By Lee Wright
A few months ago, an article was presented in this publication that explained the new multi-level marketing regulations under consideration in China, and additional updates are being provided. To continue to provide information on current developments for our clients looking to do business in China, we now provide a summary of new franchising laws in China and its basic components.
Effective February 1, 2005, the Chinese Ministry of Commerce adopted new franchising “provisional measures” which affect both foreign and local franchisors. The domestic law of 1997 regarding franchising has thus been repealed. The new law and its regulations require certain pre-sale disclosures to purchasers and registration with both the national and regional authorities by foreign franchisors. The requirements under this law are some of the most comprehensive in the world, and much is yet to be learned regarding implementation and interpretation of the measures and regulations moving forward.
Basic Franchisor Qualifications and Risks
For a foreign franchisor wishing to enter China with its operations, there are certain threshold issues that must be understood. First, a franchisor must have two outlets that are owned by the franchisor or its subsidiary or holding company—which imposes quite a burden on the foreign franchisor. Additionally, before subfranchising is permitted the two required franchisor owned stores must be open in China for at least one year. This requirement slows immediate subfranchising activities in China, and appears to be intended to protect local franchisees by ensuring the franchisor is established and committed to its operations in China. More significantly, it seems foreign franchisors cannot any longer offer franchises directly to prospective franchisees, or master franchisees, without setting up either a wholly owned subsidiary or joint venture in China. There is also a good likelihood that direct off-shore franchising would be deemed illegal regardless since the Foreign Investment Regulation provides that a foreign franchisor must set up a foreign-invested enterprise in order to offer franchises in China. Existing franchisors engaging in off-shore franchising operations need to consider what course of action to now follow in China, and any such past operations will be deemed illegal.
Additionally, the Ministry of Commerce must determine that a franchisor has the ability to provide franchisees with long-term business guidance and training services. Finally, the franchisor must demonstrate to the Ministry that it is an entity with good credit standing without a record of committing fraud by franchising. It is unclear how claims of fraud by other franchisees in other countries against the franchisor or its affiliated entities may affect a franchisor’s ability to set up local franchising operations. Enforcement by the Ministry and future regulations will need to be tracked to determine how this provision applies.
One other unique term under the new measures requires franchisors to be particularly cautious in designating suppliers for the franchisees, and it would be wise for franchisors to take special precautions for indemnification from suppliers. Specifically, the law holds a franchisor liable to it’s franchisees for the quality of the products supplied by the designated suppliers. If a product is bad, the franchisor will be held responsible, regardless of the terms of any written agreement.
Franchisors must also make sure they select appropriate franchisees. The law requires franchisees to have adequate funds, appropriate premises, and sufficient personnel to run the franchise location. It is not yet clear what the consequence would be to a franchisor that selects an inappropriate franchisee.
Franchise Agreement and Relationship Issues
For U.S. based franchisors, some of the key issues for consideration when going into a foreign market include determining what form a franchise agreement must legally take, what relationship issues are governed by the law, and what initial disclosures to potential buyers or franchisees must be provided.
Relationship Issues. The law in China, purportedly, is not organized to regulate the relationship issues, including termination limitations, renewal provisions, and assignment restrictions. Generally, these issues can be determined contractually. The only limitation in the law is that such issues must be dealt with on principles of “fairness and reasonableness.” In other words, if a franchisor wishes to renew with a franchisee at the end of the initial franchising term, the franchisor must not be unreasonable in its negotiations. The Ministry of Commerce will judge this standard, and it appears that additional regulations that will further clarify this issue will likely be adopted. Unfortunately, leaving such vague terms as the standard can lead to government officials delving into relationship issues.
Contractual and Disclosure Issues. The law specifically requires all franchise agreements to have fourteen specific components and requires nine disclosure requirements before the agreement is signed. The agreement components required are standard and include, among others: (i) providing the names of the parties, (ii) the content, term, and exclusivity of the franchise to be granted, (iii) payment terms, (iv) confidentiality provisions, (v) default, termination, and dispute resolution provisions, as well as other provisions standard to such agreements. All necessary disclosures must be provided to prospects at least 20 days before a contract is signed. Some specifics of disclosure include that: (i) franchisors are required to disclose the investment budget and breakdown for a franchised outlet, which includes initial investment as well as an “earnings claim,” based on its other outlets in China, (ii) franchisors must provide details of financial reports and reports on tax payments as audited by an accounting firm, and (iii) franchisor must disclose any information relating to lawsuits for the previous five years. Many of China’s disclosure requirements are currently ambiguous in nature and go beyond simple pre-sale disclosures. The franchisor is currently required to disclose “any information requested by the franchisee.” This requirement can be read to require franchisors to put representations made to a franchisee in writing, rather than making simple verbal representations. The franchisor must also continue to disclose, during the relationship, “all related information while carrying out the franchise.” The Ministry of Commerce has provided no explanation of what was intended by the unique post-sale disclosure requirement, but it is a requirement franchisors must not overlook to stay in compliance with the local law.
Foreign Franchisor Filings
The new measures in China require foreign franchisors to file an application to engage in franchising in China as mentioned previously. This application must be accompanied by copies of a franchisor’s standard franchise agreements, disclosure documents, and other business information. Franchisors must also provide their operations manual. This poses some concern as there is nothing in the law that requires the Ministry of Commerce to keep the contents confidential. Some reassurance should be sought. If the Ministry approves the franchisor, it will be informed of this fact within thirty days of receipt of the application and its attachments. Within a month of approval, the foreign franchisor must register its foreign-invested enterprises approval certificate with the industrial and commercial administrative authorities. Thereafter, annual filings must be provided each January that describes all franchisee agreements in China, executed during the previous twelve month period.
Conclusion
Clearly questions remain about how the measures will be applied and enforced in China, and what ongoing form of local presence is mandated—all to be interpreted by the Ministry of Commerce. Clearly, foreign franchisors must demonstrate commitment to China to qualify, regardless. As the issues outlined herein are further clarified through implementation and application, additional updates will be provided. If you are looking at franchising or are already franchising in China, please contact us directly, and we will work with you in looking at options and additional specific requirements and provide you a translated copy of the measures for your review.
For more information please contact Lee Wright at: LeeW@mrsfields.com.