Saturday, May 26, 2007

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

More Interpretative Problems
A. Franchisor Disclosure Amendments
Disclosure Guidelines states:

Article Seven With respect to changes to information provided in the
registration, a franchisor shall petition the registering agency to amend such
changes within thirty days of such changes.

Obviously, the letter of the law requires "changes" to be amended, but the sticky issue here is what do "changes" encompass. All changes, material and immaterial? Or just material?

It puzzles that that the government would impose the heavy burden of amending just any changes on a franchisor, especially foreign franchisors who operates in many countries with a high frequency of immaterial changes to the franchise system. But I am not in the position to twist arms with the express provisions in the Chinese law. So I consulted with a Chinese franchise lawyer based in Mainland China. He noticed the ambiguity in the Registration Guidelines too, and he opines that the "changes" referred to in Article Seven of the Registration Guidelines only encompass immaterial changes. Since he is in the process of writing an article on the same topic, I will wait for him to disclose his reasoning behind the interpretation even though I agree with him.
B. "Where exactly do I register?"--Franchisor
Article Three Relevant departments, in charge of commercial regulations in the
Ministry of Commerce, Provinces, Autonomous Regions, and Municipalities, are the
proper registration agencies. If franchising operations are within Provinces,
Autonomous Regions, and Municipalities, shall register the franchise in the
departments in charge of commercial regulations; if franchising operations cross
boundaries of Provinces, Autonomous Regions, and Municipalities, the franchise
shall be registered in the relevant department of the Ministry of Commerce.
Franchising to occur within provinces (省),autonomous regions (自治區),municipalities (直轄市), a franchisor needs to register in government agencies in charge of regulating commerce, and the cities must be the ones what have administrative districts (設區市).
Franchising to occur beyond geographical boundaries of provinces (省),autonomous regions (自治區),municipalities (直轄市), a franchisor needs to register with the Ministry of Commerce.
This rule begs the question: "If a franchisor wants to franchise within its province and beyond, does it have to register with the local agencies and the Ministry of Commerce?" According to a Chinese franchise lawyer, the answer to this question is affirmative.

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

Franchisor Registration
A. Timing of Registration

According to Article Six of the Registration Guidelines, “a franchisor shall register the franchise with governing registration agency within fifteen (15) days of the date of the execution of the first franchise contract with a franchisee in China.” In the same vein as the analysis above, “days” refer to calendar days rather than business days. And those franchisors already in operations in China have till May 1, 2008 to register their franchises.

B. Required Documents for Registration

Before initiating the registration process, it is advisable for a franchisor to ascertain with which agency to register the franchise. China has a complex administrative structure in that it is divided into provinces, autonomous regions, and municipalities, which are under direct control of the central government. As stated in Article Three of the Registration Guidelines, franchising to take place within provinces, autonomous regions, or municipalities shall be registered in the highest administrative agencies in charge of commercial regulations; whereas franchising to occur beyond or across boundaries of provinces, autonomous regions, and municipalities shall be registered with the Ministry of Commerce of China. Deciding the right place to register a franchise is a crucial first step in the registration process.

After choosing the right place, the next thing a franchisor need to know, naturally, is what documents to prepare for registration. Article Five of the Registration Guidelines is devoted to specifying the requisite documents for registration with any registering agency. Article Five requires the following:

(1) Basic information about the franchise.

(2) Basic information about the geographical distribution of all the franchised units in China.

(3) A copy of the franchisor’s marketing plan.

(4) A copy of the franchisor’s corporate business license or other important documents evidencing eligibility.

(5) A copy of the registrations of the franchisor’s trademarks, patents or other business resources related to the franchising operations.

(6) Documents provided by a commercial regulatory department in a city with administrative districts, evidencing a franchisor’s compliance with Article 7 Section 2 of the Regulations; with respect to company-operated units located outside China, a franchisor shall provide documents evidencing same (including Chinese Translation), which shall be notarized and certified by a Chinese Consulate located in the administrative region as such company-operated units.

The above section does not apply to a franchisor in franchising operations before May 1, 2007, but such a franchisor shall provide a copy of the first franchise agreement executed by both the franchisor and a franchisee inside China.

(7) Sample Franchise Contract.

(8) Table of contents of the Franchise Operation Manual (Must include the page number of each chapter and the total number of pages. With respect to the Franchise Operation Manual accessible via franchise system intranet, provide the estimated pages after printing.).

(9) With respect to franchising of services or products subject to pre-approval pursuant to relevant laws and regulations, a franchisor must provide documents evidencing such approval by relevant government agency.

(10) Franchisor’s affidavit, signed and sealed by legal agent of such franchisor.

A foreign franchisor needs to pay special attention to (6) of Article Five. The Regulations regrettably kept the “two company-operated units for at least one year” requirement (“2 + 1 Requirement”). It is an eligibility requirement whereby only franchisors with two existing company-operated units in operations for over a year can franchise in China. As onerous as it might be, the Registration Guidelines clarified the uncertainty inherent in the Registrations as to whether a foreign franchisor can satisfy the “2 +1” requirement with units in operations in its home country. And the answer is affirmative.

Item (6) suggests that in order to satisfy the requirement, a franchisor, however, has to have the assertion that it has two company-operated units in operation for over a year notarized and certified by a local Chinese Consulate. The Registration Guidelines do not address how item (6) works if the two company-operated units are located in two geographical places far away from each other, for instance Seattle, Washington and Houston, Texas. Shall the two units be notarized and certified by just one consulate or two? To avoid the potential problem of non-compliance, the author suggests that they be certified by the consulate administratively responsible for the location where the unit is.

C. Method of Registration

For ease of management, registration of franchise has gone hi-tech in China. A franchisor can directly fill out items (1)—(3) on the Chinese version of the Ministry of Commerce website:, the rest of the items can be submitted on the same site in PDF format. But in order to start the process, a franchisor has to create an account and password. The English version of the website does not yet have the registration management data base running yet as of May 16, 2007, but the laws have gone into effect for 16 days. Navigating the Ministry of Commerce website is not exactly a breeze even for the author whose native language is Mandarin Chinese. Therefore, a attempting to register in the Chinese government database could present considerable difficulties to a foreign franchisor who has limited knowledge of the Chinese language.

In the unfortunate event that a registering agency finds deficiency in registration documents, the franchisor may be required to submit additional supplemental materials seven days following the initial round of registration. And if the franchisor submits materials as requested by the agency, the agency, according to Article Ten of the Registration Guidelines, is required to register the franchise within ten days of the submission of additional materials. Given the time difference, vast geographical distance, and language barriers, it might in reality take longer than ten days if a problem occurs in the registration process unless the foreign franchisor has local counsel inside China.

D. Changes after Registration

A registered franchisor is also required to file changes and annual reports with the registering agency. Article Seven of the Registration Guidelines mandates that “with respect to changes to information provided in the registration, a franchisor shall petition the registering agency to amend such changes within thirty days of such changes.” (Emphasis added) “Changes” are not modified by any adjectives, therefore, it means any changes, material or immaterial. It seems, undoubtedly, very burdensome to amend any changes with the registering agency. However, the critical word “petition” might be the word that decreases the burden to amend. After changes occur in the franchise system, the franchisor should petition the agency to amend. It is up to the agency to either grant the petition or deny the petition to amend. Logically, if the petition is granted, then amendment becomes mandatory; if not, amendment would be unnecessary. Of course, absent a clear and transparent demonstration of the standards to be used by the agency in its evaluation of the petitions, the franchisors would not know what types of changes ought to be amended and what not to.

Franchisors’ annual report filing seems less problematic than amendments. The bright line rule requires an annual filing before March 31. Article Eight of the Registration Guidelines states that the annual filing report should include basic information regarding new, cancelled, renewed or amended franchise contracts in the past year. Even though the law does not require that amended contracts be offered to future prospective franchisees, the annual filings become public information listed in the Ministry of Commerce website, which is easily accessible for any interested prospective franchisees.

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.

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

With the recent promulgation of the Commercial Franchise Information Disclosure Management Measures (“Disclosure Guidelines”) and Commercial Franchise Registration Management Measures (“Registration Guidelines”), the Chinese franchise regulatory framework is basically complete. The two Guidelines were drafted and promulgated in accordance with the Regulations of the Commercial Franchise Operations (“Regulations”), and they supplement the Regulations with specific details on its enforcement. Even though the two Guidelines have eliminated a lot of uncertainty in the Regulations, they still have potential pitfalls for foreign franchisors in their compliance measures. The next two blogs aim to to expose the areas where dangers lurk in a franchisor’s attempt to comply with the Guidelines.