New China Franchise Regulation

The world's most populous country, China, is opening its door to foreign franchisors, in accordance with its WTO commitments. To accommodate this new reality, the Chinese government has published a new franchise regulation. On Dec. 31, 2004, the Ministry of Commerce (“MOFCOM”) published Measures for the Regulation of Commercial Franchise Operations (the “Measures”).

The Measures will take effect on Feb. 1, 2005, and they will completely replace the previous regulatory system, under which a regulation issued in 1997 applied to domestic (Chinese) franchisors (the “Interim Measures”), with somewhat uncertain impact on foreign franchisors. The Measures also will supersede proposed Provisional Measures that were published for comment in Nov. 2004, which were to have applied to non-Chinese franchisors offering franchises through foreign-invested enterprises (“FIEs”). The new Measures will thus be the sole legal framework under which franchisors will operate in China, and they will apply to foreign and domestic franchisors.

The Measures are primarily presale disclosure obligations imposed on the franchisor. These obligations are not particularly onerous, but they are quite ambiguous and raise many practical issues. The franchisor's obligations include disclosure of, among other things:

• its registered capital, audited financial statements, and information regarding tax payments;
• services or goods the franchisor can supply to the franchisees, and related restrictions or conditions;
• the “operational results” of the franchisees, including the initial investment required for a franchised unit and information about terminated franchisees; and
• any information “requested by a franchisee.”

This last requirement is particularly troublesome because it suggests that existing franchisees, in addition to prospective franchisees, may have disclosure rights. Moreover, it potentially expands the disclosure obligations of franchisors to an unlimited number of items. This open-ended category could be highly disruptive to franchising in China and introduces an element of risk because the Measures grant franchisees a private right of action for economic losses caused by a franchisor's misrepresentation or omission.

The Measures go well beyond mere disclosure and seek to interject a substantial degree of regulation into the franchisor-franchisee relationship. At the outset, a franchisor may not offer franchises in China until it has operated two “company-owned” units in China for more than 1 year. Similar requirements have generally not been favored in other countries because they impose an unnecessary burden upon a franchisor, while the results of the company-operated units may not provide a true indication of whether the business model will work for a franchisee. This provision reflects the concern that Chinese regulators have with foreign franchisors that do not have any presence in China.

The Measures also require franchisors to act in accordance with the principles of fair dealing, honesty, and trustworthiness. While these are, of course, laudatory goals, it remains to be seen how such a subjective standard will be viewed by Chinese government agencies, bureaucrats, and courts in the context of a typical franchise dispute.

Another provision of concern is the requirement that a franchisor be liable for the products and services provided by its designated suppliers, notwithstanding the fact that the franchisor is not permitted to be the sole supplier “except for monopolized goods and those goods that have to be supplied by the franchisor or its designated supplier to ensure the quality of the franchise operations.” Although the purpose of these provisions is understandable, it is troubling that a foreign franchisor is assumed to have influence over, or responsibility for, a third-party supplier ' whether that supplier is based in the United States, Europe, China, or elsewhere.

Although the Measures as a whole apply to both domestic and foreign franchisors, the application and approval system is only imposed upon FIE franchisors. That is, before an FIE can offer franchises in China, it must first apply for approval from various government agencies. By contrast, a domestic Chinese franchisor can bypass this protocol and start offering franchises without submitting to any such approval process. This dichotomy affords domestic franchisors some protection from competition by foreign franchisors; it thus serves the purpose of promoting the development of domestic franchisors.

The measures are widely expected to be replaced in the future by formal legislation, tentatively titled the Commercial Franchise Regulation (the “Regulation”). The Regulation has been pending before the State Council of the PRC for some time, and its contents are confidential and subject to change by the State Council. We hope ' and will urge ' that the flaws in the current Measures be addressed in the Regulation. For now, however, it is the Measures that must engage the attention of franchisors interested in the China market.

For more information regarding the Measures, you can read the recent FranCast at www.envoynews.com/piperrudnick/e_article000344455.cfm?x=b11,b1krkSmB,w, in which you also will find a Mandarin version of the Measures and an unofficial English translation.

The world's most populous country, China, is opening its door to foreign franchisors, in accordance with its WTO commitments. To accommodate this new reality, the Chinese government has published a new franchise regulation. On Dec. 31, 2004, the Ministry of Commerce (“MOFCOM”) published Measures for the Regulation of Commercial Franchise Operations (the “Measures”).

The Measures will take effect on Feb. 1, 2005, and they will completely replace the previous regulatory system, under which a regulation issued in 1997 applied to domestic (Chinese) franchisors (the “Interim Measures”), with somewhat uncertain impact on foreign franchisors. The Measures also will supersede proposed Provisional Measures that were published for comment in Nov. 2004, which were to have applied to non-Chinese franchisors offering franchises through foreign-invested enterprises (“FIEs”). The new Measures will thus be the sole legal framework under which franchisors will operate in China, and they will apply to foreign and domestic franchisors.

The Measures are primarily presale disclosure obligations imposed on the franchisor. These obligations are not particularly onerous, but they are quite ambiguous and raise many practical issues. The franchisor's obligations include disclosure of, among other things:

• its registered capital, audited financial statements, and information regarding tax payments;
• services or goods the franchisor can supply to the franchisees, and related restrictions or conditions;
• the “operational results” of the franchisees, including the initial investment required for a franchised unit and information about terminated franchisees; and
• any information “requested by a franchisee.”

This last requirement is particularly troublesome because it suggests that existing franchisees, in addition to prospective franchisees, may have disclosure rights. Moreover, it potentially expands the disclosure obligations of franchisors to an unlimited number of items. This open-ended category could be highly disruptive to franchising in China and introduces an element of risk because the Measures grant franchisees a private right of action for economic losses caused by a franchisor's misrepresentation or omission.

The Measures go well beyond mere disclosure and seek to interject a substantial degree of regulation into the franchisor-franchisee relationship. At the outset, a franchisor may not offer franchises in China until it has operated two “company-owned” units in China for more than 1 year. Similar requirements have generally not been favored in other countries because they impose an unnecessary burden upon a franchisor, while the results of the company-operated units may not provide a true indication of whether the business model will work for a franchisee. This provision reflects the concern that Chinese regulators have with foreign franchisors that do not have any presence in China.

The Measures also require franchisors to act in accordance with the principles of fair dealing, honesty, and trustworthiness. While these are, of course, laudatory goals, it remains to be seen how such a subjective standard will be viewed by Chinese government agencies, bureaucrats, and courts in the context of a typical franchise dispute.

Another provision of concern is the requirement that a franchisor be liable for the products and services provided by its designated suppliers, notwithstanding the fact that the franchisor is not permitted to be the sole supplier “except for monopolized goods and those goods that have to be supplied by the franchisor or its designated supplier to ensure the quality of the franchise operations.” Although the purpose of these provisions is understandable, it is troubling that a foreign franchisor is assumed to have influence over, or responsibility for, a third-party supplier ' whether that supplier is based in the United States, Europe, China, or elsewhere.

Although the Measures as a whole apply to both domestic and foreign franchisors, the application and approval system is only imposed upon FIE franchisors. That is, before an FIE can offer franchises in China, it must first apply for approval from various government agencies. By contrast, a domestic Chinese franchisor can bypass this protocol and start offering franchises without submitting to any such approval process. This dichotomy affords domestic franchisors some protection from competition by foreign franchisors; it thus serves the purpose of promoting the development of domestic franchisors.

The measures are widely expected to be replaced in the future by formal legislation, tentatively titled the Commercial Franchise Regulation (the “Regulation”). The Regulation has been pending before the State Council of the PRC for some time, and its contents are confidential and subject to change by the State Council. We hope ' and will urge ' that the flaws in the current Measures be addressed in the Regulation. For now, however, it is the Measures that must engage the attention of franchisors interested in the China market.

For more information regarding the Measures, you can read the recent FranCast at www.envoynews.com/piperrudnick/e_article000344455.cfm?x=b11,b1krkSmB,w, in which you also will find a Mandarin version of the Measures and an unofficial English translation.