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
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.
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
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
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
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.
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.
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.
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.