Guide to franchising in China

With China’s opening of its market and recent succession into the WTO, it has undergone rapid development in the past two decades. Due in part to such growth and in combination with its massive 1.3 billion population (330 million in its middle-class alone as compared to America’s total population of 300 million), it represents the world’s largest yet ‘untapped’ consumer market. For many franchisors seeking to market reliability associated with brand recognition and systematic organizational structures to the oftentimes chaotic and fragmented consumer sector (particularly the food and personal service industries), China will be both the largest yet most challenging opportunity in the 21st century.

Fortunately for both consumers and those in the franchising industry, 2007 arguably brought about the largest liberalization of this sector since the “Opening Up” reforms of 1979.That being said, however, foreign franchisors have, in the past, seen their share of successes and failures, many of whom have ‘stuck it out’ throughout China’s market changes to become a consumer household name, such as McDonald’s, KFC and Pizza Hut.

In 1997, China’s Ministry of Internal Trade promulgated the Administration of Commercial Franchise Procedures (Trial Implementation and hereinafter “Franchise Procedures”) representing the first set of regulations directed at specifically addressing issues pertaining to the franchise sector. The Franchise Procedures introduced two types of franchises: i) direct franchising and ii) sub-franchising. The Franchise Procedures provided for the basic structure of current franchising laws, which requires the disclosure of material information to prospective franchisees and includes the following: basic information about the franchisor; operational results of the franchisor; financial results of its franchise outlets; fees and payment obligations; and, terms and conditions for goods and services provided to franchisees. The Franchise Procedures also established the quasi-governmental China Chain Store and Franchise Association (“CCFA”). (Note that the Franchise Procedures were interpreted as not being applicable to cross-border franchise operations.)

In 2004, as part of China’s accession into the World Trade Organization (WTO) and commitment to the principles therein, the Ministry of Commerce issued the Measures for the Administration of Franchise Operations (“Franchise Measures”) effective February 1st, 2005. The Franchise Measures were promulgated shortly after the Measures on the Administration of Foreign Investment in the Commercial Sector, which liberalized foreign investment in the retail and wholesale distribution industry. Unlike the Franchise Procedures, the Franchise Measures not only permit foreign investment in the franchising sector but also contain an entire chapter drafted exclusively for this purpose.

Much like the Franchise Procedures, the Franchise Measures focused largely on franchisor disclosure, but also included the “two-plus-one” requirement, which mandated franchisors to operate two company-owned stores in China prior to commencing franchising activities. Obviously, this has prevented many start-up franchisors from immediately commencing operations in China and was a disincentive for market entry. Moreover, the promulgation of the Franchise Measures and the requirement that all franchising operations be conducted only by PRC entities has effectively removed the alternative measures being used by foreign franchisors for many years, including licensing arrangements and international franchising agreements.There have, however, been recent modifications to the franchising framework with the promulgation of a number of new laws in 2007 which will be further discussed below.

II. Current Legal Framework and Franchising Structures in China

In May of 2007, MOFCOM replaced the Franchise Measures (2005) with the Regulations on the Administration of Commercial Franchises (“Franchise Regulations”). The Franchise Regulations, together with the MOFCOM-issued Administrative Measures for the Information Disclosure of Commercial Franchises (“Information Disclosure Measures”) and the Administrative Measures for Archival Filing of Commercial Franchises (“Archival Filing Measures”) currently govern franchising structures in China and set out the following requirements:

Article 2 of the Franchise Regulations states that the regulations are applicable to all investors engaged in commercial franchise operations in China“Commercial Franchise” is defined in the Franchise Regulations as “business activities whereby a franchisor, through execution of agreements, allows a franchisee to use operational resources, such as a trademark, logo, patent, know-how and others which are owned by the franchisor [refers to legal (not natural) persons], and the franchisee conducts business under the unified business model in

accordance with the provisions of the contract and pays franchise fees to the franchisor.

Franchisors must own a well-developed business model, and be capable of providing continued operational management, technical support, business training and other services to the franchisee.

Additionally, franchisors must own at least two company-owned stores for a period of at least one year. Noticeably missing is the phrase “in China”, which allows for new foreign entrants to immediately commence franchising activities in China.

Within fifteen days from executing the first franchise agreement, the franchisor must file with MOFCOM, specifically i) if the franchising activities take place within a single province, autonomous region or municipality under the central government (Beijing, Shanghai, and other major cities), then with the MOFCOM of that province, autonomous region or municipality under the central government; or ii) if franchising activities take place in more than one province, autonomous region or municipality, then at the national level MOFCOM.

However, it is necessary to note that the franchisor must, within 30 days of any change potentially impacting the filing, apply for an alteration of its filings.

5. Copies of certificates of trademarks, patents and other business resources related to franchise activities;

9. Written undertaking evidencing franchisor’s complies with the Qualifications and the Two-Plus-One Rule;

10. Certificate evidencing compliance with the Two-Plus-One rule, issued by the city level in China and, for franchisors using space outside of China, business certificates translated, notarized and authenticated by the Chinese embassy; and,

1. Other documents as required.

Completed filings may be cancelled in the event of any of the following occurrences:

1. Franchisor's business license was cancelled by the competent registration authority because of illegal operations;

2. MOFCOM receives a court order regarding the cancellation of the filing due to illegal operations of the franchisor;

3. Franchisor was discovered to have failed to disclose material information or provided false information; and,

4. Franchisor itself cancels the filing.

4. Disclosure of Information

The following materials must be provided to the prospective franchisee a minimum of thirty days prior to the signing of the Franchise Agreement:

1. Basic information on the franchisor and franchise activities:

a. Franchisor's name, address, contacts, legal representative, general manager, registered capital, scope of business, and the number of regular chains including their addresses and phone numbers;

a. A brief introduction to the commercial franchise activities of the franchisor;

b. Basic information on the archival filing of the franchisor;

c. If the franchisor's associated company provides products and services to the franchisee, the associated company's basic information must also be disclosed; and,

d. Information on any bankruptcy and/or application for bankruptcy of the franchisor or of its associated company in the preceding five years.

2. Basic information on the business resources of the franchisor

a. Information available on registered trademarks, company logos, patents, proprietary technologies, and business methods, etc;

b. If the owner of any of the above-mentioned business resources is the associated company of the franchisor, then the basic information of the associated company must also be disclosed (the franchisor is also required to explain how to manage the franchise system upon termination fo the license contract); and,

c. Information on the business resources of the franchisor (or its associated company) in relation to litigation or arbitration.

3. Basic information on franchise expenses:

a. If the type, amount, criteria and payment method of fees collected by the franchisor or on behalf of a third party cannot be disclosed, then the franchisor must explain the reason for the non-disclosure; if the fee collection standards are inconsistent, then the franchisor is required to disclose both the maximum and minimum standards, and explain the reason thereto;

b. The collection thereof, return conditions, return time, and return on investment; and,,

c. If the franchisee is required to pay a fee before the Franchise Agreement is concluded, then the franchisor must explain in writing the use of the fee and the conditions and method of return.

4. Information on the prices and conditions of the products, services and equipment provided to the franchisee.

a. Whether the franchisee must purchase products, services or equipment from the franchisor (or its associated company), including the prices and conditions thereof;

b. Whether the franchisee must purchase products, services or equipment from the suppliers appointed or approved by the franchisor; and,Whether the franchisee has the discretion to choose its own

a. suppliers and the standards for the selection of its suppliers.

5. Information on the continuous provision of services to the franchisee.

a. Detailed content, manner of provision and implementation plans for professional training, including the training location, approach and duration; and,

b. Details regarding technical support and a catalogue of the operation manual of the franchise including the number of pages therein.

6. Methods and content of guidance and supervision over the franchise activities of the franchisee:

a. The franchisor's methods and content of guidance and supervision over the franchise activities of the franchisee, the franchisee's obligations and consequences for failing to fulfill them.

b. Whether the franchisor is jointly liabile with the franchisee for complaints by and compensation to consumers, and how to share such liability.

7. Information on the investment budget of the franchise:The expenditure fpr the investment budget may include the following: initial fee; training fee; real estate and decoration fee, procurement fee fpr equipment, office supplies,

a. furniture, etc; initial inventory; water, electricity and gas fees; fees needed to obtain licenses and other governmental approvals; and working capital; and,

b. The statistical source and estimation basis for the above-mentioned fees.

8. Information on franchisees within China:

a. Information on the present and estimated number of franchisees, geographical distribution, scope of license, and as to whether or not they are subject to an exclusive regional license (if so, details of the scope thereof must also be explained)

b. Information on the evaluation of the performance of the franchisee, the actual or estimated average sales volume, costs, gross and net profits of the franchisee, the source of the above-mentioned informationduration of and franchise networks involved (if the information is speculative, then the franchisor shall explain the basis for its speculation, and specify that the actual performance of the franchisee may differ from its speculation.

9. Abstracts of the franchisor's financial and accounting reports and of the audit reports in the last two years audited by the accounting or auditing firms.

10. Information on any major litigation or arbitration involving any franchises of the franchisor in the last five years.

a. Major litigation or arbitration refers to litigation and arbitration involving litigation fees of more than RMB 500, 000; and,

b. Basic information as to the location of the litigation or arbitration and the judgment or award must also be disclosed.

11. Information on any record of major illegal operations of the franchisor and its legal representative.

a. Where either the franchisor or its legal representative has been imposed with a fine, by the competent administrative law enforcement authorities, exceeding not less than 300, 000 but more than 500, 000; and,

b. Where the franchisor and its legal representative have been subject to criminal penalization.

12. Franchise Contract

a. Sample franchise contract; and

b. If the franchisor requires its franchisee to sign with the franchisor (or its associated company), other franchise contracts (sample contract shall be provided at the time of contracting).Note that where the franchisor is found to have concealed or provided false information, the

franchisee may rescind the Franchise Agreement.

5. Franchise Agreement

Although franchise contracts are in practice comprehensive and lengthy, the Franchise Regulations require certain clauses be provided in the relevant franchise agreement:

1. basic information on the franchisor and franchisee;

2. content and term of the franchise;

3. types, amounts and payments of franchise fees;

4. specific content and manner of provision of operational guidance, business training, technical and other services to franchisee;

5. quality standards, quality control measures for the provision of products and services by franchise operations;

6. promotions and advertisements of products and services of franchise operations;

7. arrangements for consumer rights, and assignment of liability in franchise operations;

8. amendment, rescission and termination of the franchise agreement;

9. liability for breach;

10. dispute resolution; and

11. other matters as agreed upon between the franchisor and franchisee.

The Franchise Regulations also require the contract contain a clause setting out the time period during which the franchisee may rescind the agreement (post- execution of the contract). Unless otherwise specified, the initial term of the contract must not be less than two years.

Further, where deposits or other fees are required prior to execution of the franchising agreement, provisions for the use and refund of the same must be expressly stated therein.

Advertising and promotional fees collected by the franchisor must be used specifically for such stated purposes and accounting thereof should be provided to the franchisee within a timely basis.

The franchisor is required to report annually, by March 31, the status of each franchise agreement.

6. International/Cross-Border Franchising

International or cross-border franchisors must file, in accordance with the Archival Filing Measures.

7. Penalties

Penalties for the violation of the Regulations are as follows:

1. Failure to meet Qualifications (see Item 2): confiscation of illegal income, and fine of RMB 100,000 to RMB 500,000;

1. Franchising by individuals (natural person): confiscation of illegal income, and fine of RMB 100,000 to RMB 500,000;

2. Failure to complete Filing Requirements: order time limit for rectification and fine of RMB 10,000 to RMB 50,000, and where franchisor fails to file within the time limit a fine of RMB 50,000 to RMB 100,000 and public announcement; and,

3. Failure to provide Franchise Agreement thirty days prior to the signing or failure to disclose or concealing information relevant to the franchisee: fine of RMB 10,000 to RMB 50,000, or where serious RMB 50,000 to RMB 100,000 and public announcement thereof.

8. ‘Grandfathering’ ProvisionsCompanies already conducting franchising activities have one year to file according to the Franchise Regulation.

III. Conclusion

China represents a tremendous opportunity for international franchise operations. Although there are numerous challenges and complexities in establishment and operations, the recent legal changes have largely liberalized the franchising market for foreign investors. In combination with the current rates of economic growth, the timing is ideal for foreign franchisors to explore opportunities in the Chinese market.

For further information, please contact:

Gregory Sy

Vice-chair, International Practice Group

Tel: 86-10-6517-1188

Email: gregsy@grandall.com.cn

Currie Lee

Foreign Counsel

Email: currielee@grandall.com.cn