Tips for franchising in China

My company owns a successful chain of retail shops across the US and Australia. We're now looking at expanding into China for obvious reasons. I'm not clear about franchising laws in the PRC and to my limited knowledge, they are still not quite developed. Are there any guidelines I should follow when considering entering the Chinese market through franchising? Are there limitations to a franchising strategy for foreign franchisers? In short:

The international perspective

Keys to successful franchising in China

Franchising is essentially a tool to remotely control the products, quality, look and feel of a business that is run by an independent entrepreneur. Besides a good brand, location and business model the essential ingredients for this to work in China are good franchisees, good quality control, good training and support, and when trust fails, effective and swift sanctions. The tools required to maintain the balance of these ingredients are good, comprehensible contracts and good local management.

Franchisees in China will often overestimate their capabilities. Worse, some franchisees' motivation may be to use the franchise only as a spring board for their own independent business. Only a thorough due diligence on franchisees, including extensive interviews and background checks can help identify the right franchisees. It is important to recognise that Chinese franchisees may be less predictable for the foreign franchisor.

Franchise agreements are process driven tools. They should be structured in a manner so that a franchisee can understand them and knows clearly what is expected of him/her. Given China's short history of effectively using contracts, this is even more important. As dispute resolution in China does not always provide effective remedies, the contracts should provide for tools that allow control, rewards and sanctions to manage the franchisees without having to employ contentious mechanisms.

Efficient and active management is key and the best contractual framework is useless without it. Many Chinese franchisees will, at some point, wonder if the franchise is still beneficial to them or if they could earn more independently. To use this natural thought process constructively and avoid conflicts, a positive communication and integration is advised. Rewards and sanctions should always be based on a clear understanding if the objectives of franchisor and franchisee are still sufficiently aligned.

Your own presence in China – ideally 100% invested by you, the foreign business – is preferable to models relying entirely on a sub-franchisor or another third party to manage franchise networks in China. Only your own local knowledge, close communication, control and support, as well as quick direct action, will allow for the optimal building and management of a franchise network in China. Foreign franchisors using Chinese sub-franchisors often discover that their objectives or expectations are incompatible, but because an unhealthy dependence on these sub Franchisors was quickly created, they lost control over the franchise network.

Matthias Mueller
Partner
Salans

The domestic perspective

Compared with other countries like the United States, Great Britain or Australia, the business model of franchising is relatively new in China. It was not until November 14 1997 that China promulgated its first set of rules, the Administration of Commercial Franchise Measures (Trial Implementation) (商业特许经营管理办法 (试行)), which was repealed in 2005 with the issuance of the Administration of Commercial Franchising Measures (商业特许经营管理办法) (Measures).

On January 31 2007, the State Council of the People's Republic of China adopted the Regulations for the Administration of Commercial Franchising (商业特许经营管理条例) (Regulation), which came into force on May 1 2007 and is still the dominant governing regulation till now. It is applicable to all franchise activities (not only domestic franchises, but also foreign franchisors that intend to conduct business in China) that take place within the territory of the PRC. Later in the same year, the Measures for the Administration of Record Filings in Connection with Commercial Franchising (商业特许经营备案管理办法) (Filing Rules) and the Measures for the Administration of Information Disclosure in Connection with Commercial Franchising (商业特许经营信息披露管理办法) (Disclosure Rules) were issued. They each respectively set up the requirements and procedures for filing and information disclosure to enhance those that had been regulated in the Regulation in detail. The Regulation, Filing Rules, and Disclosure Rules comprise the franchising industry's current governing documents.

Compared to the previous Measures, the Regulation provides more explicit guidance on the following five points: (1) the definition of “commercial franchise”; (2) necessary qualifications for a Franchisor operating in China; (3) franchise contract; (4) disclosure requirements; and (5) filing with relevant government authorities.

According to Article 3, a commercial franchise business means an enterprise (Franchisor) that owns the operational resources such as registered trademarks, company logo, patents and know-how, and by means of contracts, licenses another business operator (Franchisee) to use such operational resources owned by the Franchisor. The Franchisee will conduct its business activities under a uniform business system and pay franchise fees to the Franchisor in accordance with the contractual stipulations. Thus, there are four elements to determine a franchise business:

- The Franchisor possesses ownership of registered trademarks, enterprise logo, patents, know-how and other operation resources;
- The Franchisee conducts its business activities under a uniform business provided by the Franchisor;
- There must be a written contract between the two parties; and
- The Franchisee pays franchising fees to the Franchisor.

The Regulation stipulates the necessary qualifications for a franchisor operating in China, which are as follows:

- No unit or individual other than an enterprise shall conduct franchise activities as a franchisor;
- A Franchisor 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 Franchisor shall possess at least two directly operating stores, in operation for more than one year. This is the so-called “2+1 Rule”. As reiterated in the Filing Rules, there is no geographic limitation on where the two operation stores should be located. This is a significant change compared with the Measures.

When a Franchisor meets the aforementioned qualifications, it must file a recordal with the competent commerce authorities within 15 days from entering into an initial franchise contract according to the Filing Rules.

Although the Regulation has made great progress towards clarifying administration in the franchising area, there remains various vague aspects which will hopefully be improved in the future.

Sophie Tan
Legal counsel
Lehman Lee & Xu