Saturday, May 26, 2007

Franchise in China--Opportunities & Challenges Come Along with the New Law (I)

Franchisor Disclosures

A. Timing of Disclosure

Consistent with the Regulations, Article Four of the Disclosure Guidelines requires a franchisor deliver a written disclosure document to a prospective franchisee at least thirty days (30) before the execution of a franchise contract. In addition, the franchisor must also concurrently provide a copy of the franchisor’s sample contract. Nothing regarding first meeting, contemplated in the current U.S. FTC Franchise Rule, is mentioned in the Disclosure Guidelines. Rather, it is the number of days that is the focal point of the time of delivery. Further, Disclosure Guidelines do not mention whether the days are either calendar or business days, but the author believes it is probably safe to assume that the thirty days refer to business days, which is consistent with the new U.S. FTC rule (replacing the ten business days with fourteen days.). In Mandarin Chinese, calendar days and working days have clear distinctions. Calendar days are typically shortened as “days”, whereas working days cannot be shortened. The exact language used in the Disclosure Guidelines is “Days.”

B. Content of the Disclosure Document

Article Five of the Disclosure Guidelines lays out the basic format of the necessary components of a disclosure document. In terms of functionality, the Article Five requirements resemble the current FTC disclosure format. Note that China does not currently have an equivalent of the Uniform Franchise Offering Circular (“UFOC”) in the United States. The following is a summary of the twelve items required under Article Five:

1. Basic information about the franchisor and its franchising activities;
2. Basic information about the franchisor’s business operational resources;
3. Basic information about franchise fees and charges;
4. Information about the pricing, conditions of products, services, and equipments to be provided by the franchisor;
5. Information about continuous training to be provided by the franchisor;
6. Franchisor’s methods and content of guidance for and supervision of franchisee in its operations;
7. Information about the investment budget for a franchise outlet;
8. Information about franchisees inside Mainland China;
9. Abstracts of the franchisor’s audited financials of the most recent two years;
10. Information about major litigations and arbitrations involving the franchisor in its franchising activities;
11. Information about major violations of operations not in compliance with the law, and major criminal violations; and
12. Franchise contract.

C. Areas of Concern for Franchisors

One area of concern for an international franchisor stems from information disclosure about franchisees inside China. If a foreign franchisor already has outlets in China, the franchisor needs to state the number of current franchisees, their geographic distribution, authorized operational areas as well as whether such areas are protected by exclusivity. In addition, earnings claims are required under Section 8 of Article Five, which departs from the current FTC Rule on earnings claims. An interpretative problem arises if a foreign franchise does not have franchise outlets in China yet. Should the franchisor provide earnings claims based on data collected from operational outlets inside the franchisor’s home country? The author does not believe that such earnings claims would be acceptable in China for a number of reasons.

First, Section 8 of Article Five clearly states that article requires information about franchisees inside Mainland China. Obviously, franchisees outside China fall outside the purview of this section. Second, subsection 2 of Section 8 demonstrates a concern for geographical relevance of earnings claims based on data collected inside China since it requires the franchisor to state conspicuously that such claims may differ from actual operational results of other prospective franchisees. Inferentially, earnings claims based on data collected outside China create a greater market relevance issue for any prospective franchisees in China who seek to rely on any indications of profitability.

Another point of concern for franchisors is the ambiguous ban on making earnings claims in a franchisor’s advertisements. Article Six provides: “A franchisor shall not engage in fraudulent and misleading conduct in its marketing and advertising; a franchisor’s advertisement shall not contain propaganda for any individual franchisee’s operational earning results.” Its prohibition of advertisement featuring an individual franchisee’s earnings has sound reasoning because such an advertisement would mislead prospective franchisees where such advertised earnings do not have market relevance to prospective franchisees.

However, Article Six is silent with respect to advertisement using average earnings data. A strict reading of Article Six would lead a reasonable reader to conclude that earnings data based on average operational results of franchisees does not constitute “propaganda for any individual franchisee’s operational earning results” within the meaning of this Article. In contrast to ads based on a specific franchisee’s earning results, ads using average earning results of many franchisees, presumptively, do not have the same mal-effects. (The author doubts the logic of Article Six, but strict reading of a Chinese statute without legislative history does not allow other interpretations absent further administrative opinions on this topic.)

D. Protections for Franchisors

Any franchisor should rightfully have the reason to be concerned about confidentiality before making disclosures to prospective franchisees, especially in a foreign country. In a country like China, where protection of intellectual property is by no means adequate, a franchisor should, however, not retreat from a risk of exposure to IP violation by locals. In fact, a reassuring trend in China has been developing, which ought to dispel some of the fear about rampant IP theft in China. Fore example, Article Seven of the Disclosure Guideline emphatically states that a franchisor has the right to require a prospective franchisee to sign a confidentiality agreement prior to making any disclosures.

Furthermore, Starbucks' victory speaks for itself with respect to IP protection in China. Additionally, reports of widespread IP violations without redress in China typically occur in the sectors of commerce, where the government does not have an effective enforcement framework. However, in commercial sectors, such as franchising, both the courts and the administrative agencies have demonstrated the willingness and will to enforce IP laws rigorously to create a friendly investment environment for foreign capital.

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