By Philip F. Zeidman and Tao Xu

Introduction

It is not difficult to understand why China is viewed by businesses around the world as an indispensable market. Its size alone is staggering (1.3 billion people). Its purchasing power is equally impressive (on a purchasing power parity basis, it is already the second largest economy in the world).

What attracts most prospective sellers of goods and services, of course, is China’s astonishing growth rate.  Even during the recession which has plagued the rest of the world China has continued its remarkable trajectory, with retail spending increasing steadily by 15 percent and more.

For franchisors, there are some aspects of China which make it especially attractive. The size of the middle class, while smaller as a percentage of the population than in some other countries, is a powerful magnet; within a generation it will be roughly 4 times the size of America’s, for example.

Another measurement by which China is almost uniquely attractive is its number of large cities. Since franchisors (or their multi-unit developers or master franchisees) seek out concentrations of population, so as to make it possible to reach their target markets in an economic and logistically feasible fashion, the number of cities in China with more than 1 million population is eye-popping: 94, compared to 9 in the United States.

Consider, a more subjective measure: Only a generation ago Western goods and services were virtually unknown in China. Today, by virtue of television, movies and social media, there is a ready market in China for a wide range of Western products. Moreover, a certain cachet has attached to those who are familiar with these products, as an emblem of “modernism” and “globalization”.

Franchisors have flocked to China in recent years — not only the well known names from the United States (McDonald’s, YUM!, Burger King, virtually all the hotel chains) but also a number of smaller companies (Sir Speedy, Abrakadoodle). Beyond US companies, many franchisors from other parts of the world have begun to respond to the beckoning appeal of the Chinese market, including some French companies such as Accor and others. Finally, franchising as a method of distribution has not been lost on Chinese companies themselves, which have embraced it.

Regulation of franchising in China

 Regulation of franchising in China can be thought of as occurring in two rather distinct phases. The first began as far back as 1997, when rules were first announced. The decade which followed, which included the adoption of “Measures for the Regulation of Commercial Franchise” in 2004, the lifting of certain restrictions and other halting steps, were marked by a degree of confusion – both by the domestic regulators and by foreign franchisors seeking to understand their obligations. It was during this period as well that the first disputes arose – disputes which continue to this day – as to the status of these regulations and the consequence of violating them.

The second phase of regulation of franchising can be dated to 2007. That year’s Franchise Regulation represents a major improvement over the past, and reflects the Chinese government’s willingness to adopt a more liberal regulatory regime. Perhaps the most striking feature was the gratifying response of the government to the efforts by the International Franchise Association and others to remove the “in China” requirement from the 2+1” rule, i.e., a franchisor must still demonstrate that it has operated at least two company owned units for at least one year before franchising in China, but those two units need not be in China itself, thus opening up the market significantly.

From the outset, it was recognized that not all provisions of the regulation of franchising could be contained in the Franchise Regulation itself, and the government has therefore issued two sets of Implementation Guidelines. It is important for a franchisor to read and follow those provisions along with the Regulation itself.

The most prominent feature of the current Franchise Regulation is its “disclosure” features. The list of what must be disclosed will not come as a shock to any franchisor which has already learned to deal with disclosure laws in France (Loi Doubin), the United States, and a number of other countries.

The process in China, however, is somewhat different than elsewhere. As in certain other countries, there is a requirement of disclosure of the information in advance of the consummation of the contract(not less than 30 days). In addition, however, the franchisor must register with the Government, but not until after the franchisor has sold its first franchise; the Government must respond by registering the document no more than a certain number of days following its receipt of all required materials.

Finally, there is a mandatory cooling-off period, a period during which a franchisee is allowed to rescind the franchise agreement after it has been signed. Unfortunately, the government has not spelled out the precise period of time which will suffice. Presumably, one week should be adequate, as this is clearly modeled after the 7-day cooling-off period required in Australia.

Beyond the disclosure document, there are certain other aspects of the regulation of franchising in China which are worth noting. Most significant, franchising activities must be “conducted in compliance with the principles of free will, fair dealing, honesty and good faith.” The uncertainty of how this will be interpreted in the future remains, but it has not thus far created difficulties.

One of the potentially most troubling features of the original regulation has now been substantially ameliorated. Originally, joint liability was imposed upon franchisors for injuries or other damage suffered by customers. The 2007 version of the Regulation only requires that the franchise agreement specify who will be responsible for customer liability issues.

Most recently, the Ministry in charge of enforcing the Regulation issued two new sets of Implementation Rules to replace the existing rules. They serve to clarify a few issues in connection with the disclosure and registration requirements. The changes are evolutionary, and do not represent any major departure from the existing practice and interpretation. It is notable, however, that the Ministry retreated from further liberalization reflected in the earlier drafts of these new rules. Their reluctance to follow, and the circulation of a draft of a set of “punishment” rules, may suggest the Government will still take a more active role in enforcing the existing Regulation and rules.

It should be noted that the regulation of a franchise agreement and relationship in China does not end, with the Franchise Regulation itself. There is obvious interaction with contract laws and a series of other laws and regulations affecting facets of the franchise operation. One should particularly note, however, the issue of trademark laws and of foreign exchange controls. Since China is a “first-to-file” country with its trademark registration authority taking a very rigid view of its trademark laws, foreign franchisors will be well advised to secure their rights in China as early as possible. With respect to getting money out of China, while it has become much easier than in the past, foreign franchisors still frequently run into delays caused by China’s foreign exchange control regime.

Conclusion

No one entering China should be under illusions about some of the difficulties which will be faced. It is difficult to find qualified and competent franchisees, although that problem has eased slightly in recent years as more and more Chinese are being exposed to franchising, and are receiving education and employment experience outside China. The blistering pace of growth in China has begun to cool, in part because of government measures to reduce the threat of inflation.

But the magnetic appeal of this large and growing market is such that more and more franchisors are venturing to China and finding ways to overcome these obstacles. And it is not an overstatement to conclude that any franchisor with aspirations to an international presence simply cannot afford to ignore the Chinese market.

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Philip F. Zeidman (Philip.Zeidman@dlapiper.com) is a Senior Partner in the Franchising and Distribution Practice of DLA Piper, based in Washington, DC. Tao Xu (Tao.Xu@dlapiper.com) is an Associate based in the firm’s Northern Virginia office. DLA Piper, an international law firm, is General Counsel to the International Franchise Association.