Setting up a Franchise in China: Key Legal & Regulatory Issues to Consider

by Reking Chen

Subway recently signed a deal that is expected to result in the opening of 4,000 new restaurants in China over the next two decades. The deal is a master franchise arrangement with its franchisee, Shanghai Fu-Rui-Shi Corporate Development Co., Ltd., who will have the exclusive rights to manage and develop all of Subway’s restaurants in China. This deal is not just the largest in Subway’s history – it is potentially one of the largest the food & beverage industry has ever seen.

With over 1.4 billion people and many high-profile deals, China certainly appears promising for franchises. However, success in this market is far from guaranteed, as many brands have learned. In addition to cultural differences and competition from local competitors, potential franchisors must navigate the legal and regulatory landscape as well. In this article, we will address some of the key legal issues to consider when setting up a franchise in China, with an emphasis on master franchise agreements.

I. Key Franchise Provisions Under Chinese Law

The definition of a franchise is somewhat broad under Chinese law. As defined by the Commercial Franchise Administration Regulations Ordinance No. 485 of 31 January 2007, a franchise must contain the following three elements:

1. The franchisor, through an agreement, grants other operators (i.e., franchisees) the right to use the franchisor’s business-operating resources, including registered trademarks, logos, patents, and proprietary technologies.
2. The franchisees conduct business under a uniform mode of operation.
3. The franchisees pay franchise fees to the franchisor according to the agreement.

Other significant regulations related to franchise setup in China include:

• the Commercial Franchise Record Filing Administrative Measures, Ministry of Commerce Decree No. 5 of 2011; and
• the Commercial Franchise Information Disclosure Administrative Measures, Decree No. 2 of 2012.
  
  

II. Basic Requirements for Franchises in China

To set up a franchise, franchisors must comply with the following requirements:

1. First, only enterprises can engage in business as franchisors. The enterprise should have a mature business model and the ability to provide franchisees with continuous business guidance, technical support, and business training.
2. Second, the franchisor should comply with the “2+1” rule (discussed further below), which essentially means that it must operate at least two directly owned outlets for more than one year before it may set up a franchise in China.
3. Third, franchisors in China are subject to a national network-based filing system. This requires the franchisor to:

a) file certain information about the franchise with the competent commercial authorities within 15 days after signing the first franchise agreement with its franchisee;

b) report operational results to the competent commercial authorities on an annual basis; and

c) report material updates about the franchise business on an ongoing basis.

Finally, franchisors are also required to disclose certain information to prospective franchisees in writing in the form of a Franchise Disclosure Document (“FDD”) at least 30 days before the signing of the franchise agreement. Failure to complete and provide the FDD could give rise to a claim by the franchisee for termination or rescission of the agreement, and in certain cases monetary damages.

III. What is a Master Franchise Agreement?

Put simply, a master franchise agreement is a key component of a franchise model where a party that wishes to franchise its business concept/brand (“Master Franchisor”) bundles and grants a package of rights and resources (“System”) to another party that wishes to establish business units mirroring that of the Master Franchisor and develop the market (“Master Franchisee”). Usually, these rights are granted for a specific territory, and include the right to open and operate franchised units, as well as the right to sub-franchise the System to third parties who can open and operate units using the same business model and business resources.

This is one of the most popular franchise models for international businesses seeking to expand in China. This model allows a Master Franchisor to delegate the work of setting up and operating franchise units to a Master Franchisee who has clear advantages in navigating the various regulatory complexities and cultural differences that exist within the Chinese market, and who is often better suited to deal with staffing, supply chain, and management issues. In short, a reliable Master Franchisee can prevent the headaches – and in some cases, the potential regulatory issues – a Master Franchisor may otherwise face when seeking to increase its China presence on a large scale. McDonald’s is perhaps the most famous example of a master franchise arrangement in China. Papa John’s also has two master franchisees in China: one covering the northern portion of the country and another covering the south.

Of course, not all franchise models use master franchise agreements. But they are especially popular among companies looking to dramatically increase their presence in new markets, as the Master Franchisee (usually a well-established local partner) is often better suited to formulate a strategy and address local market conditions than the Master Franchisor. In practice, a Master Franchisee will normally be required to first open and successfully operate a number of pilot units in the territory before being permitted to sub-franchise to others.

IV. Risks Associated with Master Franchise Agreements

Although master franchise agreements offer several benefits for companies looking to expand rapidly, they also pose several risks, including:

1. The inability to directly supervise the sub-franchisees on the ground, which can lead to quality control issues and other problems.
2. Disputes that may arise when it comes to terminating master franchise agreements, particularly if the business is unsuccessful.
3. The Master Franchisor’s total dependence on the Master Franchisee for success in the market. In fact, it is not uncommon for a Master Franchisee to walk away from an agreement and start a competing business once it has accumulated the experience, know-how, supply chain, network, and knowledge from its relationship with the Master Franchisor. This is possibly the main risk to any potential Master Franchisor.

Master franchise agreements, by their very nature, tend to stake the company’s success on a single partner. Thus, finding a suitable Master Franchisee is paramount to preventing the entire arrangement from failing and damaging the entire brand’s reputation. Furthermore, it is vital that the master franchise agreements are properly drafted and that they provide adequate protection to the Master Franchisor.

V. Other Common Franchise Arrangements in China

In addition to master franchise arrangements, the following approaches are also common in China:

1. Single-Unit Franchise Arrangement: In this arrangement, the franchisor grants a franchisee the right to open a single unit. While this is likely the quickest and most flexible option for setting up franchised business units, it does not easily allow for the kind of rapid growth that a master franchise arrangement does and in some cases could result in reduced efficiency and inconsistent quality for the brand (imagine if KFC had to deal with 9,000 different franchisees from outside of China). Some franchisees will want to operate several units, and thus may enter into multi-unit franchise agreements or area development agreements with the franchisor. However, unlike a master franchise arrangement, such agreements may not give franchisees the right to sub-franchise. Single-unit franchise arrangements are more often employed by local Chinese franchisors and franchisors who otherwise have deep rooting in the market, including Haidilao, the most popular hotpot restaurant brand in China.
   
2. WFOE/JV Arrangement: Establishing a Wholly Foreign Owned Enterprise (“WFOE”) or a Joint Venture (“JV”) is a popular alternative for some businesses, because it allows a franchisor to directly supervise the business, expand it in its own image, and potentially better protect its intellectual property. Furthermore, establishing a WFOE or a JV may make the transition into China a smoother and potentially less rushed process, as the business will be able to gradually adapt to the local market. By opening a JV, a foreign franchisor can bring on a Chinese partner with local know-how to help it to better operate the business. KFC used a JV arrangement with an SOE partner to enter China in 1987 and later began offering franchise opportunities. Starbucks previously had JV partnerships for its China operations, and then bought back 100% of its stores in 2017.

There are two common methods for adopting a WFOE/JV arrangement:

• Authorize the WFOE/JV (via a franchise agreement) to open business units in China. Under this arrangement, the Chinese entity opens and operates units on its own, with the flexibility to grant sub-franchises when needed (subject to franchisor/shareholder approval).
• Have the WFOE/JV act as a sub-franchisor, with the authority to grant sub-franchises to franchisees. Here, the Chinese entity’s role is primarily to develop and manage sub-franchisees. Under this method, the WFOE/JV may be able to rely on its foreign parent’s operations to satisfy the “2+1” rule, subject to the discretion of the local commercial authorities.

In addition, some franchisors have chosen to establish a WFOE/JV to help supervise and provide services to the franchisor’s China franchisees who are otherwise engaged through a master franchise arrangement or a single-unit franchise arrangement.

In any event, a WFOE/JV will be subject to regulatory restrictions on foreign investment. In addition, these entities can be somewhat slow and costly to set up compared with single-unit franchise agreements and will have ongoing compliance obligations to meet.

Choosing the most suitable market entry option requires careful consideration and an in-depth analysis of various commercial and regulatory factors. Doing this legwork, however, will significantly increase the chances of a franchise’s success in China.

VI. The “2+1” Rule

As mentioned above, both local and foreign franchisors are required to have operated at least two company-owned units for at least one year before they can set up a franchise in China. Many foreign franchisors, particularly those who do not operate any of their own stores, find this to be the biggest challenge when planning to enter the Chinese market.

If prospective franchisors ignore this rule and enter the market anyways, they may be subject to, among other penalties, orders to adopt rectification measures, fines, asset seizures, and/or having their names publicized on lists of violating entities.

To ensure compliance with the “2+1” rule, franchisors should do the following:

1. First, conduct a comprehensive business review to evaluate whether there are any company-owned units that will satisfy the requirement. These can be operated by the franchisors themselves or their qualified affiliates.
2. Second, if no company-owned units can be utilized, then the franchisor may consider either opening two new units or acquiring two existing units from a franchisee. Once these two units have been operated by the franchisor or its qualified affiliates for more than one year, the franchisor will be deemed to have complied with the “2+1” Rule. In some cases, master franchising arrangements involving an offshore structure can be considered to potentially circumvent the “2+1” rule (i.e., the System is granted at the offshore level to a non-Chinese entity, which then grants the System to one or more China subsidiaries). But such arrangements can be slow to set up, and may be subject to other regulations.

VII. Takeaways & Tips for Potential Franchisors

Franchising in China presents many opportunities and challenges. We suggest businesses to take the following steps when setting up any franchise in China:

1. Conduct adequate research to ensure your brand is a good fit for the China market. This may sound obvious, but many brands have learned hard lessons.
2. As China is a first-to-file country, register the brand’s trademarks and other applicable IP as early as possible. Brands should make plans for registering their social media accounts and domains early as well.
3. Carefully consider the available entry options and develop a strategy.
4. Conduct due diligence on any potential franchisee and consider the type of business model to be launched.
5. Engage local counsel to help assess available options, mitigate risk, and ensure compliance.
6. Ensure that adequate information has been disclosed to prospective franchisees before signing the franchise agreement.
7. Take your time – do not rush the process.
   
   

DaHui’s IP team has rich experience in franchising projects involving restaurants, hotels, theme parks, fitness clubs, training services, and many other types of businesses in the PRC and numerous other jurisdictions. Aside from the topics discussed in this article, there are many other points for franchisors to consider, and our team is available to discuss potential projects and answer any questions.