China’s New Franchise Regulation:
Three Steps in the Right Direction

by Philip F. Zeidman and Tao Xu

Almost exactly two years ago, on February 1, 2005, the Measures for the Regulation of Commercial Franchises (Measures) issued by the People’s Republic of China’s Ministry of Commerce (MOFCOM) went into effect.

Since their inception, the Measures have been the subject of non-stop discussion in the international franchising community—not only because the Chinese market is so important, but because of the (in)famous “two plus one” requirement. That requirement was thought by some to be a precursor of coming change in the franchise laws in other countries. Indeed, that has proved to be the case in Vietnam.

But, from the outset, the Measures operated under a cloud: the looming Regulation on Commercial Franchises (Regulation), which has been in the works for several years. Because this Regulation would be issued by the State Council, it would have much more weight, and more teeth, than the Measures. Many also hoped that the Chinese government would use the Regulation to reconsider the issues important to healthy development of franchising in China, as well as to adjust its approach to regulating franchising.^[†]

Under the more opaque system of legislative drafting in China, it is impossible to determine who made what approaches or arguments to the government. The International Franchise Association advocated extensively before the Ministry of Commerce, the Legislative Affairs Office of the State Council, and other agencies.

The new Regulation (approved “in principle” by the State Council on January 31, signed by the prime minister on February 6 and promulgated to be effective on May 1), represents a major improvement over the Measures, reflects the Chinese government’s willingness to adopt a more liberal regulatory regime, and confirms that these efforts of IFA have been well spent. Click here to read the official Regulation, in Chinese, and click here for the English translation prepared by our Beijing office.

To be sure, there are many uncertainties that remain to be resolved. For some foreign franchisors, the revised regulatory regime still represents a significant hurdle, although it is by no means insurmountable, as we have seen in our representation of clients in China. For the moment, we would like to report to our clients and friends on three important steps that the Regulation has taken in the right direction.

1. A Relaxation of the “Two Plus One” Requirement

The Measures require that a franchisor (or its subsidiary) must have two direct-operated outlets which have been in operation for more than one year, before it can franchise in China. Article 7 of the Regulation now provides:

(1)   A franchisor, when engaging in franchise operation, shall own a well-developed mode of operation and be capable of continuously providing operational guidance, technical support, business training, and other services to the franchisee.

(2)   A franchisor shall own at least two directly-operated outlets, and have operated for more than one year.

Careful readers will see that there is no explicit requirement that the outlets be “within China,” a silence that is clearly of potential benefit to foreign franchisors. The intent of this change is to give MOFCOM latitude in deciding what exactly this requirement will entail and how it will be administered. Although we cannot be certain, we believe that MOFCOM will not require, for foreign franchisors, that their two company units be within mainland China. That result would, of course, represent the success of the long advocacy efforts.

We should note, however, that this is merely a step in the right direction; it is not, by any means, a fully developed regulatory requirement that is unambiguous in its application. On the contrary, questions abound:

• Can we be certain that MOFOCM will not administratively introduce the “in China” requirement?
• How will the company-owned operations of the franchisor’s affiliates be treated?
• How will the term “direct-operated outlets” be interpreted? Will that include businesses not owned but managed by the franchisor (or its affiliate)?
• The wording of the revised “two plus one” rule seems to suggest that the two company-owned stores themselves need not be open for more than one year, so long as the franchisor’s company-owned operation as a whole has achieved that duration. Is that intended?
• What documents will the Chinese government require in verifying franchisors’ (especially foreign franchisors’) satisfaction of this requirement?

Few franchisors will want to proceed without assurance regarding these issues. MOFCOM has indicated that it will prepare “implementation guidelines” to address many of the uncertainties in applying the Regulation. We will monitor and provide updates on the drafting of these “implementation guidelines.”

2. A Turn from “Approval” to “Registration”

Instead of requiring each franchisor to be “approved” and obtain a “franchise license” before starting to franchise in China (an approach that appeared in the drafts dated as late as May 2006), the Regulation’s Article 8 now provides that franchisors need only “register” with the provincial government or MOFCOM (for those who will engage in “cross-province” franchising).

Such registration is required within 15 days after the franchisor sells its first franchise. Franchisors who have already been franchising in China are required to register by May 1, 2008.

The government agency is required to register a franchisor within 10 days following its receipt of all the required documents, which includes copies of certificate of incorporation or business license, form franchise agreement, operations manual, market plan, and evidence of franchisor’s satisfaction of Article 7 (see above). Notably, franchisor’s disclosure document and audited financial statements are not required (although they are still required to be provided to prospective franchisees).

For US franchisors who are already accustomed to meeting registration requirements in certain US states, the use of the term here under the Regulation may be misleading. “Notice filing” is probably closer to what the Regulation actually contemplates.

3. A Recognition of the Independent Relationship between “Franchisor” and “Designated Supplier”

For quite some time now, we have expected that the Regulation would include the changes we cite above under #1 and #2. Another change, however, was not anticipated, but it is quite heartening.

In the past and, indeed, despite strong arguments by IFA, throughout much of the process of drafting the Regulation, Chinese officials took a firm stance that a franchisor would be jointly and severally liable for the products and services provided by its designated suppliers. This feature appeared in the Measures, and persisted throughout various drafts of the Regulation. Happily, the Regulation is a complete contrast to this. In the new Regulation, a franchisor is not jointly and severally liable for the products and services provided by its designated suppliers.

Disclosure Requirements under the Regulation

The disclosure obligations under the Regulation remain roughly the same as under the Measures in terms of the substance, with a few adjustments. For instance, the government reserves the authority to request additional disclosure obligations—a troubling, although typical, approach. The Regulation also imposes some new obligations (e.g., a mandatory “cooling-off” period (although without a specified period of time), and much harsher penalties on violations.

A Vital Step toward an Efficient Regulatory Regime

As we indicated, the Regulation is by no means a perfect document, and much remains to be clarified by Chinese officials, through MOFCOM’s implementation guidelines and otherwise. The devil, as always, will be in the details.

Nonetheless, we are quite encouraged by these steps that the Chinese government has taken in the direction of an effective and efficient regulatory regime, which will greatly benefit both franchisors and franchisees in China. With the Chinese New Year upon us, here’s hoping that the Year of Golden Boar will bring more good news from China.

^[†] In the interest of full disclosure, please note that DLA Piper, which has served as General Counsel to the International Franchise Association since its inception, participated in numerous meetings in both China and in the U.S. with Chinese officials in the drafting phases of the new Regulation. Philip Zeidman, of the Washington, DC office of DLA Piper US LLP and Tao Xu, of the Northern Virginia office, represent the International Franchise Association in the Association’s efforts to amend the Franchise Regulation, working closely with Janet Jie Tang and Xiaoming Xie of the Beijing office of DLA Piper UK LLP.

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Published by DLA Piper US LLP
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