From the archive. This article first appeared on China Law Insider in February 2017. The franchising framework it describes, including the 2+1 rule and disclosure requirements, remains the foundation of PRC franchise regulation.
Franchising American restaurants in China was in the news amid reports that McDonald's sold its mainland China and Hong Kong businesses to a consortium between the state-owned Chinese conglomerate Citic and the American private equity firm Carlyle Group for $2.03 billion. Among the key points of the deal: it gave franchising control to the Citic/Carlyle consortium in the PRC for a period of 20 years. Insider accounts of the negotiations reported that control of future franchising rights was one of the consortium's key areas of interest.
That interest is unsurprising. Franchising foreign, and particularly American, brands in the PRC has been a very successful business model as Chinese consumers' incomes have risen with the country's economic growth. Fast food chains, retail establishments, fashion labels and a host of other industries have flourished. This makes franchising in China a lucrative opportunity, but one that must be approached with caution: foreign companies must tread carefully to comply with China's complicated legal framework for offering franchises, and the market presents unique challenges that would-be franchisors need to understand before entering.
Legal requirements to franchise under PRC law
The key regulations governing franchising in China are the Regulation on the Administration of Commercial Franchises, promulgated by the State Council, and two sets of measures issued by the Ministry of Commerce (MOFCOM): the Administrative Measures for the Registration of Commercial Franchises and the Administrative Measures for Information Disclosure of Commercial Franchises.
Before this regime, franchisors were not permitted to franchise directly from another country into China. Foreigners either had to establish entities in China to carry out the franchising or form joint ventures with Chinese partners holding foreign trading rights, then license those entities to use the franchisor's trademarks and technology. With the current regime, foreign franchisors may franchise directly from abroad into the PRC, subject to several stringent requirements. Only business entities can offer franchising opportunities. The franchisor must have a registered trademark or patent. Most importantly, the franchisor must itself own at least two outlets that have operated for at least one year, a requirement practitioners call the 2+1 rule.
Mandatory disclosures to franchisees
PRC law mandates disclosures that the franchisor must make to potential franchisees at least 30 days before a franchise agreement is signed. The required information includes the identity of the franchisor, its corporate affiliates and shareholders, its business resources, and copies of the franchisor's financial statements and audit reports for the past two years. The franchisor must also disclose the expenses of operating a franchise, the prices of products, services or equipment to be provided, the training and technological support on offer, and the level of guidance and supervision the franchisor will provide.
Significantly, the franchisor must also disclose negative information: any lawsuits or arbitration proceedings relating to franchise operations over the past five years, and records of illegal activities by the franchisor or its legal representatives resulting in criminal penalties or administrative fines above RMB 300,000. Finally, the franchisor must provide the template franchise agreement, any other required contracts, and a model investment budget for a franchise outlet.
Where franchisors stumble
The conditions PRC law places on foreign franchisors carry real consequences. Failing to fulfill the disclosure obligations can draw a MOFCOM fine of up to RMB 50,000, and a franchisee may terminate the franchise agreement if the franchisor provides false information or conceals information that may affect performance. A franchisor that designates a supplier for its franchisees is liable to franchisees for the quality of the products supplied.
Beyond the statute books, the recurring problems are practical. Chief among them is registering the brand name, including in Chinese, when first entering the market. Starbucks found itself litigating over the use of its name in the PRC after entering in 2004 because it had not trademarked the name in China quickly enough. Other brands have struggled by failing to understand local customs or enlist local partners in building supply chains and distribution. Subway has had difficulty replicating its success because Chinese consumers' tastes do not run to cold-cut sandwiches. A franchisor must also study whether its concept will work in cities as different as Urumqi, Shanghai and Beijing, and it must enforce consistency: common training, uniforms and operating procedures across every outlet. A Chicken McNugget in Suzhou has to be cooked the same way, by someone dressed in the same outfit, using the same recipe, as one in Guangzhou.
There is a very bright future in franchising in the PRC, but potential franchisors need to adhere to the letter of the law.
Enter the market with eyes wide open
As Chinese incomes rise, consumers are eager for foreign brands, and the success of McDonald's, Kentucky Fried Chicken and others demonstrates the potential of the franchising model in the PRC. Franchisors who register their trademarks properly, invest in training, find the right local partners in each market they enter, and maintain uniformity across all franchises will be positioned to capture it. The consequences of not doing so can be steep indeed.