Retail market in China is growing very fast. More and more international companies open stores in China, in first-tier cities as well as in second/third-tier.

While most major brands nowadays open directly-owned stores, many SMEs in medium market segments still prefer to rely on local distributors’ resources, network and experience of the local market.

Still, one of their main concerns is how their brand is managed by their PRC distributors. The list of brands whose reputation has been ruined by local distributors’ poor management is long.

That is why, more and more, distribution agreements provide for a tight control of the distributor’s activities by the principal. For example, the latter often pre-approves or provides store concept, the visual merchandising, the advertising campaign, the sales staff uniform, etc.

While increasing the level of details can prevent brand-management problems, this opens the gate to a critical question: is the foreign brand simply providing its products, or is it actually providing a business model that needs to be uniformly and strictly implemented?

The answer has deep legal and practical consequences. In fact, if the foreign brand actually provides a business model, its activity may be re-qualified as franchising rather than mere wholesale distribution.

This may turn out to be a problem, as franchising in PRC is allowed only under specific conditions, failing which foreign players risk heavy sanctions.

Therefore, how can a foreign brand understand whether its distribution activities in China risk to be qualified as franchising?

Franchising – Regulation and sanctions

Franchising is defined by art. 3 of Regulation on the Administration of Commercial Franchises (the “Regulation”), which were promulgated by PRC State Council in 2007, as “… the arrangement whereby a company who owns business resources such as trademark, trade name, patent and know-how, through the execution of a contract, grants a franchisee to conduct business activities with its business resources under a uniform system according to the contract and the franchisee pays franchise fees to the franchisor”.

In an interview released to the press on February 16, 2007, officials from the Legal Department of the State Council  expressed their view that franchising as such consists of four elements:

  1. The franchisor is a company who owns business resources such as trademark, trade name, patent, and know-how;
  2. Franchisee’s use of the business resources is under a uniform system stipulated in the franchising contract;
  3. The relationship between the franchisor and franchisee is contractual; and
  4. The franchisee pays franchise fees to the franchisor.

In order to avoid an abuse of the franchising business model, PRC Law provides entry-requirements for franchisors.

Basically, only entities who comply with the following conditions can operate as franchisors:

  • They shall have a business scope including “franchising” (art. 3, Administrative Measures on the Investment in the Commercial Field by the Foreign Investors of the People's Republic of China effective from 1 June, 2004);
  • It shall own at least two direct stores which have conducted business for more than 1 year (art. 7, Regulation). These shops can also be located abroad .

Within 15 days after having signed a franchise contract, a franchisor shall report it to the commercial administrative department for archival filing (Article 8, Regulation).

This registration can prove a time consuming, as a long list of documents is required (Article 5 of Administrative Measures for Archiving Commercial Franchises):

  • basic information on the commercial franchise;
  • information on all the stores of the franchisee within China;
  • the franchisor's commercial prospectus;
  • one copy of the business license of the enterprise as legal person, or one photocopy of other qualification certificate;
  • copies of registration certificates of trademark right, patent right and other business resources;
  • evidence of 2 directly-owned retail stores operating for more than 1 year;
  • catalogue of franchising operational manual;
  • franchisor's commitment letter signed and sealed by the legal representative.

It normally takes around 4 months to complete the registration.

Franchisors that operate without having the “two shops requirement” can be confiscated of all illegal gains and fined between 100,000 RMB to 500,000 RMB.

Violation of archiving obligation may lead to a fine between 10,000 RMB to 50,000 RMB.

Judicial interpretation concerning commercial franchises

Despite the definition provided by the Regulation, when dealing with extremely complex agreements it may not be crystal-clear distinguishing their nature - franchising or than ordinary distribution.

Interpretation by courts becomes then a very important criterion.

In order to address this issue, in 2011 the High Court of Beijing Municipality issued the Guiding Opinions on Several Issues Concerning the Application of Law in the Trial of Disputes over Commercial Franchise Contracts (hereinafter referred to as “Judicial Interpretation”)3.

Article 1 of the Judicial Interpretation provides for 3 fundamental features of franchise, which include:

  • The franchisor owns a registered trademark, logo, patent or any other business resource;
  • The franchisee uses the franchisor’s business resource under a specific business model upon the franchisor’s authorization; and
  • The franchisee pays franchise fees to the franchisor.

“Business resources” (as defined under article 2 of the Judicial Interpretations) include registered trademarks, logos, patents, names, trade secrets, overall business images with unique features, unregistered trademarks which have been firstly used and formed certain influence, and other business resources that may form certain advantages in market competition.

At the same time, also the Intellectual Property Tribunal of High court of Beijing Municipality issued a report regarding the trial of disputes over commercial franchise.

The report refers to three kinds of contracts: sales contract, license contract and franchise contract.

According to the report, sales contract or license contract only involve sales of products or license of intellectual property rights; supervision, management, training, technology support are excluded.

On the other hand, a franchise contract is defined as the combination of sales of products, intellectual property rights license and uniform business system.

In other words, if the contract does not involve any uniform business system, it should be regarded as license contract or sales contract.

Franchise fees may not be a mandatory element in order to ascertain a franchising scenario, as those could be waived by the franchisor. Thus, if there are no specific provisions about the payment of franchise fee, it shall be deemed that the franchisor has waived such right and this does not affect the qualification of the contract as franchise.

Finally, we can mention the interpretation on franchising - provided by Judge Xie at Guangxi Higher People’s Court – whereby a franchising contract shall contain the following elements to differentiate from other types of contracts:

  1. First, the franchisor licenses patent or know-how to the franchisee and provides necessary trainings to use the technology, instructions on how to manage the business and technical assistance. This is the most important difference from other contracts such as agency, distribution and sales.

Franchising can be structured as “Product + Trademark” or “Product + Business model”. In a typical sales contract, the trademark is attached to each and every product. They constitute an inseparable subject. However, in a “Product + Trademark” type franchising, products and the trademark are separately used.

The purpose of a sales contract is to sell the product while the purpose of a franchising contract is to manage the brand.

  1. Second, a uniform business model is agreed and the franchisor provides follow-up services to the franchisee.

Unification and standardization is another major element of franchising.

A uniform business model reflects for example on:

  • the decoration of the storefront;
  • combination of services and products and the standard;
  • classification of consumers and targeted consumers;
  • the standard to choose the location of the storefront; and
  • basic structure and management system.

Last, typical follow-up services include technical support, business training, distribution and delivery, advertising and publicity, after-sale service, etc.

Remember: it does not matter whether the contract is expressly named “franchising contract” or whether there is a franchising fee clause in the contract. The nature of the contract calls.

Some real cases

Several courts have already expressed their interpretation of “uniform business model”.

In GUANG Yongxiang v. Beijing Te Li Jie Century Green Technology Co., Ltd.,(Beijing Haidian People’s Court) the court verified that Te Li Jie company provided uniforms, name tags, posts, brochures, product manuals, member cards, operation manual, display tables, display shelves and other product promotion supplies.

Therefore, the court qualified the contract between GUANG Yongxiang and Te Li Jie as a franchising contract under the Regulation on the Administration of Commercial Franchises since 1) Te Li Jie grants GUANG Yongxiang to distribute its branded products; and 2) a uniform service image, storefront and the uniforms under the contract; and 3) GUANG Yongxiang pays franchising fees and management fees to Te Li Jie.

Likewise, in ZHANG Linxiang v. Beijing Jiu Lin Chang Shen Investment Consulting Co., Ltd.(Beijing No.1 Intermediate People’s Court), the court found that the contract signed between the parties not only granted a right to use the trademark, trade name and the VIS system owned by Jiu Lin Chang Shen, but also determined the name of the store that ZHANG Linxiang should open and that Jiu Lin Chang Shen should surpervise the business activities conducted by ZHANG Linxiang. That is to say, a business model is stipulated in the contract.

In these cases, the courts considered that the contracts’ content matched the standard content of franchising contracts, as detailed by Article 11 of the Regulation, and, in particular: “… (4) Guidance of management, technical support and training provided; (5) Quality requirements, standard and warranty of the services or goods; (6) Promotion or advertising of the services or goods;…”.

Conclusion

So far, the cases whereby distribution contracts have been re-qualified in franchising are still few. However, changes in China can happen very fast. If the authorities will decide to enforce the regulation and re-qualify the contracts, companies may need to update their business scope in order to include franchising.

To prevent these risks, foreign companies should frankly assess the real nature of their distribution agreements, and organize accordingly their PRC structure.