First identified in December 2019 in Wuhan, the capital of China’s Hubei province, the coronavirus disease 2019 (COVID-19) spread throughout the world within the weeks that followed. The ongoing coronavirus pandemic has created arguably the biggest global health crisis since the Spanish flu pandemic in 1918, as nearly 2 million COVID-19 cases have been confirmed in 210 countries and territories so far. In addition to that, the outbreak has also shaken the fault lines of the global economy, with every country now facing economic upheaval and disruption on an unprecedented scale, and Mainland China is no exception.
I. Covid-19 Impact On China-based Businesses
Things are looking particularly grim for foreign manufacturing businesses operating within Mainland China. Draconian travel restrictions have affected the performance of company networks, and uncertainty regarding taxation policies, employment, business commitments, and contracts have made planning and maintaining compliant and well-performing infrastructures very challenging. On top of that, the costs of operations have also risen dramatically, making it harder for such companies to survive in the Chinese market.
Facing existential risks, many of these affected companies are looking for ways to diversify their production sites and supply chains away from complete reliance on the place that we have known as the manufacturing epicenter of the planet, “The World’s Factory,” for the past 20 years. As foreign business operations in China play an essential part in global value chains, an increasing number of international firms scaling back or leaving China in droves will make it more difficult for China to maintain its position in global value chains. Is there any way to prevent these companies from moving their assembly lines out of China, thus keeping China’s engine of economic growth running? There is.
Franchising remains one of the easiest business models for foreign investors seeking reliability in the Chinese market. It comes with a proven success rate at minimal risk. In the Commercial Franchise Administration Regulations adopted in 2007 by the Ministry of Commerce of the People’s Republic of China (MOFCOM), franchising refers to a business development method by which a franchisor (foreign business owner) through an agreement (franchise contract) grants the franchisee (local business operator) the right to use its business operating resources to distribute its branded products and services under “a uniform mode of operation” in exchange for fees, royalties, or other compensation. The business operating resources in question may include the franchisor’s registered trademarks, corporate logos, patents, know-how or proprietary technology, etc.
III. Regulatory Implications for Franchising
Only enterprises with a mature business model that can provide franchisees with long-term training, support, and marketing programs can engage in business as franchisors. As part of China’s new franchise regulations, foreign companies must also demonstrate compliance with the “2 + 1” rule, that requires the franchisor to own and operate at least two direct-owned outlets for at least one year before it can grant a franchise in China. These outlets do not necessarily need to be in China, but they must be operated under the franchised brand.
Certain industries, including banking, telecommunications, and compulsory school education, remain closed to foreign investment.
IV. Elements of A Franchise Contract
Franchise agreements must be in writing, signed by both the franchisor and the franchisee as well as a legal representative or a person with a valid power of attorney from the legal representative. It must also include a number of provisions under the franchise regulations, including:
- Basic information of the franchisor and the franchisee;
- 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 operational guidance, technical support, business training, and other services to be provided by the franchisor;
- Quality and standards requirements, as well as guarantee measures, for the products or services offered by the franchised business;
- Allocation of promotion and advertisement of the products or services offered by the franchised 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 of contract;
- Methods of dispute resolution;
- A cooling-off period in which the franchisee may unilaterally terminate the agreement, negotiated by both parties in good faith; and
- Other matters as agreed upon by the franchisor and the franchisee.
V. Franchising Entry Strategies
For foreign franchisors, there are two company structures through which they can enter the Chinese market. One of these is by establishing a privately held limited liability company in China in the form of a wholly foreign-owned enterprise (WFOE) to grant a concession to other Chinese enterprises.
In order to set up a WFOE, foreign franchisors need:
- At least one investor from any country except China, Hong Kong, Macau, and Taiwan;
- At least one executive director or a board of directors;
- At least one legal representative;
- At least one general manager;
- At least one supervisor;
- Registered company address; and
- Business scope or description of the company’s activities within China.
In order to apply for a WFOE, franchisors ought to file their business name in Chinese. There are strict Regulations on Registration and Management of Enterprises Name and the Implementation Measures on Registration and Administration of Enterprise Names that need to be followed before selecting an acceptable name for the Chinese market.
There may also be a request on registered capital, which the WFOE may use to fund its operational activities. According to the Company Law and relevant regulations of Mainland China, apart from the actual costs of registration, there is no legally defined minimum capital requirement. Be that as it may, as attorneys for China ventures, we usually advise foreign investors to open a WFOE with a reasonable registered capital not lower than a certain amount (for example, RMB 500,000.00, depending on the business activities and industries they are in). A reasonable registered capital may help facilitate the process of incorporation and smoothly obtain certificates of registration for the WFOE, such as a business license. In addition to that, there are major tax advantages to using the capital for company operating costs in the early period of operation.
The other way is through cross-border franchising. Cross-border franchising allows franchisors to leverage the resources of the franchisees and do their business in the market, without taking such efforts to establish a presence in Mainland China. And whenever there is an economic quandary, such as the one we are all coming up against at present, the franchisors may simply slacken their business operations or terminate the franchise contract altogether. Sure, foreign businesses in China may suffer some losses because of this, but nearly not as much as they would while setting up a WFOE.
VI. Why is Cross-border franchising the way to go?
Setting up a WFOE in China may be reasonably easy. Still, foreign businesses need to physically operate it in Mainland China under the compliance of relevant laws of the People’s Republic of China. After all, it is a REAL entity owned by foreign investors to do business in the market. The foreign investors shall face the risks in operation besides making a profit by the WFOE. On the other hand, by “cross-border franchising,” international firms may commence their business operations in China without delay by a written franchise contract with selected franchisees, without having a physical presence in the local market. This means that franchisors do not need to be concerned about issues related to taxation, employment, and other compliances in the management of a business entity in Mainland China. Put differently; franchisors could just turn away any time, leaving the franchisees to deal with the issues themselves. Even though it seems a bit harsh to burn the bridges, it is a pragmatic approach to safeguard the interests of foreign investors.
VII. The Record Filing System
Foreign franchisors must register with the MOFCOM’s head office in Beijing, rather than with local MOFCOM departments, within 15 days from the date of the execution of the initial contract with the franchisee. Even though the failure to register is not going to impact the effectiveness of the franchise contract, a franchisor that fails to file their franchise application on time could face a fine ranging from RMB 10,000 to RMB 50,000. The list of documents and materials required for registration with MOFCOM includes:
- The franchise agreement;
- The copy of franchisor’s business license or corporate registration (filing) certificate;
- Franchise operation manuals;
- Marketing plan for the franchised operation;
- Registration certificates for trademarks or copyright (e.g., logo) used in the franchise system; and
- A written undertaking and relevant supporting documents showing that the franchisor meets the requirements of having a mature business model and complying with the “2+1” rule.
- Other documents required by the Regulation.
All of the above-mentioned documents and materials must be translated into Chinese. All certificates or documents that are prepared outside of China 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.
VIII. Due Diligence
Finding, evaluating, and signing a qualified company as the local, regional, or country franchisee is the most important part of franchising. In order to find the right franchisee with the right management skills, business track record, and capital to acquire and properly develop a franchise business, we conduct a background investigation of the prospective franchisees. We may go to Market Supervision Administration and other competent authorities to obtain exact and specific information about a franchisee, such as information about their shareholders, registered capital, management, affiliates, and past litigations or disputes. In addition to that, we also conduct due diligence on different customs and cultures between different regions and ethnic groups in China, so that franchisors may successfully adapt to local markets and maintain competitiveness.
We have been helping franchisors enter and grow in the Chinese market. We can help them find qualified franchisees as well as help them with the documentation.
IPO PANG XINGPU, with headquarters in Shanghai China, we have been helping clients from all over the world with their legal matters since 1992. We are a group of dedicated attorneys and professionals with expertise and experience in a variety of legal disciplines. Clients come to us “When Being Right Matters ®”.