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Contribution for IBA ANNUAL CONFERENCE Dubai

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Contribution for IBA ANNUAL CONFERENCE Dubai

     IBAANNUAL CONFERENCE

    * * * * *

    INTERNATIONAL FRANCHISING COMMITTEE

    * * * * *

    THE LEGAL REGIME FOR FRANCHISING IN CHINA:

    CIVIL OR ADMINISTRATIVE?

    30 October 4 November 2011

    Dubai

    Jie ZHOU, Partner, Hylands Law Firm

    Beijing, China

1. Overview

    Since 1987 when KFC set up its first store in Beijing, the franchising businesses have achieved a striking progress in China. Statistics show that by the end of 2009, there had been over 4000 franchising 1systems and 330,000 stores active in China. By the end of 2010, the figures had risen to more than 24500 systems and 400,000 stores. The high level and degree of franchising business that took almost 150 years to establish in the United States has taken only around 20 years for China. But, with such progress in this short period of time, immaturity and inexperience (and even outright fraud) in this field of business can at times be seen quite clearly. Accordingly, civil cases in relation to franchising have increased rapidly. According to research made by the IP Department of the Beijing Higher People’s

    Court (BJHPC), in 2008, this court and those under its jurisdiction (including two Intermediate People’s Courts and ten district-level Basic People’s courts, same as below) totally handled 83 cases of

    franchising contract disputes, covering 1.27% of the total number of cases they handled that year. In 2009, the figures went up to 343 and 4.45%, respectively. During the period from January to July, 2010, 3figures became 211 and 3.15 respectively.

2. Dominant Position of Administrative Power

    In China, administrative power plays a major role in the legal system, and, as a result, almost all civil matters are subject to administrative intervention. Entering the search terms “administrative law”,

    “administrative regulations”, “administrative measures” etc. into any China law database, you will surely receive numerous legal documents. Administrative law also covers the area of commercial franchise. All of the following regulations and measures forming the legal structure of commercial franchise, are “administrative”:

     st; the Administrative Measures For Commercial Franchise (Trial) of 1997 (invalid as of 1

    February, 2005 ) ; th; the Administrative Measures For Commercial Franchise of 2005 (invalid as of 29

    January, 2008 ) ;

    ; the Administrative Regulations For Commercial Franchise (May 2007) (“2007

    Regulations”);

    ; the Administrative Measures For Disclosure of Information Related to Commercial

    Franchise (May 2007); and

    ; the Administrative Measures For Recordation of Commercial Franchise (May 2007).

    In China, there are four kinds of laws. The constitution has the highest authority. After the constitution, in decreasing order of authority, comes the statutes legislated by the People’s Congress or its Standing

    Committee, then the administrative regulations as promulgated or approved by the State Council;and

    lastly the departmental regulations as promulgated by the ministries or commissions under the State Council. Additionally, judicial interpretations issued by the Supreme People’s Court (“SPC”) for the application of laws are often seen as possessing the same or greater authority than the administrative regulations.

To date, the highest law governing commercial franchise is the 2007 Regulations. The Shanxi Provincial

    Department of Commerce is so far the only local governmental agency that has promulgated administrative franchise measurers (“Administrative Measures of Shanxi Province for Recordation of

     1 http://finance.ifeng.com/news/special/cxcmzk/20100419/2070485.shtml 2 http://www.linkshop.com.cn/web/archives/2011/165000.shtml 3 http://www.chinaiprlaw.cn/file/2011032318924.html. Authored by Judge Liu Xiaojun, Beijing Higher Peoples Court.

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    Commercial Franchise (Trial)”), which is actually invalid at this point since it contradicts the provisions of Administrative Measures for Recordation of Commercial Franchise promulgated by the Ministry of

    Commerce. It can be seen that local governments rarely directly involve themselves in the legislation of commercial franchise.

3. Judicial Structure of the PRC

    To date, the SPC has not issued any specific judicial interpretation regarding commercial franchise. In the “SPC’s Yearly Report of IP Cases for 2010” (Faban [2011] No. 81, released on April 13, 2011 (“SPC 42010 Report)), there are merely two franchising cases reported (to be detailed below).

    In mainland China, each province, directly-controlled municipality, or autonomous region has a Higher People’s Court (“HPC”) in charge of the case trials within its jurisdiction – and which falls just below the

    authority of the SPC. To date, among the 26 total HPCs nationwide, BJHPC is so far the only HPC which has released Guidelines Regarding Several Issues For the Application of Laws in the Trial of Cases Related to Commercial Franchising Contracts (Jinggaofafa [2011] No. 49, released on February 24, 2011,

    the “Guidelines”). Even though the Guidelines are formally applicable to those cases handled by BJHPC itself and those courts under its jurisdiction, it is commonly viewed that, since BJHPC is one of the most influential and authoritative HPCs in China, the Guidelines shall serve as a model for other regions and even for the SPC to work out a judicial interpretation.

4. Key Points of the Guidelines

As government officials made clear soon after the 2007 Regulations came into effect, franchising is by 5nature a civil, as opposed to administrative, activity. The Guidelines have many positive features, the

    most striking feature of which, is that it sets out some norms for franchising from a civil perspective. That is, having become accustomed to the large role for administrative rules, Chinese people can often confuse civil rules with administrative rules. It is always taken for granted that in the case of a contract in violation of a compulsory administrative rule, the contract becomes null and void. The Guidelines, however, set out some tests for the validity of franchising contracts in different circumstances.

    4.1 “2+1 Rule”

    In Para 2 of Article 7, 2007 Regulations provide that, “[F]or a franchisor to be engaged in

    franchising, it must have at least two directly-operated company-owned stores and have

    operated them for at least one year” (the so-called “2+1 Rule”). The Guidelines provide that 6breach of “2+1 Rule” does not invalidate a franchising contract.

    It is notable that in the SPC 2010 Report, there is a reply from the SPC’s IP Department to

    Guangxi Higher People’s Court, holding that the “2+1 rule” under the 2007 Regulations is by

    nature a “compulsory rule for administration” rather than a “compulsory rule for validity”.

    Therefore, the fact that the “2+1” rule is not satisfied shall not give rise to invalidation of a

    franchising contract. Such a viewpoint is exactly identical to that of BJHPC. We are not sure

     4 http://www.court.gov.cn/xwzx/fyxw/zgrmfyxw/201104/t20110420_19722.htm 5 http://www.moc.gov.cn/zizhan/siju/caiwusi/xueshujiaoliu/200709/t20070920_401233.html 6 Article 8 of the Guidelines---A franchisor engaged in franchising business activities shall have at least two directly-operated company-owned stores and have operated them for at least one year. A franchising contract will not become null and void for the lack of the above-referenced qualification. However, as per the interpretation made by the Department of Circulation

    Industry Development, MOFCOM of the PRC, the so-called directly-operated company-owned store shall be owned by the

    franchisor and conduct the business of the same nature, same brand and same system as the franchisor does for franchising. As far as the concept own is concerned, it shall cover not only the franchisor having 100% ownership, but also the controlling stake in the stores. As such, the directly-operated stores owned by an affiliated company of the franchisor may be deemed as those of the franchisors own. See http://xfgc.mofcom.gov.cn/manager/news.do?method=view&id=1902303 for details.

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    whether it is merely a coincidence or a consensus of the two courts after they have exchanged

    ideas with each other.

    Note, however, that it does not mean an unqualified franchisor may conduct franchising

    business free from any concern or costs. First of all, recordation of its franchising information

    will be rejected, in which case its business creditworthiness and legitimacy for carrying out

    franchising business will be badly doubted by the potential franchisees. Secondly, if it does

    not disclose this fact to the franchisees, the franchising contract will be in great danger of being

    terminated or revoked. Last but not the least, it will be subject to an administrative penalty of

    confiscation of illegal gains and a fine in the amount ranging from RMB100,000 to

    RMB500,000.

    4.2 Eligibility for Franchisors

    In Article 3 Para 2, the 2007 Regulations provide that, “[N]o entity or individual other than an

    enterprise may conduct business as a franchisor”. As per the Guidelines, a franchising contract 7shall be null and void in the event that the franchisor to such contract is not an enterprise.

    In its 2010 Report, the SPC disclosed another reply from its IP Department to Guangxi Higher

    People’s Court, holding that, the provisions of Article 3 Para. 2 are “compulsory rule for

    validity”. That is, any franchising contract concluded with a franchisor who is an individual or

    entity other than an enterprise shall be invalid.

    The SPC, however, requires that in determining the eligibility of valid franchisor, the courts

    shall take the following factors into consideration:

    ; the owner or controller-in-fact of the operational resources;

    ; the content of information recorded with the competent commercial authority;

    ; the actual provider of services (e.g. operation advice, technical assistance and business

    training) to the franchisee;

    ; the signatory to the contract and under what name;

    ; the legal relationship between the signatory and actual owner or controller-in-fact of the

    operational resources.

    Ambiguous as the above factors may be, the SPC has hinted that the franchising contract may still be held valid even though the nominal franchisor is not officially an enterprise. That is, if the nominal franchisor is affiliated with an enterprise who is the owner or controller-in-fact of the operational resources, or, the owner or controller-in-fact of the operational resources actually performs the contractual obligations of the franchisor, the franchising contract shall be valid.

    4.3 Recordation of Franchising Information

    Pursuant to Article 8 of 2007 Regulations, within 15 days from signing its first franchising

    contract, a franchisor shall record some franchising information, e.g. sample contract,

    operational manual and marketing plan etc. with the competent authority of commerce. In

    practice, some franchisors fail to properly go through such formality. It has been debatable

    whether such failure invalidates franchising contracts. The Guidelines specify that failure to

    properly go through the recordation formality generally does not give rise to invalidation of

    franchising contracts. It seems, however, that on very few occasions, such failure may

     7 As per the interpretations made by the Department of Circulation Industry Development, MOFCOM of the PRC, the concept enterprise shall cover all kinds of companies including one-man companies, partnerships, joint stock partnerships and sole proprietorships. See http://xfgc.mofcom.gov.cn/manager/news.do?method=view&id=1902308 for details.

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    invalidate franchising contracts. The detailed tests are still to be clarified.

4.4 Goods or Services Subject to Governmental Approval

    In China, although cut year by year, there are still 500 items of goods or services, e.g.

    automobiles, books, newspaper, magazines, pharmacies and refined oil products etc., whose

    operation are subject to governmental approval. Pursuant to the Guidelines, where a

    franchising involves the goods or services subject to governmental approval, if the

    franchisor or franchisee, as the case may be, enters into a franchising contract for avoidance

    of such legal requirement, such contract shall be null and void. If, however, before the

    disputes arise, the governmental approval or permit is duly granted to the franchisor or

    franchisee, as the case may be, the court may choose not to negate the validity of the

    contract. Obviously, if a franchising involves the goods or services subject to

    governmental approval or permit, both parties shall consider the availability of such

    approval or permit.

     84.5 Stricter Tests for Termination or Revocation of the Franchising Contracts

     (i) Franchisors Concealment or Misrepresentation

     The ambiguous expression e.g. “significant change” and “relevant information” etc. 9in Article 23 of the 2007 Regulations leaves a large amount of room for franchisees to

    take advantage of or even misuse. Some agents and distributors, and even some parties to

    licence or technology transfer agreements, often wish to have the agreement held to be a

    franchise agreement so that they have the benefit of the provisions for rescission, while the

    manufacturers, suppliers and licensors often try to have the agreement defined as something 10else as part of their defence.

    Article 15 of the Guidelines, however, sets out a stricter test for this scenario by providing

    that when determining the fraud of a franchisor, the courts shall take the following factors

    into account:

; the information concealed by the franchisor;

    ; the relevancy to contract objectives of the false information or exaggerated operational

    resources;

    ; the seriousness of the falsity or exaggeration;

    ; the extent to which the false information or exaggerated information influenced the

    execution and performance of the contract.

    If a franchisor conceals, provides or exaggerates the relevant information or availability of operational resources in such a substantial manner as to mislead the franchisee into entering into the contract, the franchisee shall be entitled to request for termination or revocation of the contract.

    (ii) Revocation or Invalidation of Franchisors Operational Resources

    Pursuant to Article 12 of the Guidelines, where the operational resources are revoked

     8 “Termination” in Chinese is pronounced “Jie Chu”, and the term “Revocation” is pronounced Che Xiao. 9 Article 23: “[T]he information provided by the franchisor to the franchisee shall be true, accurate and complete and shall not

    conceal any relevant information, or provide any false information. If there is a significant change in the information provided

    by the franchisor to the franchisee, the franchisor shall promptly inform the franchisee. If a franchisor conceals relevant

    information or provide false information, the franchisee may terminate the franchising contract.” 10 See Franchising and the Courts in China: Interpretations of the Regulations, Authored by Paul Jones, P30, Vol. 15 No. 1

    April 2011, Newsletter of the International Bar Association Legal Practice Division.

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    or declared to be invalid by competent authorities, either the franchisor or the

    franchisee may request a termination of the contract. However, such request shall

    not be affirmed if the request for termination on that ground is made after the

    franchising contract has been completely performed.

    (iii) A Partys Breach of Contract

    Article 13 of the Guidelines provides that the contract may be terminated only if a

    party’s breach of the contract is so serious that the other party cannot achieve its

    “material objectives under the contract,which has been held by the court to mean

    the franchisee making use of the relevant operational resources and operating the

    franchise. In no case, however, shall such “material objectives” include profitability

    for the franchisee unless otherwise provided in the contract.

    (iv) Revocation of A Partys Business License

    Article 17 of the Guidelines provides that during the term of franchise, where one

    party fails to perform its obligations under the contract due to the revocation of its

    business license, the contract may be terminated.

    (v) Cooling Off Period

    The “cooling off period” is a term during which the franchisee has the liberty to

    terminate the contract. Article 18 of the Guidelines provides that such period is

    subject to the contract. If it is silent in the contract, it shall be reasonably fair and

    expire before the franchisee “actually makes use of the (franchisor’s) operational

    resources”.

    5. Several Shortcomings of the Guidelines

    5.1 Some Tests Are Still Ambiguous.

    Article 6 of the Guidelines provides that the validity of a franchising contract is generally not

    affected if it is not in written form. Likewise, Article 7 of the Guidelines provides that failure to properly go through the recordation formality generally does not give rise to invalidation of

    franchising contracts. Further, pursuant to Article 10 of the Guidelines, where the goods or services for franchising are subject to governmental approval, if, after the franchising contract is executed and before the disputes arise, the due governmental approval is granted to the franchisor or franchisee, as the case may be, then, the courts may choose not to negate the

    validity of the contract. The above ambiguous expressions leave a large amount of room and discretion to the judges.

     5.2 Mix-up: Termination or Revocation?

    Article 15 of the Guidelines sets out two options for the franchisees i.e. termination or

    revocation of the contract [w]hen concluding a franchising contract, if the franchisor conceals information, provides false information or exaggerates the information or operational resources substantially related to the franchising and, as a result, the franchisee is misled into the execution of the contract.

But it is notable that under PRC law, the term “revocation of a contract” is totally different

    from “termination of a contract”. In accordance with the PRC Contract Law, the right of revocation is designed for an injured party to abrogate a contract concluded as a result of serious misunderstanding or in an obviously unfair circumstance or concluded by one party against the other party’s true intention by means of fraud, coercion or exploitation of the other party’s unfavorable position. If the franchisor provides false information or exaggerates its operational resources when the franchising contract is concluded, based on the doctrine of

    culpa in contrahendo, such misconduct will be subject to revocation of the contract in

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    accordance with Article 54 of the Contract Law, as opposed to termination. In other words,

    the franchisee is to negate the validity of a contract by revocation instead of stop further

    performance of a valid contract by termination.

     11Likewise, there is another mix-up in Article 16 of the Guidelines, in which case, to the

    contrary of the circumstance under Article 15 thereof, termination instead of revocation of the

    contract shall apply in accordance with Article 94 and 95 of the PRC Contract Law.

    I am of the view that such mix-ups come from the inherent shortcomings of Article 23 of the

    2007 Regulations, which does not differerntiate between pre-contract misconducts and

    post-contract misconducts.

    5.3 Confusion: Breach or Amendment?

    Article 3 of the Guidelines provides that, if the actual performance of a contract is different

    from the provisions thereof, the actual performance shall be deemed as an amendment to the

    contract and, inter alia, a basis upon which the courts determine whether such contract is a

    franchising one or not. In my view, such a provision has some drawbacks. That is, if such

    actual performance is in fact noticed and accepted by the other party, an amendment to the

    contract due to such performance is quite acceptable. However, where the other party objects

    to or dissents from such actual performance, that performance should in fairness be deemed

    nothing other than a breach of contract.

6. Conclusion

    In summary, the Guidelines have set out some civil tests for franchising contracts under the jurisdiction of China. Though not quite clear and definite, it is absolutely a helpful and fruitful try for other courts in China, in particular, the SPC to work out a unified rule.

Bios:

Jie Zhou

Partner

Practice Areas

    Foreign Investment in China, Financial and Foreign Exchange Management, Internet Issues, IT disputes, Franchising contract /disputes, Intellectual Property, Labor and Employment, Tax.

Profile

    Upon graduating from Renmin University in 1992, Zhou Jie joined China Building Materials (Group) Corporation handling foreign direct investment and international economic co-operation matters. He joined Jun He Law Offices in 1994 and joined Beijing Haotian Law Firm at the end of 1998.

    Mr. Zhou is proud of the number of venerable clients he has represented, which include Glencore International AG. (Switzerland), Renaissance Carpets & Tapestries Inc. (USA), Kitz Corporation, Matsushita Electric Industrial Co. Ltd., Sony Corporation, Isuzu Motors Limited (Japan), NHN Co. Ltd. (S. Korea), IMR S.p.A. (Italy), Beijing Bosch & Lamb Eye-care Co., Ltd., and many others. His areas of expertise lie in copyright, trade secrets, trade mark, international and domestic trade disputes, and international investment.

     11 Article 16---“… after concluding a franchising contract, if the franchisor conceals the substantial changes of information or provides false information or exaggerates its operational resources and, as a result, substantially affects the franchise, the franchisee may request for revocation or termination of the contract.”

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Education

    Mr. Zhou graduated from Renmin University of China, receiving an Economics Management Degree and

    Law Degree (major: Intellectual Property) in 1990 and 1992, respectively.

Language

    Mandarin Chinese and English

Contact Details:

    City: Beijing

    Tel: +86 10 52019988

    Fax: +86 10 65610548

    Cell: 013901200414

    E-mail: zhoujie@hylandslaw.com

    www.hylandslaw.com

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