A look at the franchise business

The franchise business model was introduced into the PRC in the late 1980s, bringing revolutionary change to the commodity circulation system and offering the possibility of rapid growth.

Legal characteristics

In a franchise business, a franchisor grants to a franchisee, by means of a franchise contract, the right to use its registered trademark, corporate logo, patents, know-how and other business resources. The franchisee carries on business according to the standard business model of the franchisor, and pays the franchisor a franchise fee in accordance with the franchise contract.

The franchise business can be divided into (i) direct and (ii) indirect (or regional) franchising. Direct franchising means that a franchisor grants an applicant a franchise, and the franchisee sets up a franchise network to carry on business in accordance with the franchise contract, but is not allowed to sublicense others to deal in the franchised products. Indirect franchising means that a franchisor grants a franchisee an exclusive franchise in a designated area, and the franchisee may sublicense to other franchisees, or set up its own franchise network to do business in the designated area.

From the above, we can see that the franchise business has the following legal characteristics: a franchisor possesses independent intellectual property rights and other relevant qualifications, which are the preconditions for the franchisor to enter into a franchise contract with a franchisee; the core of the franchise business is the grant of a franchise which may comprise registered trademarks, corporate logos, patents, know-how and other business resources; and the franchisee is required to possess certain external characteristics in common with those of the franchisor in order to operate the franchise business. This means that terms must be incorporated into a franchise contract in order to establish a “standard business model”; and the franchisee must pay the franchisor a franchise fee accordingly.

Current franchise legislation

Rapid development of an applicable legal regime only began in 1997, and can be roughly divided into three stages:

1. Initial steps (1987-1997)

The franchise concept was first seen in China with KFC moving into the market in 1987. This was followed by extensive market and brand expansion programmes by Chinese enterprises (including the iconic enterprise Li Ning). By 1997, a number of Chinese ministries and commissions had promulgated rules and regulations concerning the franchise business, among which was the Commercial Franchise Operation Tentative Measures published by the then Ministry of Internal Trade, suggesting that the legitimacy of the franchise business model was approved by the government.

2. Development of the legal regime (1998 – 2004)

The number of franchise enterprises operating in China jumped from less than 500 in early 1998 to more than 1,900 in 2004. Significant progress was also made in franchise legislation. Between 1999 and 2003, a number of government departments promulgated franchise-related rules and regulations.

The Ministry of Commerce issued the new version of the Commercial Franchise Operations Measures on 31 December 2004, which contained more detailed provisions for the franchise business model than before.

3. Improvement (2005-present)

Since 2005, further legislation has been passed. The State Council approved the promulgation of the Commercial Franchise Operations Regulations on 6 February 2007, pursuant to which the Ministry of Commerce published a set of implementing rules, namely the Information Disclosures by Commercial Franchise Operations Measures and the Filing by Commercial Franchise Operations Measures on 6 April 2007.

Analysis of legal issues

The following legal issues in the franchise business are worthy of our attention:

Access to the franchise market

A franchisor must have the following: an independent corporate capacity; a well-developed business model; the capacity to provide franchisees with operational guidance, technical support, business training and other services on an ongoing basis; and at least two directly operated stores which have been operating for more than one year. A franchisee must be a legally qualified legal person or a natural person; it must have the necessary business resources; and it must have relevant business management abilities.

Franchise contracts

After a franchisor and a franchisee have agreed on a franchise business, they must enter into a written franchise contract to specify their respective rights and obligations. In addition to the basic terms of a contract, the franchise contract must contain, among others, the following terms: franchise business items, duration of the franchise business and the area where the franchise business is to operate; type, amount and methods of payment of franchise fees such as joining fees, royalty fees and deposit-specific details, and methods of delivery of operational guidance, technical support, training and other services; the quality, standard requirements and warranty measures of the products or services; the promotion and advertising of the products or services; the protection of consumer rights and indemnification against liability; and confidentiality clauses.

Filing and reporting

The franchisor must file the franchise contract with the competent department of commerce within 15 days after the contract is initially executed. The franchisor is required to report to the department of commerce, in the first quarter of each year, details of franchise contracts entered into in the previous year.

Information disclosure obligations of franchisor

The franchisor must, at least 30 days prior to the execution of the franchise contract, provide the franchisee, in written form, with the information stipulated in the Regulations and a copy of the franchise contract. The information so provided must be true, accurate and complete. The franchisor must not withhold any relevant information or provide false information.

Harry He is a partner of AllBright Law Offices. His main practice areas are foreign direct investment, M&A and labour disputes.