Executive Summary

The PRC franchise regulations, which became effective February 1, 2005, attempted to clarify the process by which foreign franchisors could extend their businesses to China. Although these regulations helped clarify the expectations of foreign franchisors operating within China, they have remained silent on the key issue of whether foreign franchisors may enter into cross-border franchise arrangements without first establishing legal entities of their own in China. Chinese regulatory authorities have advised informally that such cross-border franchise arrangements are tolerated under this new regime, but formal guidance memorializing this policy, upon which foreign franchisors may rely, is not expected until early 2007.

Background & Implications of New PRC Franchise Regulations

On December 30, 2004, the Ministry of Commerce (the "MOC") of the People's Republic of China ("PRC" or "China") published the Measures for the Administration of Commercial Franchises (the "Measures"). These represent the first promulgations expressly governing franchise operations conducted within the PRC by both domestic and foreign-invested enterprises ("FIEs").

The Measures are guidelines for implementing the Regulations on Foreign Investments in Commercial Industry (the "Commercial Regulations"), which became effective June 1, 2004. The Measures became effective on February 1, 2005, replacing the 1997 Interim Measures of Administration of Commercial Franchise Operations (the "Interim Measures").

The Interim Measures generated confusion and frustration among foreign franchisors, as the Interim Measures did not expressly apply to foreign franchisors or FIEs. Moreover, although opening the door for foreign companies to establish franchise operations in China, the Commercial Regulations have required foreign franchisors to establish FIEs through which to pursue their franchising arrangements in China. This requirement contradicts China's WTO undertakings.

The Measures attempt to clarify these ambiguities and regulate the relationship between foreign franchisors and franchisees which are incorporated in the PRC (including FIEs). Regrettably, the Measures are silent on the key issue of whether foreign franchisors may enter into cross-border franchise arrangements with franchisees in the PRC without the foreign franchisors first establishing an FIE in China. Some have interpreted the Measures to require the establishment of an FIE.

The Measures permit a foreign franchisor to either establish a new FIE to carry out franchising operations in the PRC or, if the franchisor has an existing FIE, to apply for the "business scope" of that FIE to be upgraded to include commercial franchising. However, the Measures fail to address cross-border franchising arrangements between foreign franchisors and PRC franchisees. Therefore, the PRC authorities have not yet provided formal, written guidance confirming that cross-border franchising is permitted in the PRC and, if it is, whether the requirements in the Measures (e.g., two directly-operated stores with a one year operating history) apply to such transactions.

Our consultations with the MOC, the PRC regulatory authority promulgating and responsible for interpreting and implementing the Measures, suggest that cross-border franchises are permitted without the foreign franchisor being required to establish an FIE in China. Formal clarification of this issue is expected by early 2007.

In the meantime, the problem for such foreign franchisors is that not all Provincial level foreign trade regulatory authorities (the "COFTECs") are willing to accept registration of cross-border franchise agreements. COFTEC registration is generally a pre-requisite for the outward remittance of royalties. For example, while the Beijing COFTEC has expressed its willingness to accept such registration, the Shanghai COFTEC is not ready to process registration of cross-border franchise contracts for the time being. The Shanghai COFTEC is willing, however, to follow its past practice of accepting the registration of such contracts as "technology import and export contracts" if the word "franchise" is not mentioned in such contracts.

This issue is made even more complicated by the expectation that the Measures will be replaced by higher level legislation--tentatively entitled the "Commercial Franchise Regulation" (the "Regulation")--which have been pending before the PRC State Council for some time. As of now, it is uncertain whether and when the Regulation will be adopted, whether it will apply to foreign franchisors, and whether the Regulation will be substantively consistent with the terms in the Measures. According to our contacts within the MOC, the Regulation is expected to be published in early 2007. The contents of the draft Regulation itself are still confidential and subject to change by the State Council.

What Foreign Franchisors Need to Know about the Measures

Two Franchise Models. The Measures permit a franchisor to grant either a master franchise or individual, direct franchises, allowing in each case the franchisee to sub-franchise in China.

Franchisor Qualifications. The Measures specify certain qualifications for undertaking franchise arrangements in China. Most notable for foreign franchisors wishing to roll-out franchises within the PRC is the requirement that a foreign or FIE franchisor has operated, for over one year, at least two directly-operated franchise businesses (or stores owned by its subsidiary or holding company) within the PRC.

Franchise Term. The Measures provide that the duration of a franchise agreement should normally be no less than three years.

Information Disclosure. A foreign or FIE franchisor is required to provide any prospective franchisee, at least twenty days before execution of any franchise agreement, with a draft of the franchise agreement and written materials containing a variety of specified information relating to the franchise operation. This required disclosure includes: background information on the franchisor; the franchisor's audited financial statements; information about existing franchisees; and information regarding all relevant litigation during the preceding five years.

The Measures also grant a private cause of action to a franchisee for any economic losses caused by a franchisor's misrepresentation or omission in connection with such disclosure.

Confidentiality. An obligation is imposed on franchisees to keep their franchisors' trade secrets confidential, both during the period of the franchise agreement, and following its expiration or termination. In addition, confidentiality obligations are imposed on prospective franchisees which receive trade secrets as part of the pre-contract disclosure process.

Trademarks and Trade Names. Unlike the U.S., China has a "first-to-register" trademark system that requires no evidence of prior use or ownership, leaving registration of popular foreign trademarks open to anyone. It is imperative that any foreign franchisor considering establishing a franchise in the PRC take immediate steps to register its trademarks and trade names with the relevant PRC authorities. A failure to do so can have devastating consequences. Franchisors should also register their trademarks and trade names as domain names.

Without implementing a proactive trademark registration plan in China, problems may also emerge after a franchisor terminates a relationship with its franchisee: the franchisee sometimes continues using the franchisor's proprietary trademarks by registering the trademark for its own business and offering similar services or products, either directly or indirectly. This can occur because China has two separate systems for the registration of trademarks and trade names. Trademark registration with the PRC Trademark Office is valid across the whole country. Trade name registration, however, is with different levels of business registry offices and applies only to the jurisdiction of the local registry office.

The Measures require that a franchisor must possess trademarks, trade names, and other economic resources which it may legally authorize franchisees to use. The Measures also stipulate that after a franchise agreement expires, the franchisee must not use the franchisor's trademark or trade name without authorization, or register the franchisor's trademark as a trademark or a trade name.

Finally, a franchisor must register its trademark license before PRC franchising operations commence. If the franchise business will utilize patents, the franchisor similarly must enter into and register in China a patent license.

Franchise Fees. The Measures explicitly permit franchisors to collect the following types of fees from franchisees: one-off initial franchise fees, periodic operational fees, and other fees as agreed in the franchise agreement for the supply of goods and services.

Reporting. Each January, franchisors are required to file with the local regulatory authorities a report containing information on franchise agreements signed during the previous year.

FIE-Specific Requirements. In addition to these general requirements, FIEs must obtain specific approval to engage in franchise activities. As part of the approval process, a FIE is required to submit to its original approval authority documentation evidencing the FIE's compliance with the franchisor qualification requirements imposed by the Measures. FIEs are also required to submit the written disclosure documentation which must be provided to franchisees. FIE franchisors must further report to both the local commerce regulatory authority and its original approval authority each January specified information regarding its franchising operations during the previous year.

"Amnesty" for Existing Franchises. The Measures provide an "amnesty" for those FIE franchisors offering franchises in the PRC prior to the adoption of the Measures. Provided that their franchising operations have not been conducted in a fraudulent manner, a form of amnesty is offered to these FIEs whereby they are required to file a report of their franchising operations and undertake the approval procedures described above to expand their business scope, as applicable.

Penalties for Non-compliance. Franchisors or franchisees that fail to satisfy the qualification requirements may be required either to remedy the non-compliance, or pay a fine of a maximum of RMB 30,000 (approximately US $3,625), or both. In addition, in circumstances where the violation is considered sufficiently serious, the business license of the offending party may be cancelled by the Administration of Industry and Commerce.

Conclusion; Practical Options and Considerations

There remains a great deal of uncertainty regarding how the Measures will work and be implemented over time. We will continue to monitor and provide updates regarding developments in the PRC, particularly as the Chinese authorities settle upon uniform policies and procedures for implementing the Measures and as the expected supplemental franchise legislation is finalized and made public. In the meantime, what should foreign franchisors do, given the fluid state of PRC regulations?

The answer depends upon your sense of urgency to enter the Chinese market, your risk tolerance for regulatory ambiguity, your financial resources and your strategic commitment to the market, among other factors. However, any foreign franchisor interested in China would be well advised at this point to:

1. Immediately register, in English and Chinese, all relevant franchise trademarks and trade names in the PRC, for reasons explained above. 
2. If your PRC business plan does not already contemplate establishing FIEs in China as part of your China franchise strategy, and you do not have an immediate need to be in China, consider waiting until cross-border franchising regulations are promulgated, providing formal and clear regulatory guidance for such arrangements.
3. If you need to be in China now, are comfortable with a higher degree of ambiguity, consider establishing your first cross-border franchise with a franchisee operating in Beijing, where the authorities have indicated a greater willingness to recognize and honor such arrangements.
4. Never rely on word-of-mouth anecdotes regarding how things are done in China. Utilize competent legal counsel with direct lines of communication with the PRC regulatory authorities responsible for interpreting and implementing all of these rules. The authorities in China possess a great deal of discretion, and their internal practices and policies, which change from time to time, can only be ascertained reliably through direct dialogue with them. In China, no surprises are pleasant surprises.

Faegre & Benson offers a highly experienced team of China Practice legal professionals, based in both our U.S. and Shanghai offices, dedicated to representing U.S. multinationals in franchising and other complex commercial transactions throughout the PRC. For more information, contact George Martin (gmartin@faegre.com), Brian Schnell (bschnell@faegre.com), or Bill Killion (wkillion@faegre.com).