Franchisors: Beware of Advertising Minefield in China

When I first finished translating China’s new Regulations on the Administration of Commercial Franchise (“Franchise Regulations”) in the spring of 2007, I feared that some franchisors would easily get confused over the provisions relative to advertising. That fear was not unfounded because one franchisor’s battle wounds in Beijing could reveal that dangers lurk in the new Franchise Regulations.

With respect to advertising, Article 17 provides in subsection 2 that:

A franchisor shall not engage in fraudulent and misleading activities in the course of advertising and publicizing a franchise. In its advertising, the franchisor shall not include content concerning a franchisee’s earnings results in the franchise operation. [Please note that the text is extracted from my translation, and it may differ slightly from other versions out there.]

Clearly, the Franchise Regulations prohibit a franchisor from general fraudulent and misleading statements in its advertising. “Don’t promise what you cannot deliver” is the basic message. At the same time, however, a franchisor in China is also forbidden from stating anything about profit margins, or earnings forecast. It translates into--Don’t say anything about how much money a franchisee can expect to make in a given amount of time from running a franchise. Simple enough, right?

Not really, because the same Franchise Regulations require a franchisor to disclose financial performance assessment of the franchise to prospective franchisees in its mandatory disclosure document. See Article 22 (8); see also Measures on the Administration of Information Disclosure of Commercial Franchise (“Disclosure Guidelines”) Article V (8) (ii).

To put the rules on advertising about earnings in a nutshell, a franchisor shall not advertise about the earnings forecast or financial performance of the franchise; but, the franchisor shall make mandatory disclosures about the earnings forecast or financial performance of the franchise to perspective franchisees in a written disclosure document. If a franchisor sticks to the rules in a nutshell, it should be able to stay clear of the mines in the advertising field.

In the United States, this kind of statements about profit margins or financial performance is commonly referred to as earnings claims under 16 C.F.R. § 436.9 (c) (2006) (the “New FTC Franchise Rules”), which is prohibited unless the franchisor has included earnings claims in its Item 19 of the Franchisor Disclosure Document (“FDD”) pursuant to 16 C.F.R. § 436.5 (s). And under the New FTC Franchise Rules, the inclusion of the Item 19 in the FDD is totally optional. Most franchisors stay clear of making earnings claims in Item 19 to avoid the added cost of providing substantiating data, and to shun possible fraud and/or misrepresentation lawsuits by franchisees arising out of such earnings claims.

Last week, a Chinese franchisor in Beijing fell victim to (or got stung by, depending on your perspective) the Article 17 of the Franchise Regulations. According to a Chinese report (Chinese only), the franchisor runs a franchise specializing in children’s haircuts. Allegedly, the franchisor handed out publications containing statements about the franchise, such as, “running a franchise, annual gross income 48, 200 Yuan, annual total costs 10,800 Yuan.” A franchisee signed a franchise agreement with the franchisor, paying a total fee of 22,800 Yuan. After operating a franchise unit for a few months, the franchisee discovered that actual operational results did not measure up to forecasts in the franchisor’s advertisement. So, the franchisee reported the franchisor to the Beijing Haidian District Office of the Administration of Industry & Commerce, which ruled that the franchisor violated Article 17 of the Franchise Regulations.

The final outcome of the case includes a rescission of the contract, return of the 22,800 Yuan, and an administrative penalty of 30,000 Yuan.

I would like to think that this is a simple case of statutory misinterpretation rather than one of corporate greed. Assuming it is the former, I would hope that franchisors remember the rule in a nutshell-- a franchisor shall not advertise about the earnings forecast or financial performance of the franchise; but, the franchisor shall make mandatory disclosures about the earnings forecast or financial performance of the franchise to perspective franchisees in a written disclosure document.