China's Developing Franchising Market

Thus far, franchise operations have penetrated virtually all segments of the retail industry, including drug stores, home appliances, supermarkets, garments, and photo shops. Up to now, China's franchise market has covered the majority of categories of franchised businesses established by the European Franchise Federation (EFF) which recommended its categorization system to the World Franchise Council (WFC) in the beginning of 2006. According to this system, China's franchising market covers 13 categories of franchise-related businesses, However, there is very limited franchise activity in office equipment, education, and heath and beauty services sectors.

Foreign presence in the franchise market is substantial. Of the top 20 international franchisers, 15 have already entered the Chinese market. Over the past year, in view of China's improvements in its regulatory environment and the stable development of its franchise industry, foreign franchisers, such as Burger King, Super 8, Bojangles, Applebees and Uniglobal Travel, have quickened their pace in exploring the Chinese market. The entry of foreign franchises has not only promoted new business concepts and expanded the coverage of franchise-related businesses in China, but has also introduced advanced management skills and marketing methods which stimulates the overall development of China's franchise industry.

Concurrently, local franchises are also making rapid progress. The sports business company Li Ning for example, a company established in 1990 by one of China's most famous athletes, currently has more than 2,500 franchisees and has become the largest franchiser in the field of sports products.

The Changing Regulatory Environment

The business model of franchising is relatively new in China, as compared to other countries. It was not until November 14 1997 that China promulgated its first set of rules which dealt specifically with commercial franchise operations, the Rules for the Administration of Commercial Franchise Operation-Trial Implementation (the Franchise Rules).

The Franchise Rules were somewhat general in nature, with the term “franchising” defined in Article 2 as follows:

Franchising refers to the arrangement whereby a Franchiser, by entering into a franchise agreement, authorizes a Franchisee to use its trademark [including the service mark], trade name, products, patent, know-how and business system. The Franchisee shall conduct the business under the standardized business system of the Franchiser according to the provisions of the agreement and pay the Franchiser the relevant fees.

Although the Franchise Rules were repealed in 2005 with the issuance of the Measures on the Management of Franchises (Franchise Measures), the Franchise Rules were important, as they formed the basis upon which subsequent franchise rules and regulations were drafted and issued by Chinese authorities.

On January 31 2007, the State Council of the People's Republic of China, at the 167^th executive meeting, adopted the Regulation on the Administration of Commercial Franchise (Regulation), which is to be effective on May 1 2007.

According to the literal drafting, the Regulation will be applicable to all “franchise activities” that will take place “within the territory of the People's Republic of China”. This provision clearly intends to convey that the Regulation will apply to not only domestic Franchisers and their franchises, but also foreign Franchisers that intend to conduct business in China, regardless of the structure adopted.

Several of the important features of the new Regulation are as follows:

Definition of a Commercial Franchise

The new Regulation defines “franchise business” as a system whereby:

a Franchiser, by signing a contract, authorizes a Franchisee to use registered trademarks, enterprise logo, patents, know-how, business models and other operational resources owned by the Franchiser, and the Franchisee conducts its business activities under a uniform business system and pays franchise fees to the Franchiser in accordance with the contractual stipulations.

In summary, there are four necessary elements which constitute a “franchise business”:

¡¤ A franchiser shall be an enterprise which possesses ownership of trademarks, enterprise logo, patents, know-how and other operational resources;

¡¤ A written franchise contract exists between franchiser and franchisee;

¡¤ A franchisee conducts relevant business activities under a uniform business system; and

¡¤ A franchisee pays franchise fees to the franchiser.

Qualifications for Franchisers

The new Regulation also clearly sets out necessary qualifications for franchisers operating in China, as follows:

¡¤ No unit or individual other than an enterprise shall conduct franchise activities as a franchiser; namely, the provision implies that only enterprises registered in China are entitled to conduct franchise business;

¡¤ A franchiser shall possess a well-established business model and shall have the ability to provide franchisees with long-term business guidance, technical support and training services; and

¡¤ A franchiser shall possess at least two directly operated stores, in operation for more than one year.

Disclosure Requirements

The new Regulation stipulates that franchisers must provide franchisees with basic information related to the franchise business and text of the franchise contract, in writing, a minimum of 30 days prior to the date on which the formal franchise contract is executed.

The basic information must include:

¡¤ Name, domicile, legal representative, registered capital and business scope of the franchiser and basic information regarding its franchise activities;

¡¤ Information related to registered trademarks, company logo, patent, know-how and its business model;

¡¤ Type, amount, and payment terms of the franchise fees (including requirement of guarantee deposit and conditions and method of return of guarantee deposit);

¡¤ The price and conditions of use for products, services and equipment provided to the franchisee;

¡¤ Contents of the operations guide, technical support and training services, and the procedures to supply such services and the implementation plan;

¡¤ Methods of guidance and supervision over the business activities of Franchisee;

¡¤ Investment budget for the franchise network;

¡¤ Number, location and business condition of its current Franchisees in China; and

¡¤ A summary of financial statements audited by an accounting firm and summary of audit report for the past two years.

The new Regulation further provides that where a Franchiser conceals relevant information or provides false information, the Franchisee may cancel the franchise contract.

Filing with Relevant Government Authorities

To strengthen the administration of franchise businesses, the Regulation provides for two types of franchise filings: initial franchise filing and annual franchise filing.

¡¤ For an initial franchise filing, a franchiser must file a record with the local commerce authorities within 15 days of entering into the initial franchise contract.

¡¤ For an annual franchise filing, a franchiser must, in the first quarter of each year, report on the status of the franchise contracts in the past year to the local commerce authorities.

However, the Regulation does not specify what information is to be filed or the specific procedures for the annual franchise filing. Hopefully, these details will be formulated and developed in implementing regulations and policies to be issued by either the Ministry or Commerce or the China Chainstore and Franchise Association prior to the effective date of the Regulations.

Franchise Contracts

The Regulation has detailed requirements on the terms and conditions that must be included in the franchise contracts, with all franchise contracts to cover at a minimum the following:

¡¤ Basic information about the franchiser and franchisee;

¡¤ Content and terms of the franchise;

¡¤ Type, amount, and payment terms of the franchise fee;

¡¤ Details of operation guidance, technical support and training services and the procedures for supplying such services;

¡¤ Quality standards and requirements, and relevant guarantees for the products or the services;

¡¤ Promotions and advertising of the products or the services;

¡¤ Protection of consumers' rights, interests and liabilities for damages, and relevant compensation, arising out of the franchise;

¡¤ Amendment, cancellation and termination of the franchise contract;

¡¤ Liabilities for breach of contract;

¡¤ Dispute resolution; and

¡¤ Other clauses agreed to by Franchiser and Franchisee.

In the previous Franchise Rules, the term of the franchise contract had to be not less than three years. Comparatively, the new Regulation is more flexible, which means that, if agreed to by the Franchisee, the term of the contract may be less than three years after the initial term.

Moreover, the Regulation enhances protection for Franchisees by adding unilateral termination rights, in that the Franchiser and Franchisee must stipulate in the franchise contract that the Franchisee may unilaterally terminate the contract within a stipulated period of time.

Retrospective Effect on Existing Franchisers

Franchisers permitted to conduct franchise activities prior to the promulgation of the new Regulation must report to the local commerce authorities for filing purposes within one year after implementation of the Regulation.

Franchises under the new Regulations

The Regulation is still somewhat vague as to what is meant or intended in several important areas. Until either the State Council or the Ministry of Commerce issue detailed policy statements concerning such aspects, there will continue to be some uncertainty in the franchise business sector concerning compliance requirements.

Nevertheless, the Regulation will most definitely cause a 'reshuffling' in China's franchise market. “The promulgation of these Regulations”, states Mr. Pei Liang, General Secretary of CCFA (China Chainstore and Franchise Association), “will serve as a powerful guarantee for relevant franchise enterprises, provide legal support for the development of China's franchise industry and, to a certain degree, change the current situation under which the rights and interests of investors and potential franchisees may not be sufficiently protected. Following the issuance of the Regulation, enterprises that cannot measure up to the relevant standards will be disqualified from the market and those engaging in business in compliance with the standards will be awarded more market opportunities with better protection of relevant brands. Thus, it is believable that a standard market environment and a clear direction of policy will evoke more harmonious development of China's franchise industry.”