Franchise agreements

Common features and contractual requirements

What are the common elements of franchise agreements in your jurisdiction? Do any requirements or restrictions on contractual provisions apply?

Franchise agreements must be in writing and must include a number of provisions under the franchise regulations, including:

  • the nature of the franchise business;
  • the term of the agreement;
  • the type, amount and payment method for franchise fees;
  • standards of operation for the franchised business, including the technical support and training to be provided by the franchisor;
  • the quality standards for the products or services;
  • allocation of responsibility for the promotion and advertising of the business; 
  • allocation of responsibilities and liabilities for the protection of consumer rights;
  • provisions regarding amendment, cancellation and termination of the franchise agreement;
  • default provisions and liability for breach; and
  • dispute settlement mechanisms.

Further, franchise agreements must contain a cooling-off period in which the franchisee may unilaterally terminate the agreement. The length of the cooling-off period is not prescribed by the franchise regulations and should be negotiated by the parties in good faith.

International franchisors should follow certain formalities of executing a contract in the People’s Republic of China (PRC)  to ensure that it can be enforced against the franchisee. The franchisee’s official name in Chinese must be used. Neither companies nor individuals in China have official English names. As pinyin (ie, English) versions of names are not reversible into Chinese characters, it is impossible to identify a company or individual by their English name alone. If the franchisee is a legal entity, the contract must be signed by 法定代表人 (often translated as ‘a legal representative’ or a person with a valid power of attorney from the legal representative. The contract must be sealed with the company’s official seal and parties should initial each page of the document.

Are parties to a franchise agreement subject to an implied or explicit duty of good faith?

Yes, the law in the PRC is based on the principle of good faith in negotiating and performing contracts, which is the opposite of the common law doctrine of caveat emptor(‘buyer beware’). Article 4 of the General Principles of the Civil Law, Article 6 of the Contract Law and Article 4 of the franchise regulations require the parties to act fairly, honestly and in good faith.

Are franchise agreements subject to any formal or documentary requirements, including registration?

There is no requirement to register a franchise agreement or franchise disclosure document; however, franchisors should register with the Ministry of Commerce (MOFCOM) within 15 days of the first franchise agreement being signed.  The list of documents required for registration with MOFCOM includes:

  • franchisor’s standard form of franchise agreement;
  • the franchise agreement signed with the first franchisee in China;
  • the corporate registration certificate;
  • registration certificates for trademarks or copyright (eg, logo) used in the franchise system; and
  • evidence of compliance with the 2+1 Rule.

All franchisors in China must have a mature business model and demonstrate compliance with the requirements of Article 7 of the franchise regulations. Article 7(2) of the franchise regulations (the 2+1 Rule) requires that a franchisor must have owned and operated at least two outlets for at least a year. According to the practice developed by MOFCOM officials, the outlets may be owned and operated by the franchisor’s subsidiaries or, in some cases, other affiliates; the outlets may also be located outside China if they are operated under the same franchise brand. If the outlets are located outside China, franchisors may use statements issued by trade organisations (eg, the International Franchise Association) to show compliance with the 2+1 Rule. Chinese courts generally agree that it is possible to have a mature system without complying with the 2+1 Rule, which in practice means that the franchise agreement will be valid (assuming non-compliance with the 2+1 Rule is properly disclosed), but registering with MOFCOM will be problematic.

All documents must be translated into Chinese. Documents that are prepared abroad must be notarised and either legalised at the Chinese embassy in the country of origin or certified according to the Hague Convention on Abolishing the Requirement of Legalisation for Foreign Public Documents.

International franchisors should register with MOFCOM’s head office in Beijing, rather than with local MOFCOM departments. The franchisor should register any changes in the information submitted to MOFCOM within 30 days.

Trademark licence agreements should be registered against the respective trademark registration with the China Trademark Office.

Due diligence

What due diligence should both parties undertake before entering into a franchising agreement?

Conducting due diligence on a prospective franchisee is an essential step in a franchise transaction in China. In major urban centres, a lot of information about a corporation can be obtained online (in Chinese), including:

  • shareholders;
  • registered capital;
  • management;
  • affiliates; and
  • past litigation.

At the very least, a franchisor should start by obtaining a copy of the individual’s passport or identity card. If the prospective franchisee is a PRC company, the franchisor’s lawyers should obtain a copy of 营业执照 (business licence). Business licences disclose the Chinese character name of the corporation which must be used in the contract – even if the contract is in English – to ensure that the contract may be enforced against the franchisee. The business licence will also disclose the name of 法定代表人 (often translated as ‘the legal representative’, who is the only person who can sign for the company unless he or she issues a power of attorney to another person to sign the agreement.

Pre-contractual disclosure

Are franchisors subject to pre-contractual disclosure requirements? If so, do any exemptions apply? What remedies are available to franchisees in the event of breach of these requirements?

Article 22 of the franchise regulations and Article 5 of the information disclosure measures require the franchisor to disclose certain information to the franchisee in writing at least 30 days before signing the franchise agreement. Information that must be disclosed includes:

  • the franchisor's registered trademarks, business logos, patents, proprietary technology and operational or business format model;
  • the type, amount and payment method for franchise fees, any required security deposits and the conditions and method of refunding a security deposit;
  • the terms and conditions for supplying products, services and equipment by the franchisor;
  • a description of the continuous services to be provided to the franchisee, including operating guidance, technical support and training; 
  • the investment budget for a franchise location;
  • the list of existing franchise outlets within the PRC and an assessment of their business performance (an earnings claim);
  • summaries of the financial statements and audit reports (audited by an accounting firm) for the past two years; and
  • a description of franchisor’s franchise-related lawsuits and arbitrated matters for the past five years, and information about bankruptcies for the past two years.

Article 23 of the franchise regulations prohibits franchisors from concealing any relevant information, even if not specifically listed. Further, Article 42 of the Contract Law prohibits a party from intentionally concealing key facts relating to the making of the contract. These provisions can be interpreted as a requirement to disclose all material facts, even if such information is not listed in the regulations.

Choice of law

May the parties freely choose the governing law of the franchise agreement?

Parties in a foreign-related transaction may select foreign law to govern the franchise agreement; however, parties cannot contract out of the application of the franchise regulations and choosing foreign law is not always recommended.

When choosing governing law and dispute resolution forum, international franchisors should consider where they would need to enforce a judgment or arbitral award. If the franchisee’s or guarantor’s assets are in the PRC, enforcing a foreign judgment may be either difficult or impossible, as China enforces foreign court decisions only if there is a treaty with the respective jurisdiction or if this jurisdiction enforces Chinese judgments. There is currently no such treaty or reciprocity with the United States, Canada, Australia or the United Kingdom – in such cases, litigation in China is a preferred route.

PRC is a party to the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (New York, 1958). While Western companies overwhelmingly prefer arbitration to litigation in Chinese courts, arbitral awards must still be approved by a local court for enforcement – this process is as expensive and time consuming as a trial. Further, certain issues (eg, ownership of a Chinese-registered trademark) are unlikely to be eligible for arbitration. Arbitration tends to be more expensive and time consuming than litigating directly in a Chinese court.

Contrary to popular belief, Chinese courts are efficient and generally friendly to foreign parties. The World Bank Group’s enforcing contracts indicator ranks China fifth in the world for cost and time required to enforce a commercial contract in court and quality of judicial process (for comparison, the United States is ranked 16th, Hong Kong 28th and Canada 114th). Parties litigating in Chinese courts should choose PRC law to govern the franchise agreement in order to avoid costs and delays in adducing evidence of foreign law.

Fees

What fees are typically charged under a franchise agreement?

Fees charged by international franchisors in China may include:

  • royalties;
  • initial franchise fees;
  • development fees;
  • advertising fund fees; and
  • interest on late payments.

The type, amount and method of payment of franchise fees are not prescribed by the franchise regulations and must be negotiated between the parties. However, international franchisors should consider some practical aspects when negotiating franchise fees:

  • Due to foreign currency exchange regulations, weekly or biweekly payments by a local franchisee to an overseas recipient are difficult to administer. For example, a domestic entity needs State Administration for Foreign Exchange approval to purchase foreign currency exceeding the $50,000 annual limit. Chinese payors transferring money overseas must submit certain paperwork to the bank, including a tax authority-issued tax recordal form. Therefore, royalty and other regular payments are usually charged on a monthly or quarterly basis.
  • As English is not commonly spoken in mainland China, adverts targeting Chinese consumers must be in Chinese and adapted to local customs and culture. If an international franchisor charges advertising fund fees, a separate fund for Chinese advertising should be considered.
  • If the franchisor charges a pre-contractual deposit, the purpose of this payment and conditions of refund (if the deposit is refundable) must be evidenced in writing.
  • Chinese parties are rarely comfortable providing personal guarantees. Instead, domestic franchisors charge a security deposit, which may be returned to the franchisee on the expiration of the franchise agreement if the franchisee complied with the obligations under the agreement.

Renewal

Do franchisees have a right of renewal?

There is no prescribed right of renewal. The minimum term of the franchise agreement is three years (unless the franchisee agrees to a shorter term); many domestic franchise agreements in China have a term of three to five years.

On what grounds may a franchisor refuse to renew?

A franchisor is not obliged to comply with a request for renewal.

How are renewals of franchise agreements usually effected? Do any formal or substantive requirements apply?

Renewal of the franchise agreement must be evidenced in writing. A new disclosure is not required if the franchise agreement is renewed on the same terms and conditions. Renewal of a trademark licence must be recorded with the China Trademark Office.

Termination

On what grounds may a franchisor terminate a franchise agreement? Are any remedies available to franchisees in this regard?

The grounds for terminating a franchise agreement must be set out in the franchise agreement. Except for the cooling-off period set out in Article 12 of the franchise regulations, there are no prescribed grounds of termination. However, any termination provisions of the franchise agreement must comply with the duty of good faith and Chapter VI of the Contract Law. 

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