Update on 2007 Regulations

In the last week of April 2007, China’s Ministry of Commerce issued new franchise administration rules as a follow-up to the Regulation on the Administration of Commercial Franchise promulgated in February and made effective May 1 of this year. The new rules are important steps toward clarifying the regulation. In particular, the Administration Rules on Commercial Franchise Filing clarify the so-called "two plus one" rule and support the view that offshore franchisors will no longer need to operate at least two locations in China. New rules also elaborate on information disclosure.

Cross-border franchising

Prior to implementation of the regulation, international franchisors primarily used a cross-border licensing approach to enter the Chinese market, because China did not approve of cross-border franchising at that time. The franchise measures adopted in 2004 announced the "two stores one year" or "two plus one" rule, requiring a franchisor to operate a minimum of two directly owned stores for at least one year within Chinese territory. The regulation, promulgated in February of this year, reiterates the rule but without mentioning "geographic limitations."

Many commentators saw the omission as a deliberate, if tacit, acknowledgment that the Ministry of Commerce will no longer require a foreign franchisor to own at least two units in China. The new filing rules, implemented as of May of this year, endorse this view. Article 5 (6) requires a franchisor to provide documents showing that it has satisfied the "two plus one" requirement, acknowledging explicitly that the "directly operated outlets" may be "located outside China."

Therefore, Article 5 (6) appears to sanction cross-border franchising. This position has been supported by Ministry of Commerce officials at various China and international franchise events held over the past few months. Although this conclusion conflicts with Article 3 of the 2004 Commercial Measures, which have not been repealed, it is common in Chinese rule-making for an older set of rules to remain on the books although a newer set effectively supersedes it. Moreover, as the 2007 regulation was issued by the State Council, a body higher than the Ministry of Commerce, it overrides the measures issued by the ministry insofar as they are inconsistent. The filing rules, although also issued by the Ministry of Commerce, are issued pursuant to the regulations. In any case, Chinese officials have stated that they intend to repeal the measures when the time is right. The upshot is that the state of the law in China today appears to allow cross-border franchising.

The ministry has also issued new rules on information disclosure. Article 5 of the Administration Rules on Commercial Franchise Information Disclosure enumerates 12 categories of information to be disclosed:

1. Basic information on the franchisor and the franchise activities, including information regarding the bankruptcy or application for bankruptcy of the franchisor over the past five years.

1. Basic information on the franchisor’s possession of operational resources, including information regarding any litigation or arbitration that has occurred in relation to such resources.

1. Basic information regarding franchise fees.

1. Prices and conditions of products, services, and equipment to be supplied to the franchisee.

1. Continuous services to be provided to the franchisee.

1. Specific methods and contents of guidance and supervision on the franchisee’s operation, including whether and how the franchisor will bear joint and several liability for customer complaints. This provision helps to clarify the Regulation’s requirement that franchise contracts include information on "liability for damages/compensation arising out of the franchise."

1. Investment estimates of franchise stores/outlets.

1. Relevant information on franchisee(s) within China.

1. Abstract of financial accounting report and abstract of auditing report of the past years. This provision reiterates a clause from the Regulation.

1. The franchisor’s material litigation and arbitration in the past five years related to the franchise activities. The Regulation had required a franchisor to disclose "all issues relating to litigation and arbitration during the past five years."

1. Record(s) of material illegal operation of the franchisor or its legal representative.

1. Franchise contract text.

In the event of violation by a franchisor, Article 10 of the Disclosure Rules gives the franchisee "the right to report to the competent commercial administration authority." The provision suggests that enforcement mechanisms will be implemented more as a result of complaints rather than proactive ministry supervision of the sector.

Conclusion

Since promulgating the 1997 Franchise Rules, China has continued the difficult process of creating a legal structure for the franchise business model in China. The latest administration rules, while they certainly do not bring the process to a close, take important steps in the right direction.

Richard Wageman is Of Counsel for DLA Piper UK LLP Beijing.