Are You Thinking About China?

Over that last year, a number of cases have become available to help answer this question. In China, much more emphasis is placed on the uniformity of the system rather than on the element of control, as in the United States.

In a decision in Beijing dated Oct. 10, 2008 (Wang Jing v. Beijing Ruili Sunshine Beauty Co., Ltd.), the court first looked at the definition of a “franchise” in the Franchise Regulation to determine whether a contract was a “franchise agreement.” The translated definition is as follows:

Article 3 ' In this Regulation a commercial franchise (hereafter referred to as a “franchise”), refers to an arrangement whereby an enterprise (hereafter referred to as a “franchisor”) through an agreement grants other operators (hereafter referred to as the “franchisees”) the right to use its business operating resources, including registered trademarks, logos, patents, and proprietary technologies; whereby the franchisee conducts business under a uniform mode of operation; and whereby the franchisee pays franchise fees according to the agreement. No entity or individual other than an enterprise may conduct business as a franchisor.

The court said that in the agreement in question, the defendant (and alleged franchisor) was required to provide a complete management experience, including the defendant's technology, management support and methods of identification. It said that because the two sides signed a contract that had the characteristics of a “franchise agreement,” then it was a “franchise agreement.”

However, plaintiffs in other cases have not been successful in claiming that a particular contract is a franchise agreement. The Suzhou Intermediate People's Court in Jiangsu Province ruled in Zhao Bin v. Jiangsu Longli Qisheng Biotechnology Co., Ltd., (dated Aug. 6, 2008) that the contract under consideration did not involve the licensed use of intellectual property rights or a unified business model, and therefore it was not a franchise agreement. Similarly, in a case in Beijing (Tianjin Jinsui Tax Technology Co., Ltd. v. Taiji Computer Co., Ltd., dated Nov. 17, 2008), in an unfortunately brief analysis, the court agreed with the defendant that the agreement in question was in the nature of a “sales agency contract,” not a franchise agreement. There was no evidence that the defendant provided for a license to use intellectual property, according to the court.

It should be noted that the Chinese term for franchising, “texujingying,” which first appeared in 1997, has been used in broader contexts than the relationships covered by the Franchise Regulations. The word has also been used to refer to authorized dealerships (See Hu Aihe v. Salt City Pavilion Lake Thrifty Window Blinds, Jiangsu Higher People's Court, June 2, 2006) and similar arrangements. Ministry of Commerce (“MOFCOM”) representatives have verbally indicated that they intend to read the definition broadly.

In April 2009, judges from the Beijing courts, a MOFCOM representative, and others met in Beijing. Among their discussions was whether the uniform business model is the key element that defines a franchise. The MOFCOM representative said that paying royalties is not a prerequisite for being a franchise in China. In summary, a franchise agreement is created when there is a grant of rights, the payment of fees and a uniform mode of operation. This definition will tend to include more authorized dealers than the concept used in the United States.

Will Your System Be Operated in China?

Many franchisors have tried to avoid compliance with Chinese franchise requirements by having a Chinese master franchise set up an entity outside of China (which, for purposes of Chinese law, includes Hong Kong and Macau). The franchisor then grants the franchise for China to that entity. It is doubtful that this will work, although the arrangements have not yet been challenged in court. Article 2 of the Franchise Regulations is translated as “Commercial franchising activities conducted within the territory of the People's Republic of China shall comply with this Regulation.” In other words, it is where the franchises operate that count.

Also, the outside-China arrangements have proven cumbersome for tax purposes, and some franchisors are trying to restructure them.

What About Compliance With the 2+1 Rule?

The increase in franchise litigation has created confusion over the status of the 2+1 Rule. The 2+1 Rule is in the second paragraph of Article 7 of the May 2007 Franchise Regulation, and it translates as, “For a franchisor to be engaged in franchising it must have at least 2 directly operated company-owned stores and have operated them for at least 1 year.” It appears to be a primary requirement for franchising, but the courts have not been consistent in applying it.

For example, in Wang Jin v. Beijing Sunlight Ruili Beauty Co. Ltd., the court specifically cited Article 7 of the Franchise Regulation and ruled that because it was not complied with, the franchise agreement was null and void.

However, in Liu Yongxing v. Talent Cat (Beijing) International Brand Management Consultants Co., Ltd., decided by the Beijing No. 1 Intermediate Court on April 10, 2009, the appeal court upheld a decision of the Haidian District Court that said exactly the opposite:

The provisions of Article 7 of the Franchise Regulations on eligibility requirements for franchisors are administrative provisions and not mandatory provisions, and thus a violation does not lead to the legal consequence that the contract is null and void.

There are several more cases on either side of this divide. Until recently, most of them were district court decisions, the lowest level for handling these matters.

The April 2009 meeting in Beijing of judges, MOFCOM, and others included extensive discussion of the 2+1 Rule. One side maintained that it is only an administrative provision, the breach of which may only impose administrative penalties (fines) on the franchisor, but will not invalidate the contract. The other side maintained that it was a substantive requirement, which, if not met, invalidated the franchise agreement.

What was most interesting is that the representative of MOFCOM and the most senior judge supported the “administrative” position. To Liu Jixiang of the Beijing Higher People's Court, the first part of Article 7, which requires a mature business model, is mandatory, but the second paragraph, the 2+1 Rule, is an administrative guide. If the 2+1 Rule is simply an administrative guide, this will be of major significance to foreign franchisors seeking to enter China. If they are comfortable that they have a mature business model, then they will not be liable for rescission. But how to handle the requirements of the filings with MOFCOM is another story. Fortunately, the representative of MOFCOM at the meeting stated that MOFCOM will consider locations held by indirectly owned corporations to be the same as locations directly held by the franchisor seeking registration.

Have You Registered Your Trademarks in English and Chinese?

Because of a backlog in the PRC Trademarks Office, the current estimate for a simple registration is three years. It is very difficult to translate most English brand names into Chinese. For a franchisor whose brand is only in English, the Chinese will create their own version of the brand; I have usually found inconsistent translations on official forms, such as the trademark registrations. For this reason, retailers often decide to create a new brand in Chinese.

There is still a problem in the PRC Trademarks Office with over-reliance on the Nice Classification system to determine when marks are confusing or not. Thus, it is prudent to register both Chinese and English marks in as many classes as the franchise budget will allow. Fortunately, registrations in China are not expensive.

Finally, when the franchise agreement is signed, a short-version trademark license agreement should also be signed and registered with the Trademarks Office.

There are other issues in China as well. Make sure that you have experienced counsel.

Paul Jones is principal of Jones & Co. in Toronto, and he has consulted with the People's Republic of China on development of franchising regulations. He can be contacted at [email protected].

Retail sales in China were up 15% in August. This year, more cars have been sold in China than in the United States. China is already clearly headed out of the recession.

If you have been thinking about entering the China market to diversify your revenue stream, here are some legal issues to consider.

Will Your System Be a Franchise Under Chinese Law?

Over that last year, a number of cases have become available to help answer this question. In China, much more emphasis is placed on the uniformity of the system rather than on the element of control, as in the United States.

In a decision in Beijing dated Oct. 10, 2008 (Wang Jing v. Beijing Ruili Sunshine Beauty Co., Ltd.), the court first looked at the definition of a “franchise” in the Franchise Regulation to determine whether a contract was a “franchise agreement.” The translated definition is as follows:

Article 3 ' In this Regulation a commercial franchise (hereafter referred to as a “franchise”), refers to an arrangement whereby an enterprise (hereafter referred to as a “franchisor”) through an agreement grants other operators (hereafter referred to as the “franchisees”) the right to use its business operating resources, including registered trademarks, logos, patents, and proprietary technologies; whereby the franchisee conducts business under a uniform mode of operation; and whereby the franchisee pays franchise fees according to the agreement. No entity or individual other than an enterprise may conduct business as a franchisor.

The court said that in the agreement in question, the defendant (and alleged franchisor) was required to provide a complete management experience, including the defendant's technology, management support and methods of identification. It said that because the two sides signed a contract that had the characteristics of a “franchise agreement,” then it was a “franchise agreement.”

However, plaintiffs in other cases have not been successful in claiming that a particular contract is a franchise agreement. The Suzhou Intermediate People's Court in Jiangsu Province ruled in Zhao Bin v. Jiangsu Longli Qisheng Biotechnology Co., Ltd., (dated Aug. 6, 2008) that the contract under consideration did not involve the licensed use of intellectual property rights or a unified business model, and therefore it was not a franchise agreement. Similarly, in a case in Beijing (Tianjin Jinsui Tax Technology Co., Ltd. v. Taiji Computer Co., Ltd., dated Nov. 17, 2008), in an unfortunately brief analysis, the court agreed with the defendant that the agreement in question was in the nature of a “sales agency contract,” not a franchise agreement. There was no evidence that the defendant provided for a license to use intellectual property, according to the court.

It should be noted that the Chinese term for franchising, “texujingying,” which first appeared in 1997, has been used in broader contexts than the relationships covered by the Franchise Regulations. The word has also been used to refer to authorized dealerships (See Hu Aihe v. Salt City Pavilion Lake Thrifty Window Blinds, Jiangsu Higher People's Court, June 2, 2006) and similar arrangements. Ministry of Commerce (“MOFCOM”) representatives have verbally indicated that they intend to read the definition broadly.

In April 2009, judges from the Beijing courts, a MOFCOM representative, and others met in Beijing. Among their discussions was whether the uniform business model is the key element that defines a franchise. The MOFCOM representative said that paying royalties is not a prerequisite for being a franchise in China. In summary, a franchise agreement is created when there is a grant of rights, the payment of fees and a uniform mode of operation. This definition will tend to include more authorized dealers than the concept used in the United States.

Will Your System Be Operated in China?

Many franchisors have tried to avoid compliance with Chinese franchise requirements by having a Chinese master franchise set up an entity outside of China (which, for purposes of Chinese law, includes Hong Kong and Macau). The franchisor then grants the franchise for China to that entity. It is doubtful that this will work, although the arrangements have not yet been challenged in court. Article 2 of the Franchise Regulations is translated as “Commercial franchising activities conducted within the territory of the People's Republic of China shall comply with this Regulation.” In other words, it is where the franchises operate that count.

Also, the outside-China arrangements have proven cumbersome for tax purposes, and some franchisors are trying to restructure them.

What About Compliance With the 2+1 Rule?

The increase in franchise litigation has created confusion over the status of the 2+1 Rule. The 2+1 Rule is in the second paragraph of Article 7 of the May 2007 Franchise Regulation, and it translates as, “For a franchisor to be engaged in franchising it must have at least 2 directly operated company-owned stores and have operated them for at least 1 year.” It appears to be a primary requirement for franchising, but the courts have not been consistent in applying it.

For example, in Wang Jin v. Beijing Sunlight Ruili Beauty Co. Ltd., the court specifically cited Article 7 of the Franchise Regulation and ruled that because it was not complied with, the franchise agreement was null and void.

However, in Liu Yongxing v. Talent Cat (Beijing) International Brand Management Consultants Co., Ltd., decided by the Beijing No. 1 Intermediate Court on April 10, 2009, the appeal court upheld a decision of the Haidian District Court that said exactly the opposite:

The provisions of Article 7 of the Franchise Regulations on eligibility requirements for franchisors are administrative provisions and not mandatory provisions, and thus a violation does not lead to the legal consequence that the contract is null and void.

There are several more cases on either side of this divide. Until recently, most of them were district court decisions, the lowest level for handling these matters.

The April 2009 meeting in Beijing of judges, MOFCOM, and others included extensive discussion of the 2+1 Rule. One side maintained that it is only an administrative provision, the breach of which may only impose administrative penalties (fines) on the franchisor, but will not invalidate the contract. The other side maintained that it was a substantive requirement, which, if not met, invalidated the franchise agreement.

What was most interesting is that the representative of MOFCOM and the most senior judge supported the “administrative” position. To Liu Jixiang of the Beijing Higher People's Court, the first part of Article 7, which requires a mature business model, is mandatory, but the second paragraph, the 2+1 Rule, is an administrative guide. If the 2+1 Rule is simply an administrative guide, this will be of major significance to foreign franchisors seeking to enter China. If they are comfortable that they have a mature business model, then they will not be liable for rescission. But how to handle the requirements of the filings with MOFCOM is another story. Fortunately, the representative of MOFCOM at the meeting stated that MOFCOM will consider locations held by indirectly owned corporations to be the same as locations directly held by the franchisor seeking registration.

Have You Registered Your Trademarks in English and Chinese?

Because of a backlog in the PRC Trademarks Office, the current estimate for a simple registration is three years. It is very difficult to translate most English brand names into Chinese. For a franchisor whose brand is only in English, the Chinese will create their own version of the brand; I have usually found inconsistent translations on official forms, such as the trademark registrations. For this reason, retailers often decide to create a new brand in Chinese.

There is still a problem in the PRC Trademarks Office with over-reliance on the Nice Classification system to determine when marks are confusing or not. Thus, it is prudent to register both Chinese and English marks in as many classes as the franchise budget will allow. Fortunately, registrations in China are not expensive.

Finally, when the franchise agreement is signed, a short-version trademark license agreement should also be signed and registered with the Trademarks Office.

There are other issues in China as well. Make sure that you have experienced counsel.

Paul Jones is principal of Jones & Co. in Toronto, and he has consulted with the People's Republic of China on development of franchising regulations. He can be contacted at [email protected].