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March 13, 2007

Guest Column: China Adopts New Franchise Regulation

[Editor's Note: We are grateful to Paul Jones for today's post on China's new franchise regulation, in which he delineates the differences between it and previous franchise regulations. Mr. Jones is a franchise and intellectual property lawyer in Toronto, Canada, and a Chinese speaker. The international law program at John Hopkins University currently uses his paper on the interpretation of the previous Commercial Franchise Measures to illustrate the differences between common law and civil law. He may be contacted at this address.]

China has just released a new franchise Regulation (商业特许经营管理条例) to come into effect on May 1, 2007. It replaces the existing Commercial Franchise Measures (商业特许经营管理办法) that came into effect on February 1, 2005. [In Chinese.] The new regulation (hereinafter, "Regulation") is significantly different from previous Measures that had caused considerable concern amongst international franchisors and led to intervention by the U.S. Trade Representative.

The Regulation tries to balance a variety of international and domestic concerns and there is some question as to whether it manages to satisfy the needs within China for intervention to prevent fraud and abuse, and the international desire for easier access to the China market. The new Regulation has clarified that it will apply to all franchises operations in China equally. The Measures had a separate chapter (第七章外商投资企业的特别规定) that had requirements for Foreign Invested Enterprises (FIE), but it was not clear from the text what triggered the requirement to set up an FIE, and some questioned whether these separate requirements were in line with China’s WTO commitments. The Regulation has eliminated this issue by eliminating separate requirements for FIEs.

Another international concern was the requirement for a franchisor to have owned and operated two locations in China for at least one year. The requirement to have owned and operated two locations has been retained in the Regulation, but the requirement that they be in China has been removed. Foreign franchisors that have met this requirement in their home market will now be eligible to franchise in China.

But there are also restrictions to try to curb the rampant fraud in the domestic market for franchises. The State Council’s Legislative Affairs Office and the Ministry of Commerce (国务院法制办、商务部) also released a set of questions and answers on the new Regulation. [In Chinese.] They describe the Regulation as having five aspects that are designed to deal with problems in the franchise market.

Firstly, only corporations and other legal entities can be a franchisor. Individuals may not be franchisors. Franchisors must have a mature business model and have the resources to provide support.

Secondly, franchisors must disclose sufficient information for the franchisee to make a suitable investment decision. This information must be accurate, complete and not omit related information. Previously, U.S. franchise lawyers had complained strongly about the vagueness of the unfamiliar civil law drafting in this section. The wording has been changed, but the obligation to disclose all material facts may still arise out of Article 42 of the Contract Law (合同法). Article 42 requires that parties negotiate a contract in good faith and not conceal “key” or “material” facts (重要事实). It is based on similar provisions now codified in Germany’s Bürgerliches Gesetzbuch. German courts have relied on the equivalent law to impose an obligation of pre-contractual disclosure on franchisors in several cases. The questions and answers clearly indicate that the General Principles of the Civil Law (中华人民共和国民法通则) and the Contract Law continue to govern franchising.

Thirdly, franchisors must now register within 15 days of signing their first franchise agreement in China. The Regulation specifies certain documents that must be submitted for registration, such as a marketing plan, but does not specify the fees, if any.

Fourthly, the Regulation stipulates a number of items that must be in a standard form franchise agreement, including an unspecified cooling-off period.

And finally, the Regulation sets certain standards for the relationship, such as requiring the franchisor’s approval for the transfer of locations and requiring the franchisee to protect the franchisor’s commercial secrets.

The Regulation will make it easier for foreign firms to enter the China market, but the greater concern will continue to be not the laws and the courts, but the lack of more developed “rule of law” culture, or as the State Council calls it, the “chaotic market conditions” (市场秩序较为混乱).

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