Legal Issues Related to Franchising in China

By Fraser Mendel

Investing into China is now seen as unavoidable by those businesses that aspire to rapid growth. Using the franchise model to structure that investment can provide many benefits to a business, but the challenges posed by the Chinese regulatory and business environment need to be evaluated carefully and companies need to adjust their franchise models accordingly in order to benefit from the Chinese market.

Franchising as a distinct business model only began in China in the early 1990s, and was not formally addressed by PRC law until the 1997 Administrative Measures on Commercial Franchising (Tentative) were promulgated by the (then) Ministry of Internal Trade to regulate franchise operations including convenience stores and services. These Tentative Measures established a rudimentary legal framework for franchising, yet applied only to domestic franchising operations. Since no regulatory framework has yet been specifically established for foreign companies' franchise operations in China, it has been necessary for foreign companies to use a variety of structures in order to replicate the advantages of a franchise model.

The prospects for a clearer franchising regulatory environment have steadily increased, especially following China's accession to WTO. China's WTO commitments for franchise operations include removing restrictions on geographical location, number, equity ratio and form of establishment for foreign investment by no later than December 2004. Recently, the State Economic and Trade Commission (the successor to the Ministry of Internal Trade) issued its 10th Five-year Plan for national chain store operations and franchising, which specifically identifies the necessity of bringing in foreign franchisers and passing new laws to support the development of chain stores.

Although lacking a clear regulatory framework, American franchisers have used various models to tap into the burgeoning Chinese market (just two of the many approaches adopted are illustrated below). These range from designating an offshore master franchisee for all or part of China, which frees the franchiser from dealing with many of the complexities of China, to actually setting up a joint venture in China to engage in operations. Having a greater number of ''on the ground'' activities in China entails greater cost, but presumably also provides increased control and flexibility.

In China, franchising is typically divided into two categories: the franchise of a product or trade name, and the franchise of a particular business model in exchange for fees or royalties. The franchise of a product or trade names involves licensing the use of a trade name in exchange for fees or royalties, and can include exclusivity obligations. Business model franchises typically involve licensing the use of a complete business model - which may include the license of trade names, business plans, training materials and related services - in exchange for fees and royalties.

In all franchise models it is important for foreign franchisers to take steps to protect their trademarks, intellectual property, brand and, ultimately, their reputation in China. Even if a franchiser will not be directly operating in China, it needs to take the proper protective steps to ensure that China remains a profitable market for the franchise.

China has an extensive registration system for trademarks, copyrights, patents and technology transfer agreements. This system is based on a first-to-file basis, though with some exceptions for 'famous' trademarks. In preparation for franchising in China, a franchiser should register its trademarks, URLs and, as appropriate, any patents as early as possible. This will protect the franchiser with respect both to franchisees and non-licensed competitors. Some franchisers registered their trademarks in China years in advance of setting up their first operations, knowing that at some point in the future having those brand names registered would be a valuable asset.

The franchiser should investigate potential franchisees thoroughly to ensure that the Chinese party has legal person status, a registered business scope consistent with the requirements of the franchise, and, if necessary for the business, possesses foreign trade rights necessary for directly contracting with and purchasing from foreign entities. Since there is no simple system for checking a company's background or credit standing, the franchiser must take the time to confirm the identity and capabilities of the potential franchisee, including directly asking hard probing questions.

When a franchiser enters into a franchise arrangement with a franchisee in China, many of the contracts that document the relationship need to be filed with government authorities and some must receive approval from different government authorities. Failure to obtain a necessary approval, or to file a trademark, patent or technology licensing agreement with the relevant authority, can result in the franchisee being unable to make payments to the franchiser.
Due to uncertainties in the enforcement of a franchiser's trademark rights against a sub-franchisee, it is common to require that a trademark licensing contract be executed between the master franchiser and all remote sub-franchisees to ensure enforceability.

For certain technology, PRC technology import regulations impose various mandatory requirements, including permitting a licensee of technology the right to continue using acquired technology after the initial license expires. The franchiser should take steps to adequately address such issues, particularly to ensure that there are adequate controls in place on the use and transfer of the technology.

Due to the multiple regulatory approvals and filings that need to be made with respect to trademark and technology licenses, as well as cross-border service contracts and consulting arrangements, it is common to use multiple interlocking agreements to document the franchise relationship rather than a single, all-encompassing franchise agreement.

The regulatory environment for franchising in China is complex and constantly developing. While this poses many challenges to franchisers looking to enter the Middle Kingdom, those who take the time to understand the market and adapt their franchise model to the Chinese environment can profit from the opportunities offered by China.