Understanding China's New Franchise Regulations

Although China's definition of a franchise is somewhat similar to what is encountered in the United States, its rather broad and vague language is troublesome. Article 3 of the regulations define a commercial franchise as ' … the business activities whereby the franchisor through executing contracts, allows the 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.' However, there is no definition of what is meant by a 'franchise fee,' and consequently it remains unclear whether the regulations intend to cover product distribution franchises. Although the regulations do not explicitly address master franchise relationships, from the breadth of the definition one can assume that master franchises are covered. What is left unclear is to what extent branded management agreements (commonly used in the hotel industry) or the license component of a branded joint venture might be deemed franchises subject to the regulations.

The new regulations now put in place permanently the controversial 'two plus one requirement' that was first introduced with the measures. However, the key difference is that the regulations do not require that the two units be operated in China. Additionally, the even more controversial aspect of the two-plus-one requirement under the measures ' namely applying it retroactively to existing franchise systems in China ' has now been removed. Although meeting the two-plus-one requirement with units operated abroad is a welcome liberalization, a number of aspects of this requirement remain unanswered, such as whether: a) the units must be owned by the exact same franchisor entity that is franchising in China or may be owned by an affiliate; b) whether the franchisor's management of an outlet owned by a third party (a common practice in the hospitality industry) suffices to meet this requirement; or c) whether this requirement need only be met at the commencement of franchising in China, or whether it must continue to be met so long as franchises are being sold in China or so long as franchises remain operational in China.

Although MOFCOM has informally indicated it will apply the two-plus-one requirement with some flexibility, it remains to be seen what will be accepted. Perhaps most troublesome is that the regulations do not provide any relief for the 'pure' franchise company that franchises exclusively without operating any outlets itself. The two-plus-one requirement essentially is a proxy for a franchisor demonstrating that it has a well-developed business format and is capable of providing required assistance to franchisees, but it fails to provide any flexibility in demonstrating a legitimate franchise operation by any other means.

Article 5 of the Regulations confers on various governmental agencies the authority to supervise and administer the franchise regulations, depending on where the franchisor is conducting its business. This authority is delegated to a provincial, autonomous region, or municipality level to
the extent that a franchisor's activities are limited to their jurisdictions. Franchisors whose activities cross jurisdictions or who engage in cross-border franchising are regulated by the competent commercial authority of the State Council, i.e., MOFCOM. This means that the authority to deal with the registration process and potential penalties for violating the regulations are defused through various governmental agencies. Yet, for foreign franchisors, the appropriate agency is likely to be MOFCOM.

Article 8 requires the franchisor to register within 15 days after the execution of the first franchise agreement. This registration process is to be Web-based and is intended to be a means for collecting statistical data on franchising, in addition to confirming qualification requirements. Certain information will be publicly available, enabling interested parties to contact franchisors. The filing guidelines specify that the application must include a number of items, including a sample franchise agreement, the table of contents of the operations manual, and a marketing plan (much like the requirement in Item 20 of the UFOC relating to projected expansion of the franchise system). The franchisor also will need to demonstrate how it has complied with the two-plus-one requirement. In the event the two-plus-one requirement is to be met in a foreign country, certificates from local authorities will be necessary to evidence the operations of those units, along with Chinese translations and Chinese Embassy or Consulate certification.

Article 7 requires material amendment filings, and Article 19 requires a franchisor to annually update certain information by March 31 of each year. The filing is effective indefinitely, but subject to cancellation for violations of law or the franchisor providing false information. The franchisor also may voluntarily cancel the filing. The filing guidelines impose various penalties for failing to comply.

The regulations and disclosure guidelines set out the detailed disclosure requirements that a franchisor must follow in its disclosure documents. The categories of disclosure are fairly typical of franchise laws found throughout the world. Perhaps the most controversial aspect of disclosure requirements is a mandate to disclose the 'evaluation of the operational status of the existing franchisees in China.' Thus, the disclosure guidelines appear to contemplate a mandatory earnings claim. 'The franchisor shall disclose the franchisees' actual or estimated average sales volume, cost, gross profit, net profit, and simultaneously explain the sources of the aforesaid information, time span, franchise stores/outlets concerned, etc.' For a franchisor first embarking on expansion into China, this presumably means that financial projections must be provided and that there is no option for avoiding the disclosure. A major concern here is the difficulty of making such projections with any kind of reasonable basis in a new country, and the uncertainty of potential legal liability for the franchisees not achieving the estimates.

Conclusion

In sum, although the Chinese franchise regulations are an incremental improvement over the hastily promulgated prior franchise measures, they remain troublesome from the standpoint of foreign franchisors, particularly compliance with the two-plus-one requirement and the mandatory earnings claims.

Erik B. Wulff is a partner in the Washington, DC, office of DLA Piper US LLP and is editor-in-chief of this newsletter. He can be contacted at 202-861-6410 or [email protected].

The new franchise regulations recently issued by China's State Council became effective on May 1, 2007. Shortly after their promulgation, MOFCOM, the ministry that has authority to interpret and implement the regulations, issued two implementation guidelines, namely the Administration Rules on Commercial Franchise Filing and the Administration Rules on Commercial Franchise Information Disclosure. The regulations are intended not only to provide presale disclosure to prospective franchisees, but also to restrict use of franchising to legitimate business operators. Moreover, the regulations seek to gather statistical data on the scope of franchise activities in China through a franchise registration process.

These regulations reflect a more permanent regime of regulating franchising in China, and they were preceded by the rather controversial 'Franchise Measures' promulgated by MOFCOM effective Feb. 1, 2005. A particular concern for foreign franchisors with the prior franchise measures was a requirement to have two company-owned units operating in China for one year before becoming able to obtain government approval to franchise (the so-called 'two plus one' requirement), and this requirement was said to apply even to companies that had existing franchising systems in China. This was the government's effort to weed out disreputable operators, but it also caused concerns for legitimate businesses. The new franchise regulations take a less restrictive approach to franchising in China, but still leave much to be desired.

This article explores some of the major requirements of the new regulations, highlighting some of the areas of concern.

Although China's definition of a franchise is somewhat similar to what is encountered in the United States, its rather broad and vague language is troublesome. Article 3 of the regulations define a commercial franchise as ' … the business activities whereby the franchisor through executing contracts, allows the 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.' However, there is no definition of what is meant by a 'franchise fee,' and consequently it remains unclear whether the regulations intend to cover product distribution franchises. Although the regulations do not explicitly address master franchise relationships, from the breadth of the definition one can assume that master franchises are covered. What is left unclear is to what extent branded management agreements (commonly used in the hotel industry) or the license component of a branded joint venture might be deemed franchises subject to the regulations.

The new regulations now put in place permanently the controversial 'two plus one requirement' that was first introduced with the measures. However, the key difference is that the regulations do not require that the two units be operated in China. Additionally, the even more controversial aspect of the two-plus-one requirement under the measures ' namely applying it retroactively to existing franchise systems in China ' has now been removed. Although meeting the two-plus-one requirement with units operated abroad is a welcome liberalization, a number of aspects of this requirement remain unanswered, such as whether: a) the units must be owned by the exact same franchisor entity that is franchising in China or may be owned by an affiliate; b) whether the franchisor's management of an outlet owned by a third party (a common practice in the hospitality industry) suffices to meet this requirement; or c) whether this requirement need only be met at the commencement of franchising in China, or whether it must continue to be met so long as franchises are being sold in China or so long as franchises remain operational in China.

Although MOFCOM has informally indicated it will apply the two-plus-one requirement with some flexibility, it remains to be seen what will be accepted. Perhaps most troublesome is that the regulations do not provide any relief for the 'pure' franchise company that franchises exclusively without operating any outlets itself. The two-plus-one requirement essentially is a proxy for a franchisor demonstrating that it has a well-developed business format and is capable of providing required assistance to franchisees, but it fails to provide any flexibility in demonstrating a legitimate franchise operation by any other means.

Article 5 of the Regulations confers on various governmental agencies the authority to supervise and administer the franchise regulations, depending on where the franchisor is conducting its business. This authority is delegated to a provincial, autonomous region, or municipality level to
the extent that a franchisor's activities are limited to their jurisdictions. Franchisors whose activities cross jurisdictions or who engage in cross-border franchising are regulated by the competent commercial authority of the State Council, i.e., MOFCOM. This means that the authority to deal with the registration process and potential penalties for violating the regulations are defused through various governmental agencies. Yet, for foreign franchisors, the appropriate agency is likely to be MOFCOM.

Article 8 requires the franchisor to register within 15 days after the execution of the first franchise agreement. This registration process is to be Web-based and is intended to be a means for collecting statistical data on franchising, in addition to confirming qualification requirements. Certain information will be publicly available, enabling interested parties to contact franchisors. The filing guidelines specify that the application must include a number of items, including a sample franchise agreement, the table of contents of the operations manual, and a marketing plan (much like the requirement in Item 20 of the UFOC relating to projected expansion of the franchise system). The franchisor also will need to demonstrate how it has complied with the two-plus-one requirement. In the event the two-plus-one requirement is to be met in a foreign country, certificates from local authorities will be necessary to evidence the operations of those units, along with Chinese translations and Chinese Embassy or Consulate certification.

Article 7 requires material amendment filings, and Article 19 requires a franchisor to annually update certain information by March 31 of each year. The filing is effective indefinitely, but subject to cancellation for violations of law or the franchisor providing false information. The franchisor also may voluntarily cancel the filing. The filing guidelines impose various penalties for failing to comply.

The regulations and disclosure guidelines set out the detailed disclosure requirements that a franchisor must follow in its disclosure documents. The categories of disclosure are fairly typical of franchise laws found throughout the world. Perhaps the most controversial aspect of disclosure requirements is a mandate to disclose the 'evaluation of the operational status of the existing franchisees in China.' Thus, the disclosure guidelines appear to contemplate a mandatory earnings claim. 'The franchisor shall disclose the franchisees' actual or estimated average sales volume, cost, gross profit, net profit, and simultaneously explain the sources of the aforesaid information, time span, franchise stores/outlets concerned, etc.' For a franchisor first embarking on expansion into China, this presumably means that financial projections must be provided and that there is no option for avoiding the disclosure. A major concern here is the difficulty of making such projections with any kind of reasonable basis in a new country, and the uncertainty of potential legal liability for the franchisees not achieving the estimates.

Conclusion

In sum, although the Chinese franchise regulations are an incremental improvement over the hastily promulgated prior franchise measures, they remain troublesome from the standpoint of foreign franchisors, particularly compliance with the two-plus-one requirement and the mandatory earnings claims.

Erik B. Wulff is a partner in the Washington, DC, office of DLA Piper US LLP and is editor-in-chief of this newsletter. He can be contacted at 202-861-6410 or [email protected].