for franchisors is that, after termination of a franchise contract, the former franchisee “must not apply to register the franchisor51s registered trademark for goods or services of similar categories; must not apply to register words or letters identical or similar to those of the registered trademark of the franchisor as the trade name component in an enterprise name; and must not use, for identical or similar goods or services, symbols identical or similar to that used in the franchisor51s registered trademark, trade name or outlet decoration” (Article 16).

In addition to these mandatory protections, many franchisors will prefer to negotiate for even broader protections that are not limited to similar goods or services.

Each trademark (Article 31) and each patent (Article 30) that is licensed requires separate legal compliance including a separate filing of the licence agreement. The Procedures state that trademark licensing contract filings must be handled “before launching and developing franchising activities”, which is illogical because the deadline under trademark regulations requires only that a trademark licensing contract be filed within 90 days of its effective date. Franchisors can probably obtain a quicker start to fee remittances by characterizing fees as franchise usage fees, because trademark licence fees cannot be remitted until formal completion of PRC Trademark Office filing, which often takes more than half a year.

Term, Renewal, Fairness & Standard Terms

The minimum term will be three years “in general”(Article 15). The Procedures do not follow the approach of some jurisdictions in prohibiting a franchisor from refusing to renew a franchise without good cause. The franchisor need only negotiate a possible renewal in accordance with the principles of fairness and reasonableness.

The Procedures include several references to “negotiation in accordance with the principles of fairness and reasonableness”. This reflects broader tendencies in PRC law and makes it prudent for foreign companies, when negotiating franchise or other contracts in the PRC, to document the reasonableness, purposes and context of key contract clauses. A franchisor that invites an applicant to sign a contract containing the franchisor51s standard terms is also obligated, under the PRC Contract Law (Article 39), to “reasonably call the other party51s attention to the provision(s) excluding or limiting [the franchisor51s] liabilities” and to explain them upon request.

Governmental Role

An FIE desiring to add franchising to its business scope must apply to its original foreign investment approval authority, submitting information including a sample franchise contract and franchise business operating manual, along with documents and materials “certifying” (proving) compliance with the Procedures (Article 33). An approval decision is required to be rendered within 30 days of receipt of all materials (Article 33).

A franchisor must make annual governmental filings (in January of each year) in both its own locality and the locality of each franchisee, containing the circumstances of the franchise contracts signed in the preceding year.¹²

Governmental monitoring of franchising activities is planned to extend far beyond the above business scope approvals and annual filings. The Procedures require each local department in charge of commerce to strengthen coordination of franchising activities and to offer guidance for the launch and development of “local industry associations (chambers of commerce)” (Article 27). Moreover, each such department “shall establish credit files of franchisors and franchisees, and announce the list of enterprises in violation of regulations in a timely manner” (Article 27). Strong interest in franchising activities at the central level is indicated by the requirement that local departments report franchise filings to higher levels (Article 29).

Governing Law

Franchising FIEs remain subject to the other laws, regulations and rules related to foreign investment (Article 35). In particular, industries that are prohibited to FIEs in general¹³ are also prohibited to FIE operations by way of franchising (Article 32). PRC laws of general application, notably the PRC Contract Law, also apply to contracts between FIE franchisors and PRC franchisees, unlike a cross-border or “foreign-related” contract, for which the parties can select a foreign governing law.¹⁴

Penalties

Penalties for violation of the Procedures include fines limited to Rmb30,000 and for serious cases, revocation of the violator51s enterprise business licence (Articles 38 and 39). These are relatively high fines by the standards of PRC legislation, but do not preclude other penalties for violations of laws of general application.

Offshore (Hong Kong) Master Franchisee

For small foreign franchisors who wish to avoid investing in and operating subsidiaries in the PRC, one solution will be to delegate these activities to a master franchisee located in an offshore location such as Hong Kong. Hong Kong is also a useful market in which to put foreign franchising concepts through a quick “Chinese trial run” to test whether the franchise system can successfully be adapted to Chinese language and culture. This is facilitated by Hong Kong51s duty-free import of most goods, very broad freedom of contract, and enforcement of US court judgments, along with its absence of government approval requirements, minimum capital requirements and debt-equity ratio limits, all unlike the PRC mainland. Also, a successful trial run in Hong Kong can quickly generate cash for investment in the mainland.

Conclusion

The “one-size-fits-all” approach of the Procedures will not fit every franchisor or franchisee. Some of the most onerous provisions might be softened later by implementing rules or formal or informal exemptions. If the domestic franchising market develops as fast as expected, franchising may come to be seen by MOFCOM as less sensitive and needing fewer restrictions. For now, some elements of the Procedures undermine one of the great benefits of franchising, that the franchisor itself does not need capital to spread, and benefit from, its operating system. But capital may be available from third parties, and a determined foreign franchisor with a proven and adaptable operating system can still find ways to get started.

Endnotes

1 The Procedures simultaneously repeal the previous Administration of Commercial Franchise Procedures (Trial Implementation) issued by the former Ministry of Internal Trade.

2 But see below discussion of a franchisor51s duties when proposing certain standard terms.

3 “Foreign” includes, for purposes of the Procedures, like for most economic activities, the regions of Hong Kong, Macao and Taiwan.

4 Article 3 of the Administration of Foreign Investment in the Commercial Sector Procedures, issued by MOFCOM in 2004, states that “foreign companies, enterprises and other economic organizations or individuals must go through foreign-invested enterprises established within the territory of China to engage in” franchising.

5 The logical meaning of “控股公司”is “share-controlling company” or “holding company” having a controlling shareholding in the FIE. But verbal comments by MOFCOM personnel indicate that the intended meaning, although less logical, is “share-controlled company” in which the FIE has a controlling shareholding.

6 “商业”.

7 Article 10. A contract clause purporting to waive any of these points would apparently not be valid.

8 The phrase “统一” is used often in the Procedures and due to the context is generally translated as “uniform”, but in this context the translation “unified” appears more appropriate.

9 Article 18. It appears that preliminary signatures and perhaps preliminary agreements (such as a letter of intent or memorandum of understanding, etc.) may be exchanged earlier without violating this lead-time requirement.

10 A particularly vague and open-ended disclosure item is “other information ... upon request of the franchisee”. This wording is somewhat unnerving on first reading, because it appears to enable the franchisee to “rewrite” contract disclosure terms at will, but this type of wording in PRC regulations is customarily not interpreted in this manner.

11 See Article 10 of Several Regulations Relating to Prohibition on Infringement of Trade Secrets.

12 Article 29 and Article 34. Filling must be made to the original examination and approval department in the case of an FIE franchisor.

13 Prohibited industries, along with restricted and encouraged industries, are set out in the Foreign Investment Industry Guidance Catalogue.

14 “Foreign-related” for this purpose has generally been interpreted to mean “having a major foreign party to the contract”.