China question: What are the most common legal challenges when expanding a franchise?

2. Basic information of the franchisor's possession of operational resources;

3. Basic information regarding franchise fees;

4. Prices and conditions of products, services and equipment to be supplied to the franchisee;

5. Continuous services to be provided to the franchisee;

6. Specific method and contents of guidance and supervision of the franchisee's operation;

7. Investment estimate of franchise unit;

8. Relevant information on the franchisee(s) within China;

9. Abstract of financial accounting report and abstract of auditing report of the past two years that have been audited by an accounting firm or an auditing firm;

10. The franchisor's material litigation and arbitration in the past five years related to the franchise activities;

11. Record(s) of any material illegal operation of the franchisor or its legal representative; and

12. Franchise contract text.

Lastly, remember to file your franchise with the related commercial authority, local or central, depending on the size of your franchise, within 15 days of signing the franchise contract.

Anyone about to engage in franchising should also refer to the Regulations for the Administration of Commercial Franchising (商业特许经营管理条例) .

James Liu, FranChina, Beijing

The international perspective

There are various legal challenges relating to the establishment of a franchise including issues relating to the statutory requirements for engaging in franchising, choice of the franchisees, control over your distribution network and protection of your intellectual property.

Check your business capacity

First, as required by law, you need to have at least two directly managed stores operating for more than one year in order to be a franchisor. Your company's business scope should also cover franchise activities, usually with the wording like “retail by means of franchise”. If not, you will have to extend your business scope first.

Carefully select your franchisees

Before executing any franchise agreement, conduct a thorough due diligence of your potential franchisee to assess its financial status and business reputation and uncover any disputes in which it might be involved. This is a key step to the success of a franchise.

Protect disclosed information

You are legally obliged to disclose sufficient business information to the franchisee before executing a franchise agreement, including your contact information, financial statements and prices for the products to be sold. It is advisable to require the franchisee to sign a confidentiality agreement to prevent any unauthorised disclosure of sensitive information.

Execute a detailed franchise agreement

The franchise agreement should clearly address your requirements for the operation of the franchise (like store design, staff uniforms and service quality). It can also restrict the franchisee's right to purchase products from other suppliers, or to sell products not bearing your brands or outside a designated territory. However, if you have a dominant market position in the business, any restrictions should be carefully designed because restricting a franchisee's purchases or sales may constitute: “an abuse of the dominant market position”. This abuse violates Chinese anti-monopoly laws.

Besides, even if you do not have the dominant market position, you are not allowed to fix the resell prices or restrict the minimum resell prices of the products to be sold by franchisees to third parties, as this is also a violation of Chinese anti-monopoly laws.

Your franchisee may also have access to your intellectual property, including your trademarks, sales expertise or special management software that you have developed for your business. Make sure you have properly protected these IP rights in China. In the franchise agreement, the franchisee should be prohibited from using your IP for any purpose other than the franchise business and from sublicensing this IP to third parties, without your consent.

You should also make sure the termination clauses could protect your interests. Keep the duration of the franchise agreement short, so that you will not be bound to work with the same franchisee for a long period and reserve the right to renew it only at your discretion. Specify the circumstances (like failure to meet sales targets or serious breaches) where you may unilaterally terminate the franchisee agreement. Also detail post-termination obligations to prevent the franchisee from seeking compensation from you, continuing the business using your IP or presenting itself as your franchisee once the franchise agreement terminates. Last but not least, integrate appropriate clauses to deal with aspects of the franchise following termination of the franchise agreement, which should enable you to freely decide whether to purchase back the inventory and close the store, continue operating it by yourself or appoint another franchisee to take it over.

Filing your franchise business

Do not forget to file your new franchise business with the competent commission of commerce within 15 days after the first franchise agreement is signed, according to 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). Otherwise, you will risk a fine of between Rmb10,000 ($1,600) and Rmb50,000, or between Rmb50,000 and Rmb 100,000, if you still do not file it after the authority orders you to do so.

Antoine de la Gatinais and Li Kai, Gide Loyrette Nouel, Shanghai