NEW FRANCHISE REGULATION TO BE EFFECTIVE FEBRUARY 1

Introduction

Over the past several years, developments regarding the adoption of a franchise law in China have taken various turns, culminating in significant activity in the last two months of 2004. As predicted in our December 3, 2004, FranCast reporting on China’s draft Provisional Measures on the Regulation of Foreign-invested Enterprises Engaging in Commercial Franchising Business (the Provisional Measures), the Ministry of Commerce of the People’s Republic of China (MOFCOM) published the Measures for the Regulation of Commercial Franchise (the Measures) over the New Year weekend. This FranCast will report on the newly adopted Measures and the effect we believe they will have on franchising in the world’s most populous country.

Background and Implications for Franchisors

MOFCOM issued the Measures on December 31, 2004. We have obtained the official copy of the Measures in Mandarin and prepared an unofficial English translation. Our analysis is based on those documents, as well as on consultation with our partners in our Hong Kong and Shanghai offices and others engaged in the process in China.

The new Measures will take effect on February 1, 2005. They will completely replace the previous regulatory system, under which a regulation issued in 1997 applied to domestic (Chinese) franchisors (the 1997 Interim Measures for the Regulation of Commercial Franchise Operations [the Interim Measures]), with somewhat uncertain impact on foreign franchisors. They will also supersede the proposed Provisional Measures, issued for comment in November 2004, which were to have applied to non-Chinese franchisors offering franchises through foreign-invested enterprises (FIEs). It appears that MOFCOM wisely decided to abandon this dichotomy. The Measures will thus replace both the Interim Measures and the Provisional Measures and become the sole legal framework under which franchisors will operate in China, applying to foreign and domestic franchisors so long as the franchise operations are conducted within the People’s Republic of China.

As we also reported in the December 3, 2004 FranCast, these Measures are themselves expected to be replaced, perhaps in late 2005 or 2006, by formal legislation – tentatively entitled the Commercial Franchise Regulation (the Regulation). The Regulation has been pending before the State Council of the PRC for some time. The State Council privately solicited comments on the draft Regulation in late December; and, as 2004 was drawing to a close, our firm submitted comments. The contents of the draft Regulation itself are still highly confidential and subject to change by the State Council. We will report further on the draft Regulation when appropriate. For the present, it is the Measures which must engage the attention of franchisors interested in the China market.

That is because, in our view, the Regulation likely to be enacted into law will adopt in substantial degree the same provisions as were found in the Provisional Measures and the Interim Measures and which are now found in the new Measures. The drafts of the Regulation that we have reviewed are identical or very similar to the Measures, including provisions such as those discussed in this FranCast. This likely reflects the Chinese government’s determination that the policy judgments underpinning its Measures are appropriate and that, once issued, the Measures will become the sole legal framework under which franchisors will operate in China in the near future. While we can hope – and advocate – that any Regulation ultimately enacted into law will be revised to address the current problems we perceive, we think it is unlikely that the fundamental approach will change.

What Franchisors Need to Know about the Measures

We reviewed the Provisional Measures in detail in the December 3, 2004, FranCast and will not repeat those particulars here in the interest of brevity. Rather, we will focus on what is new.

1. Coverage

Subfranchising

The Measures now clearly state that they will apply to subfranchising. Unfortunately, there is no language spelling out the government's view of the relationship between the franchisor, the subfranchisor and the subfranchisee. Moreover, there is no clear statement as to which party – the franchisor or the subfranchisor – bears the responsibility for providing disclosure to prospective subfranchisees.

Direct Off-Shore Franchising

The Measures are silent on the possibility of foreign franchisors offering franchises directly to prospective franchisees in China without setting up a wholly-owned subsidiary or joint venture in the PRC – the so-called “direct off-shore” approach to franchising. Reading this omission in the Measures, together with the Measure for the Administration of Foreign Investment in the Commercial Sector (the Foreign Investment Regulation), which took effect in early 2004, we believe there is a significant likelihood that direct off-shore franchising will be deemed illegal since the Foreign Investment Regulation explicitly provides that a foreign franchisor must set up an FIE in China in order to offer franchises in the country.

We have learned that the drafters of the Regulation have stated their intention to remove this uncertainty in the Regulation. However, the Measures reflect their concern with the possibility that a foreign franchisor might offer franchises in China without a physical presence there. An example of this concern is reflected in the new requirement discussed immediately below.

2. Qualifications to Be a Franchisor in China

Here, the Measures include a significant departure from the earlier draft Provisional Measures: they now adopt a requirement that before offering franchises, a franchisor must first establish and operate two company-owned units in China for more than one 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 in the Measures reflects a similar requirement that is included in the draft Regulation and appears to reflect the concern, as observed above, that Chinese regulators have with foreign franchisors that do not have any presence in China.

3. Disclosure Obligations

The disclosure obligations that were included in the Provisional Measures are not significantly changed in the Measures. While these disclosure obligations are not excessively onerous, some of the requirements remain ambiguous and raise practical concerns. For example, the requirement that a franchisor must disclose its franchisees’ “operational results” still remains one of the most troubling disclosure obligations.

The Measures add another troublesome disclosure obligation: the franchisor is required to make any disclosures “requested by a franchisee.” First, it is unclear what is meant by use of the term “franchisee” in place of the term “prospective franchisee.” It will certainly be very worrisome if an existing franchisee can decide what a franchisor should disclose to a prospective franchisee. Even if the term is clarified as referring only to a “prospective franchisee,” the provision remains a concern. The disclosure obligations enumerated under the Measures are obligations imposed by a government agency. It would be highly disruptive to give a prospective franchisee, a private party, the right to enlarge the list of such obligations under the regulatory scheme.

The one improvement over the Provisional Measures is the clarification that the litigation history need only go back five years, and the requirement to disclose “disputes” is dropped. While we still view this requirement as overly broad, we are somewhat relieved that the disclosure obligation is at least manageable in practical terms.

Not surprisingly, the Measures now grant a private cause of action to a franchisee for its economic losses caused by a franchisor’s misrepresentation or omission. This provision, together with the ambiguous disclosure obligations, underscores the importance of careful preparation of the disclosure document.

4. Franchisor-Franchisee “Relationship” Issues

By according the parties the freedom to contract and act in accordance with the terms of their agreement, these provisions show welcome evidence of the Chinese government’s support for the sanctity of contract. As valuable as that is, there were a few substantive changes from the Provisional Measures that are unclear but that may have ominous overtones.

First, the Measures now include a provision imposing an obligation that franchise operations be conducted 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 in the context of a typical franchise dispute by Chinese government agencies, bureaucrats, subfranchisors, subfranchisees, and, of course, Chinese courts.

Second, the Measures broadly define the term “franchise fee.” The definition captures not only traditional initial franchise fees and royalties, but also takes in other sums that a franchisee pays, such as payments for goods and services supplied by the franchisor. An additional clause requires that these fees be set by the parties to the agreement – and, more importantly –determined on the basis of fair dealing and reasonableness. Again, the meaning of these terms and the imposition of a subjective standard raise serious concerns. For example, we cannot predict whether the Measures will be interpreted to require that the parties engage in negotiation over the fees, given the requirement that the fees be set by the parties. Moreover, the inclusion of a “fair dealing and reasonableness” standard may leave room for a subfranchisor or subfranchisee to argue before a Chinese tribunal that even though the parties agreed to certain fees, those fees were not actually fair or reasonable in the circumstances. Finally, the fair and reasonable standard may also be argued to apply to payments for goods and services – leaving open the possibility of disputes over this very subjective standard in the context of the tug-and-pull inherent in the bargaining between a buyer (the Chinese subfranchisee) and seller (the offshore franchisor) over the cost of a particular item or service.

Thus, the Chinese government still seeks to impose requirements that are unrelated to the terms of the franchise agreement itself. In addition to the subjective terms discussed above, another provision of significant concern is the requirement that a franchisor be liable for the products and services provided by its designated suppliers. Additionally, the Measures require that a franchise agreement include provisions addressing the issue of consumer complaints. Although the intention behind these provisions is laudatory, it is unrealistic to seek to remedy the perceived problems in this fashion. We remain troubled by the notion that a U.S.-based franchisor is assumed to have influence over, or responsibility for, a third-party supplier – whether that supplier is based in the U.S., China, or elsewhere. In this respect, the Measures impose yet more significant burdens upon franchisors.

5. Approval Process

Although the Measures as a whole apply to both domestic and foreign franchisors, the application and approval system, which also appeared in the Provisional Measures, 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.

The reasons behind this deliberate arrangement are not clear. Clearly, one possibility is to insulate domestic franchisors that might otherwise be forced to compete, unprotected, with foreign franchisors. However, that approach appears to run directly afoul of China’s WTO commitments, such as the commitment to treat foreign investors on an equal footing with domestic investors.

6. Penalties

The Measures add two specific penalties for violating the disclosure obligations, and violating the provisions requiring certain “qualifications” of the parties. First, MOFCOM can issue orders to force the parties to comply with the Measures and possibly impose fines of less than RMB30,000 (roughly US$3,600). Second, as discussed above, a franchisee is expressly allowed to sue a franchisor for economic losses caused by misrepresentations and omissions in the disclosure document. Clearly, the second is far more important to franchisors, but the role of the government in this scheme is more significant that the size of the fine would suggest.

7. “Amnesty”

The Measures also provide an “amnesty” for those FIE franchisors offering franchises in China prior to the adoption of the rule. Those franchisors are, however, required to file a report with the original registration agency summarizing their franchise operations thus far, and apply for approval, as must all other FIE franchisors, to offer franchises in China. Although no time frame has been provided in the Measures, existing FIE franchisors certainly should take the appropriate actions as soon as possible after these Measures go into effect. Of course, existing direct off-shore franchisors need to consider their proper course of action in view of the possibility (if not probability) that those arrangements have now become illegal in China, when considered under both the Foreign Investment Regulation as well as the newly-issued Measures.

Conclusion

Beginning next month, all franchisors will confront a new regulatory scheme. The Measures will apply to domestic franchisors in China as well as FIEs. The Measures, as well as the anticipated Regulation, are requirements that will be largely tolerable for most franchisors. But the regulatory approach adopted thus far and anticipated in the coming year is quite seriously flawed in many respects. We hope – and will urge – that these shortcomings be addressed in the Regulation.