China, Franchising and the 2008 Olympics: Is the Time Right?
June 02, 2008 | BY
clpstaff &clp articles &China is now the largest franchise market in the world, and the 2008 Olympic Games has the potential to further expand this market. In respect of merchandizing, the BOCOG has utilized the franchise model to an unprecedented level. China's IP laws have been in substantial compliance with international standards for several years now, but enforcement has been a problem. The Olympic Games has forced the Chinese government to implement the groundwork for effective IPR protection.
A SHORT HISTORY
The current state of the franchising industry in China is phenomenal when one considers its history. Franchising was virtually non-existent in China in the early 1990s: China enacted its first franchise law in 1997. However, the 1997 law did not refer to foreign companies and it was questionable whether foreign franchises were permitted in China. At this time there was no public awareness of the franchising model. Jim Bryant, the entrepreneur behind bringing Subway to China, once stated that his early experiences in China involved him having to teach the franchising concept to a country that had never heard of it. He recalls that when he started, there was no Chinese word for “franchise.”1
Since the 1990s the Chinese have been quick to recognize the usefulness of the franchised business model, particularly its ability to combine the benefits of small businesses with large brands, distribution and processes. However, the franchising model in China has not been attractive to those companies that predominantly use it in the West – the overwhelming majority of McDonalds and KFC restaurants in China are corporately owned (it was not until 2003 that McDonalds granted its first franchise). Legal insecurities and the immaturity of the market were the main reasons for the reluctance of these companies to use the franchise model. Also, because many industries, most importantly the retail industry, were not fully open to foreign investment, some foreign franchisees had to operate in a gray area of the law. However, other international chains like Subway, Century 21 and Athlete's Foot were more willing to use the franchise model. By the late 1990s-early 2000s Subway stores had sprung up all over China. This could be attributed to the cheaper cost of purchasing a Subway franchise in comparison to KFC or McDonalds.
In December 2004, China issued the Measures for the Regulation of Commercial Franchise (the “Measures”), which replaced the regulations issued in 1997 and also brought in new rules that applied to both foreign and domestic franchising activities in China. The main provision vis-à-vis foreign franchisors was that all foreign investors and domestic entities that wanted to conduct franchising activities in China were required to establish a legal entity in China, namely a foreign invested enterprise (FIE) or domestic company. Although China has finally allowed direct foreign participation in the franchise business sector by implementation of the Measures, there were still many deficiencies, in particular, the so-called “two plus one” requirement. This required franchisors to own and operate their brands' first two outlets profitably in China for one year, before franchising.
THE CURRENT LAW
In 2007 China's State Council issued the Franchise Regulations (the “Regulations”). The Regulations contained significant improvements to the Measures, the most significant of which is that, pursuant to Article 7, the two plus one requirement no longer needs to be satisfied in China, but rather can be satisfied off-shore. It is suggested that the removal of this restriction has substantially reduced costs that franchisors face. Further, Article 8 removed the need to seek approval before starting the franchise. The franchisors now need only to “register” with the provincial government or Ministry of Commerce (in respect of cross-provincial franchises) within 15 days of selling its first franchise. The Regulations apply to those who engage in “commercial franchising” within the territory of the People's Republic of China. Commercial franchise is defined in the regulations to mean:
“the business activities whereby the franchisor (hereinafter referred to as 'franchisor'), through executing contracts, allows the franchisee (hereinafter referred to as 'franchisee') the use of the operational resources, such as registered trademark, enterprise logo, patent, know-how, etc., that the franchisor owns, and the franchisee undertakes business under the unified business format in accordance with the provisions of such contracts, and pays franchise fees to the franchisor.” (Article 3)
When filing a registration for a franchise, under Article 8 of the Regulations a franchise must include the following documents:
1. A duplicate copy of its Business License or of its enterprise registration (filing) certificate;
2. A sample franchise contract;
3. Franchise operation manuals;
4. A marketing plan;
5. A written undertaking and relevant substantiating materials showing that the franchisor meets the requirements set forth in Article 7; and
6. Other documents and materials as stipulated by the competent commercial authority of the State Council.
Article 11 stipulates a variety of matters that must be covered in a franchise contract. Under Article 13, the minimum duration of a franchise is three years, unless otherwise agreed by the franchisee. The Regulations also contain various articles requiring good faith, honesty and disclosure by the franchisor (see Articles 4, 16, 21 and 23).
BEIJING OLYMPIC GAMES
As a result of the 2005 and 2007 reforms, combined with liberalization of foreign investment in China generally, the regulatory environment for franchising has greatly improved.2 This has provided far greater flexibility for foreign brands. The 2008 Olympic Games has the potential to further ignite the franchising industry. It is no coincidence that during the Olympic year the Dunkin Donuts chain, which previously abandoned its presence in China, is re-entering the China market. There are now plans to open 100 stores in Shanghai within the next 10 years.3
The Beijing Organizing Committee of the Olympic Games (BOCOG) has franchised the sale of Olympic merchandise and initially opened 600 franchise stores. However, the BOCOG soon found that this was insufficient to meet demand in the smaller and medium-sized cities, and has since licensed a significant number of additional stores. By the time the Olympics commences it is expected that the number of franchise stores will reach 10,000 with the sales target being US$700 million.4
This will mean that post-Olympics China will have a large pool of people who have knowledge and understanding of what is required in running a franchise store, and who have experienced the benefits of having an interest in the profitability of the business. Undoubtedly, this will further develop cultural acceptance of the franchise business model in China, and will also provide potential franchisors with a resource of experienced franchisees with whom to do business. This will hopefully encourage more foreign brands to recognize the utility of the franchise model in China.
Protection and management of intellectual property rights (IPR) are clearly key considerations for large-scale brands when deciding whether to adopt a franchise business model. They are even more of an issue in China where a considerable amount of IP infringement involves individuals or companies that already had business relationships with the IP owner. This questionable efficacy of IPR enforcement in China in the past has held back the development of the franchise industry – how can a franchisor prevent the use of its trade secrets by a former franchisee? This may has been a dominant reason for McDonalds' reticence to use franchising in China. China has had IP substantially in compliance with its international obligations since its accession to the WTO in 2001, yet in the past there have been concerns regarding the Chinese government's commitment to enforcing IPR. Infringement of IPR has continued to be rampant since 2001. In recent times the Chinese government has espoused a stronger commitment towards IPR, calling it an “indispensable component” of a modern state.5 This shift of commitment towards IPR can, at least partly, be attributed to China's obligations as the host city of the 2008 Olympic Games. The International Olympic Committee requires the host city take strong action to protect its IPR. As a result, there is no doubt that IP infringement in China is not as flagrant as it was five years ago. This may be the beginning of the development of respect for IPR. The interesting trend in the last five years is that Chinese companies have started to discover the benefits of respect for intellectual property. No longer is IPR enforcement in China exclusively the domain of foreign companies.
More broadly, the Olympic Games has the potential to further expose the China market to the world and contribute to further investment in China. There are very few global companies that have not entered the China market. The reality is that no company can ignore the biggest marketplace in the world; this will be even more so post-Olympics.
The Olympic Games will also offer a challenge for regulators, the BOCOG and sponsors – the use of ambush marketing. The ability of these organizations to resist this challenge may provide an indication of the ability of the franchising industry to resist the challenges it faces in the future.
*About the Author
Foreign Legal Counselor Matthew McKee is a recent addition to Lehman, Lee & Xu's Corporate Services and Tax Planning Team. Apart from an interest in franchising law, Matthew's practice primarily involves advising foreign clients on a wide variety of corporate issues, including FDI matters and international taxation issues. Matthew is an Australian qualified lawyer with previous litigation experience in corporate, commercial and equity disputes and in banking and finance securities enforcement.
Endnotes
1. Caryle Adler, “How China Eats a Sandwich”, March 1 2005, CNN Money at http://money.cnn.com/magazines/fsb/fsb_archive/2005/03/01/8253829/index.htm (as of 16 May 2008).
2. See Franchise Council of Australia, “China – The New Franchise Frontier', Franchise Business at http://www.franchisebusiness.com.au/articles/China-The-New-Franchise-Frontier_z48883.htm.
3. M. Prewitt, “Breaking down the great wall to franchising in China”, May 2 2007, China Insight at http://www.chinainsight.info/april2007/apr2007franchisinginchina.htm (as of 17 May 2008).
4. China View, “Beijing Olympic organisers to allow individuals to run franchise stores”, April 11 2007, at http://news.xinhuanet.com/english/2007-04/11/content_5962396.htm (as at 17 May 2008).
5. German Federal Ministry of Justice, Press Release (22/04/2008), “German-Chinese Rule of Law Dialogue: New Two-year Programme signed”.
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