Rouse
Yihong Ying
yying@iprights.com

China introduced new franchising regulations in 2007, which brought in stricter rules for franchising arrangements. However, the new law did not draw a clear line between franchises and other business models, such as trade mark licensing, as illustrated in a recent case.

Franchising regulations
On January 31 2007 the State Council introduced new franchising regulations, which significantly changed the legal landscape for commercial franchising in China. The Regulations on the Administration of Commercial Franchises (商业特许经营管理条例 )provided franchisors and franchisees with a guide to their rights and obligations and were an important step in the right direction. But the blurred distinction and differing enforcement regimes between trade mark licensing and commercial franchising may create some legal risk for brand owners.

The new franchising regulations specify that while the franchisor must have more than one franchised outlet to be covered by the regulations, only one needs to be in mainland China. They also have recordal and information disclosure requirements, and give the franchisee the unilateral right to terminate a franchise agreement within a certain time period. Overall, they appear to impose greater burdens and risks on the franchisor than the franchisee. In turn, it would seem natural for a trade mark owner to try to use a different business model to avoid these stricter obligations if possible. For example, these requirements do not apply to mere trade mark licences.

However, a trade mark licensor in China faces the risk that their trade mark licence is deemed to be a franchise, forcing them to bear the heavier obligations of a franchisor.

The Congming Beibei Case
In the 2009 case of Beijing Kutedidai Trading Company Limited ( KTDD) v. Chen Zijian, the Court had to decide whether a so-called Distribution Contract constituted a franchise arrangement. The licensor, KTDD, and licensee, Chen Zijian, entered into a Congming Beibei (brand) Distribution Cooperation Contract (the Contract), in which:

• KTDD granted Chen Zijian the rights to set up a supermarket with the name Congming Beibei and to distribute Congming Beibei branded goods;

• KTDD kept the trade mark Congming Beibei, and was entitled to supervise Chen Zijian;

• Chen Zijian had the right to use the Congming Beibei brand, and to manage the Congming Beibei supermarket in accordance with KTDD’s management methods and standards.

Chen Zijian claimed that KTDD had not fulfilled its disclosure obligations under a franchising arrangement, and purported to terminate the Contract.

The Court found that although the Contract was called a Distribution Contract, its nature was a franchise contract and could be terminated due to KTDD’s failure to disclose the relevant information.

It can be seen that the Court may rely on the content of a contract to decide its nature. Further, the judgment said the core of the Contract was the grant by KTDD to Chen Zijian of the right to use the business resources of the Cong Mei Bei Bei brand under a unified business format; thus the Contract fitted the features of a franchise.

While the judgment clarifies the definition of a franchise agreement, the distinctions between franchise and other business models remain uncertain.

Trade mark licensing and franchising: similar features, different obligations
In view of the above case, it is important to identify the distinctions between franchising and other business models, particularly trade mark licences.

Most trade mark licences and simple product distributorships or dealerships are not franchises as defined by the franchise regulations. But they share several key features, such as the licensee’s right to use a trade mark/ brand name and their obligation to follow set quality control standards and to pay royalties. Both licensees and franchisees benefit greatly from their association with an established name, and trade mark licensing is a key component in most franchising arrangements. However, there is still no bright-line legal distinction between them.

Article 3 of the franchising regulations defines commercial franchising as:

business activities whereby the franchisor, … allows the franchisee the use of the operational resources such as registered trade marks, enterprise logos, patents, know-how, …, that the franchisor owns; and the franchisee is required to undertake business according to the unified business format …, and pays a franchising fee to the franchisor.

This definition may still catch some trade mark licences. A possible distinction may lie in the requirement that a franchisee, unlike other trade mark licences, is “required to undertake business according to the unified business format”, presumably of the licensor. However, the situation is uncertain. For instance, trade mark owners wishing to grant a trade mark licence to their distributors, with heavy quality supervision conditions, might come close to a franchise arrangement and may still be in dangerous waters.

A company can grow its brands in China through franchising. However, trade mark owners should be aware of the risks of using that business model here. They should either plan to comply with the franchising regulations or structure their arrangements to avoid them – bearing in mind that the lack of clear legislation and government clarification creates potential legal and practical risks in doing so.