Slow Train Coming--Draft Regulations on Franchising

A glimpse of things to come for foreign franchisors

By Michael A. Aldrich and Andrew Zeng, Perkins Coie LLP

Recently, mainland China newspapers have reported that the central government has circulated a set of draft franchising regulations, the Draft Regulations for Administration of Franchising Chain Operations (''Draft Franchise Regulations''). While China issued measures governing franchise transactions in 1997, the measures and related legislation have not explicitly addressed cross-border franchises. However, the absence of regulatory direction has not handicapped the growth of the foreign franchises in the PRC over the last two decades. Indeed, by the end of 2000, China had attracted more than 400 franchisees operating more than 1000 outlets in more than 30 sectors.

The Draft Franchise Regulations suggest that, on the eve of China's accession to the World Trade Organization, the government plans to standardize the regulatory treatment of all franchise relationships, whether they are domestic or cross-border transactions. However, the timetable for the promulgation of the Draft Franchise Regulations remains uncertain at best, with estimates anticipating a further two years before enactment. Nevertheless, the Draft Franchise Regulations do give foreign franchisors a sense of the shape of things to come.

The Current Legal Regime on Franchising

The Measures Concerning Administration of Commercial Franchising (for Trial Implementation) were promulgated by the (then) Ministry of Internal Trade on November 14, 1997 (the ''1997 Franchising Measures'') and apply to enterprises, individuals and other economic organizations that engage in commercial franchise transactions within the PRC. The 1997 Franchising Measures describe two basic models of franchising; direct franchising and master franchising (sub-franchising). Direct franchising refers to a contractual relationship whereby a franchisor directly grants to an applicant franchise rights without the right to sub-franchise such rights. In contrast, master franchising alludes to those arrangements where the franchisee is granted the exclusive right to operate franchise outlets in a designated territory as well as the right to sub-franchise such rights to other parties in the territory.

Under the 1997 Franchising Measures, a franchisor is required to disclose material information prior to the execution of a franchise agreement. For instance, the franchisor must provide the franchisee with basic information regarding the franchisor, the operational results of the franchisor and its existing franchisees, the financial statements of existing outlets, fees and payment terms, as well as the terms and conditions for the sale of goods by the franchisor to the franchisee. The 1997 Franchising Measures also stipulate various types of franchise fees, such as membership fees (for the grant of the franchise rights), use fees (paid periodically during the term of the franchise), security deposit (as a guarantee for the franchisee's performance) and other service fees.

Domestic franchisors are also required to register for the record with the China Chainstore and Franchise Association (the ''CCFA''). The CCFA is a quasi-government trade association with a mandate to formulate industry rules and promote franchise relationships in China.

The 1997 Franchising Measures do not expressly address cross-border franchise transactions. According to Chinese officials at the Ministry of Internal Trade, State Economic and Trade Commission (''SETC'') and the Ministry of Foreign Trade and Economic Cooperation (''MOFTEC''), the 1997 Franchising Measures do not apply to cross-border franchise agreements.

Market Entry Strategies for Foreign Franchisors Under Current Law

In the absence of regulations expressly applicable to cross-border franchise arrangements, foreign franchisors have relied on general commercial legislation in the PRC to engage in franchise transactions. By and large, foreign franchisors have pursued two structures (or a combination of these structures) in order to enter the China market; direct equity investments and cross-border licensing. The viability of these two approaches depends on the underlying sector in which the foreign franchisor engages.

Direct Investments

The Catalog for the Guiding of Foreign Investment in Industry of the People's Republic of China, revised and issued jointly by SETC, MOFTEC and the State Planning Commission on December 31, 1997, codifies PRC policies that classify various PRC industries into different categories for the purposes of foreign investment. In all, there are four categories; encouraged, permitted, restricted and prohibited, which in turn impact the level of governmental approval required for the establishment of such projects. Hence, the legal viability of a foreign invested franchising enterprise depends, in part, on the underlying industry.

In keeping with long-standing policies of the PRC, retailing (and other types of commercial trading activities) has been classified as a restricted industry for foreign investment. Foreign investment projects in restricted industries need to pass through a time-consuming and cumbersome approval process with the central government. A handful of pilot projects had been permitted in accordance with the Circular Regarding the Response by the State Council to Questions Related to Foreign Investment in Domestic Trade, issued by the State Council in 1992, and the Measures for Pilot Projects for Commercial Enterprises with Foreign Investment, issued by SETC and MOFTEC in June 1999, which mandate central government approval for such pilot projects. In most instances, it has been difficult for new entrants to procure a central government approval.

Some foreign franchisors in restricted industries, like retailing or petrol stations, elected to enter the Chinese market through the establishment of locally approved Sino-foreign joint venture enterprises where the scope of business of such joint ventures would expressly include retailing or the operation of petrol stations. In the interests of attracting foreign capital to their localities, some local governments have been keen to turn a blind eye to the laws and policies of the central government and facilitate such restricted foreign investment projects. Of course, local governments do not have the power to overturn national laws, and foreign franchisors could not count on the protection of PRC foreign investment law in the event of a dispute with the central government about their subsidiaries. Following central government warnings and rectification exercises in the last few years, the risks inherent in relying on locally approved joint ventures have become very clear.

In direct investment franchise projects, the foreign partner's franchise systems can be conveyed to the joint venture in the form of a capital contribution or a license of intellectual property related to the foreign franchisor's products, such as trademarks, service marks, proprietary methods and systems, proprietary know-how, patents and the like. The foreign franchisor usually exerts control over the joint venture franchisee through majority equity contributions and/or management control. In this manner, and assuming that there are no regulatory interruptions, the foreign franchisors obtain dividends from the investment along with license fees for their intellectual property (essentially a form of franchise fees) from their subsidiaries.

When a franchisor's fundamental business activities are grounded in an industry that is encouraged or permitted, such as food services, the investment in and management control exercised by the foreign franchisor present less of an issue so long as its equity investment complies with other PRC investment requirements.

Cross-Border Licensing Arrangements

Bearing in mind commercial considerations of investment in the PRC and the risks involved with investing in a project with a deficient approval in restricted industries, some foreign franchisors choose to establish their franchises in China on the basis of purely contractual licensing relationships with appropriate PRC counterparts. Under this approach, no equity is injected into the PRC; rather, the foreign franchisor licenses its intellectual property and may also enter into a management contract with a PRC counterpart. In most instances, a PRC counterpart with foreign trade authority would be sought so that the counterpart could directly import the franchisor's products or services into the PRC. In some instances, foreign staff are seconded to ensure that the PRC counterpart complies with the operating procedures and standards imposed by the foreign franchisor. Again, in lieu of ''franchise fees'' per se, the foreign franchisor receives royalties for the license of trademarks and know-how, as well as a fee for managerial assistance and guidance, if appropriate. The foreign franchisor would need to ensure that any relevant approvals and recordal procedures are completed with respect to the contracts executed with its PRC counterpart and to ensure that their provisions otherwise comply with PRC law.

The Newly Published Draft Franchise Regulations

On July 25, 2001, the PRC media released the Draft Franchise Regulations, which were reportedly drafted by SETC and are currently under review by the State Council.

While the Draft Franchise Regulations do not expressly state that they supersede the 1997 Franchising Measures, the provisions of the Draft Franchise Regulations suggest that they would replace the 1997 Franchising Measures upon enactment.

The Draft Franchise Regulations reflect current PRC law by stipulating that direct investment by foreign franchisors through the contribution of capitalized technology must comply with applicable foreign investment laws. This statement appears to distinguish franchises set up in the form of a subsidiary from cross-border franchises without investment (the latter situation is not addressed in the Draft Franchise Regulations).

Article 5 of the Draft Franchise Regulations also rounds out the definitions of the 1997 Franchising Measures by adding the defined terms ''franchisor'' and ''franchisee.'' Under the draft, a franchisor is a legal person who grants to third parties the right to use its trademarks, logos and other marks symbolizing its business for the purpose of a franchise arrangement whereas a franchisee is a person to whom the aforementioned rights are granted.

The Draft Franchise Regulations describe five franchise structures. In addition to the structures for direct franchising and master franchising (sub-franchising) under the 1997 Franchising Measures, Article 8 introduces the concepts of ''area development'' franchising, agency franchising and franchise joint ventures. Area development franchising refers to those arrangements where the franchisee is granted the right to establish and operate a certain number of franchise outlets in a defined territory for a definite term, without the right to sub-franchise. ''Agency franchising'' describes those arrangements where the franchisor authorizes an agent to appoint potential franchisees on behalf of the franchisor and to provide certain services to franchisees in the designated territory; however, the franchise agreement is directly executed by the franchisee and franchisor. Franchise joint ventures are legal entities where both the franchisor and franchisee own an equity interest in the franchise outlet.

According to Article 21 of the Draft Franchise Regulations, fees and related financial matters should be handled in accordance with relevant financial regulations. By virtue of Article 21, the Provisional Rules Regarding Financial Management of Chainstore Operations, promulgated by the Ministry of Finance on September 29, 1997 (''Chainstore Financial Rules''), may be of relevance. Article 16 of the Chainstore Financial Rules provides that use fees should not exceed an amount equal to 3 percent of the gross revenue of the franchisee. While the Chainstore Financial Rules are understood to apply exclusively to domestic chainstore franchises, they do raise the issue of restrictions on franchise fees once the Draft Franchise Regulations are enacted. Of greater concern are the provisions of the Measures for Pilot Projects for Commercial Enterprises with Foreign Investment, which impose a maximum aggregate fee of 0.3% for the license of trademarks, trade names or technology over a period not to exceed ten years. It remains to be seen whether the limits imposed in the commercial trading sector will be extended to cover franchise arrangements in other industries.

Articles 22 to 26 of the Draft Franchise Regulations reiterate other provisions of PRC law relating to advertising, unfair competition and intellectual property protection.

In keeping with time-honored PRC regulatory practice, Articles 27 and 28 stipulate a registration procedure with the CCFA for domestic franchisors that engage in inter-provincial franchise transactions as well as foreign legal persons that undertake franchising in mainland China. Intra-provincial franchisors will be required to register with the CCFA's provincial branches. The Draft Franchise Regulations are silent on the issues of whether such registration will be a precondition to effectiveness or whether the CCFA will perform an approval function.

The Perennial Question: When?

The Draft Franchise Regulations are a significant indication of the current thinking of the Chinese government on franchises. The draft reflects an evolution of thought that takes the 1997 Franchising Measures as a basis for further regulatory development.

However, the Draft Franchise Regulations appear to be at a fairly nascent stage of development and do not necessarily reflect the views of other governmental agencies. In particular, it would be in keeping with prior practice for MOFTEC to recommend additional provisions for approval and regulation of foreign participation in franchise activities in the PRC and play a role in approving such transactions, if the Draft Franchise Regulations are to apply to arrangements involving foreign investment or foreign trade. In fact, officials had previously indicated that MOFTEC was studying franchise laws of various countries with a view to drafting legislation for the PRC, so it will be interesting to see whether the Draft Franchise Regulations will be revised to expressly address foreign investment and cross-border transactions or whether MOFTEC will issue its own draft applicable to foreign investment and foreign trade arrangements.

Such consensus building will certainly require time. Officials with the CCFA have stated publicly that the Chinese foreign investment regime will expressly recognize cross-border franchise arrangements by 2003. Hence, the time-honored vehicles of direct equity investment, where permissible, and licensing will continue to be relevant for foreign franchisors as the formal preparation of the Draft Franchise Regulations proceeds a pace.