China relaxes “2+1” Store Rule: Changes proposed to Franchise Disclosure and Registration

China is one of the many countries which has franchise specific legislation. In particular China requires:

• Franchise Disclosure and
• Franchise Registration

The Chinese Ministry of Commerce (“MOFCOM”) recently published proposed amendments to the rules dealing with disclosure and registration. The period of public consultation is expired, but it is still unclear when the new administrative rules will come into effect.

A short summary of the most important changes is provided below.

On Registration:

• There have been a number of improvements for Franchisors regarding the “2+1” Rule.
  A major improvement is the acknowledgement that stores operated by an affiliate of the franchisor now count towards the requirement to have two directly operated stores.  The new provision sets out that stores operated by a holding company that has the same business and the same brand as the Chinese franchisor will count as direct stores. It seems that the Chinese legislator has acknowledged that this is the way that most major franchisors are set up. However, it remains to be seen how the term “holding company” is interpreted.
• A welcome change is the clarification that franchisors engaged primarily in on-line or catalogue sales and distance learning are exempted from the “2+1” rule which requires franchisors to show that they had open and in operation at least 2 direct stores for a minimum period of one year before they engaged in franchising in China.
• In respect of the “2+1” requirement another clarification has been included for hotel brands as any hotel managed by the brand will  be considered a “direct store” for the purposes of their franchise activity.

The filing authority is no longer required to complete the filing within 10 days after receipt of a full set of documents. Although this seems to be another draw-back, the reality has shown that franchise filings were almost never completed within the 10 day period and often took considerably longer.

Whereas franchisors involved in cross-border franchising previously filed their application with MOFCOM, the new draft allows MOFCOM to delegate the registration to local offices in each province. This is an unwelcome development for international franchisors as it is now unclear if national franchisors may have to file applications for registration with the local authorities in each province where they wish to franchise.

Photocopies of business licences and trademark certificates may no longer be acceptable when submitting an application for registration.

On disclosure:

The obligation to disclose supplies and services provided by Affiliates has been widened. Effectively the definition of “affiliate” has been expanded to capture a much wider group of people including for example individual shareholders of the franchisor and their family members as well as senior management. If an affiliate owns the trademarks or supplies certain products to the franchisee this needs to be disclosed.

The list of disclosure items has been revised.

• The description of the services to be provided by the franchisor needs to be more detailed now also relates to fit-out, management, marketing and product configuration in addition to location approval and training.
• In respect of the franchise network, the draft specifies that the franchisor needs to provide information about its existing outlets in China. It is hoped that this means that foreign franchisors do not have to provide information regarding their stores outside China.
• The new draft provides that the State Council can request additional information to be disclosed.

A positive development is the new obligation of a potential franchisee to keep a franchisor’s business secrets confidential irrespective of whether a confidentiality agreement was signed. Some franchisors have had bad experiences with prospects who pretended to be interested in a franchise, but were only really interested in the secret know-how of the franchisor. Once this had been disclosed to them, they abandoned the talks with the franchisor and set off to start their own rival business. The new rule also makes it clear that a franchisee has an ongoing duty of confidentiality once a franchise agreement has been signed which will survive the termination of the franchise agreement.

For more information on franchising in China or on the proposed new disclosure and registration rules please contact Mark Abell, Babette Märzheuser Wood or Chris Wormald. If you would like a copy of the translation of the draft new law please send us an email.