Special Pre-qualifications for Franchising in China: 2+1 Rule

In China, there is a unique pre-qualification for a company to start a franchise; that is, the franchisor in question must first operate at least two company-owned units for at least one year. This is widely known as the “2+1” Rule. This rule is applicable to both Chinese and non-Chinese franchisors.  However, since this is a special requirement only seen in China, many international franchisors have found this rule as the biggest challenge when they plan to enter the Chinese market.

What is the “2+1” Rule

In China, Administrative Regulations of Commercial Franchise issued by the State Council and effective on May 1, 2007 (Franchise Regulations) regulate franchise activities, and the “2+1” Rule is explicitly addressed under the Franchise Regulations, which provides that the franchisor must first operate two company-owned units under the franchised brand for more than 1 year prior to being able to offer franchising in China. This rule is intended to affirm that the franchisor runs a mature system, and that it has the adequate resources and experience to support the franchisees effectively.

The Ministry of Commerce (MOFCOM) and its local counterparts are the regulating authorities for franchising in China, which have the authority to administer franchise recordal, regulate franchising operations, and investigate and penalize violations of the Franchise Regulations. In their view, the adoption and implementation of the “2+1” Rule can effectively reduce the risk of fraud in the franchise sector.

Implementation of the “2+1” Rule

In the years since the Franchise Regulations came into effect, there have been several variations to MOFCOM’s implementation practices with regards to the “2+1” Rule. Based on the current regulatory practice, company-owned units located outside China are generally acceptable, although some of the MOFCOM’s local counterparts in less sophisticated areas may still require the two company-owned units to be located within China.

The MOFCOM’s practices in recent years have further clarified the rule, allowing the two units to be either directly owned by the franchisor or by an affiliate provided that the affiliate is (1) a direct subsidiary of the franchisor and the franchisor holds a majority equity interest in the subsidiary; (2) a parent company of the franchisor and the parent holds a majority equity interest in the franchisor; or (3) a sister company of the franchisor and the parent company holds a majority equity interest in both the franchisor and the sister company. At this stage, there is no written restrictions on the distance in the relationships between the franchisor and the affiliate in the overall corporate structure; however, in practice, a challenge could be raised if the affiliation between the franchisor and the affiliate is too complex.

Legal consequences of failure to satisfy the “2+1” Rule

Franchisors may be subject to two aspects of risks for failing to satisfy the “2+1” Rule: ie, administrative penalties and contractual risks.

If a franchisor carries out franchising activities while it fails to meet the “2+1” Rule, it may be subject to the following administrative penalties:

• being ordered to rectify;
• being confiscated of illegal proceeds obtained from the franchising operations;
• being imposed a fine in the amount of between RMB 100,000 to 500,000; and
• being publicized for the violation and the penalty imposed.

Further, under the Franchise Regulations, franchisors are also obligated to attend to franchise recordal with the MOFCOM (in case of non-Chinese franchisors) or its local counterpart (in case of Chinese franchisors). As a key step of the recordal process, franchisors are required to submit the proof of the two company-owned units, and failing to provide such proof will result in non-approval of the recordal. Consequently, the franchisor failing to satisfy the “2+1” Rule may also be subject to the following administrative penalties for failing to complete the franchise recordal:

• being ordered to fulfil franchise recordal within a specified time limit by the regulating authority, and being imposed a fine of between RMB 10,000 to 50,000.

In respect of contractual risks, the franchisor’s failure to satisfy the “2+1” Rule will not automatically render the franchise agreement void. That said, in the event that the franchisor conceals the information that it does not satisfy the “2+1” Rule or makes false representations about its company-owned units in the franchise disclosure documents, the franchisee may likely have a good reason to terminate the franchise agreement. Indeed, there have been a few notable cases in which the courts upheld franchisees’ termination claims based on the reason that the franchisors intentionally concealed the information that they did not satisfy the “2+1” Rule.

Approaches to satisfy the 2+1 Rule

Given the significance of the “2+1” Rule and the challenge posed to international franchisors, it is advisable for international franchisors to adopt the following approaches prior to branching their franchise business into China.

As a first step, international franchisors should conduct a comprehensively review of their international business structure and operations globally for the purpose of evaluating whether there are any satisfying company-owned units, either operated by franchisors themselves or their qualified affiliates. If there is no company-owned unit that could be utilized directly, a second step could be to consider either opening two new units or acquiring two existing units from a franchisee. Once the two units have been under operation for more than one year, the franchisor will be deemed to have complied with the “2+1” Rule and may then sign franchise agreements and attend to franchise recordal in China.

DLA Piper continues to monitor the regulatory developments in the franchise sector, and our lawyers are experienced in advising on legal issues in this sector. To understand how to satisfy the “2+1” Rule in practice, contact your usual DLA Piper attorney or any of the authors.