A draft regulation on commercial franchising is expected to give a clear legal definition of shops bearing the names of international retailer brands dotting China's numerous commercial districts and shopping malls.

The regulation will be promulgated within this year, according to an official from the Ministry of Commerce, who declined to be named.

Taking a walk down the streets of any major Chinese city will confirm that international restaurant chains, foreign retailers and other brand name service companies have entered the China market in large numbers. McDonald's has more than 560 outlets in China now, and KFC has 1,000.

What is not immediately clear is the legal structure behind this profusion of shops.

Many of these international brands normally do business through franchising, and the natural inference may be that they have done the same in China.

The fact is that foreign franchising in China is still a grey area. Because of legal and practical difficulties, relatively few major international companies have a significant franchise business in China yet. Most actually own their own stores, often through a joint venture with a local Chinese partner.

But the draft regulations for franchising that are to replace the 1997 measures concerning the administration of commercial franchising, are set to define rules more clearly for foreign brands operating franchise businesses in China, according to the Ministry of Commerce official.

Franchise operation is not open to foreign investment, the official said. The 1997 trial measures for the administration of franchise operation promulgated by the former Ministry of Internal Trade were only applicable to domestic enterprises and not foreign-invested enterprises.

Foreign brands all entered the mainland market in the name of processing trade and domestic sales rather than as commercial franchises, the official said.

In fact, some have interpreted an article in the 1997 version as allowing participation by international franchisors and their affiliated companies in China. Article 3 provides that the franchise regulations apply to "enterprises, individuals, and other economic organizations which engage in commercial (including food, beverage and service industry) franchise business activities within the boundaries of the People's Republic of China."

Practically, however, direct franchising by foreign franchisors to Chinese investors is not subject to the jurisdiction of the franchise regulations, the official said.

The lack of specific provisions governing foreign direct franchising not only makes foreign franchisors hesitant to invest in China, but also exposes Chinese franchisees to potential risks from franchisors' delinquency, he admitted.

Therefore, the government has decided that foreign direct franchise arrangements be explicitly governed by the draft, he said.

One article in the new draft covering foreign invested enterprises or foreign companies requires them to submit an application to the Ministry of Commerce for approval, he said.

Domestic enterprises engaging in franchise activities only need to submit their signed franchise agreement to the authority for the record 15 days after signing the agreement. No prior approval is required for domestic enterprises engaging in franchising.

But articles involving foreign franchising are still under further discussion, which has contributed to the delay in announcing the regulation, he said.

Officials had previously said they expected new franchising rules to be finalized in 2002, and again in 2003.

"This time it is true that the regulation will be out by the end of this year since China has promised to open franchising three years following its WTO accession," the official said.

Besides the WTO requirement, government recognition of franchising has changed, said Li Xihua, a professor from the China Commercial Study Center.

At government policy level, franchising has not received the same favorable treatment accorded to direct foreign investment. Because franchising typically does not involve investing in equity, the Chinese Government generally sees no reason to grant incentives to this type of business, Li said.

Franchising allows for rapid expansion into a vast market with relatively little capital by attracting the capital contribution of the franchisee, rather than solely relying on the resources of the franchisor.

"But the government came to find that franchise is a good business mode for China, to solve its job problem and its scattered private capital," he said.

China is too large and diverse to serve with a single, top-down management command structure. Franchising allows flexibility and the dispersal of operating control to the local level. Li said this was necessary to service such a vast market.

China's capital markets are underdeveloped and franchising allows the assembly of capital from a wide base through franchisee investment, he said.

By linking the investment to complete training within a well-tested operating system, franchising makes up for the commercial inexperience of the franchisee. This is particularly important in China where prior market-related expertise is often wholly lacking, Li said. The franchisee is able to avoid the pitfalls that usually cause 80 percent of start-up small businesses to fail in most market economies.

Domestic franchising is now well accepted in China and there are an increasing number of qualified potential Chinese franchisees with strong sources of funding, Li said.

There are more than 800 franchisees in the country, operating 7,000 outlets. The infant industry is growing at a rate of 40 percent. But it is also witnessing growing irregularities, according to Li.

Chinese policymakers recognized that foreign franchisors could be an important source of high quality management know-how, and a means to raise the overall level of the industry, Li said.

In the interim, many international franchisors have made tentative steps in gaining a toehold in the market. This is exemplified by the presence of McDonalds and KFC outlets, and more recent entrants such as Subway, Kenny Rogers Roasters, A&W and Hard Rock Cafe. Albeit these are often outside a true franchise format.

Steps to catch up with the demand for better regulations on franchise arrangements will be a boost to the industry, Li said, though things may not be changing as quickly as some foreign franchise companies may like.

Legal experts, however, said concerns about intellectual property rights protection for franchisors should be solved before franchise businesses thrive in China.

Problems may emerge after a franchisor terminates the relationship with the franchisee: the franchisee could continue using the franchisor's proprietary trademark by registering the trademark for its own business, offering similar services or products, said Miao Qing, a lawyer from the Beijing-based China Trademark and Patent Law Firm.

This can occur because China has two separate systems for the registration of trademarks and trade names, Miao said. Trademark registration with the China Trademark Office (TMO) is valid across the whole country. Trade name registration, however, is with different levels of business registry offices and applies only to the jurisdiction of the local registry office.

Miao said most foreign franchisors also worried that their technology and way of operation might be illegally used in China.

The official from the ministry said this is a big concern for the draft regulation. The draft may add weight to the protection of franchisors' rights, he said. In foreign countries, similar laws often give partiality to the weaker franchisees.

(China Daily June 14, 2004)