Franchising in China: What Foreign Franchisors Should Know When Entering China’s Retail Sector

• Author: Jae Park

1. Introduction

   As the world’s most populous country, China will inevitably become the most lucrative retail market in the world. This notion has drawn myriad of foreign franchises to invest profusely and unceasingly into China, which has and continues to fuel much of China’s retail market growth. However, many foreign franchises sustain substantial losses in China due to their deficient insight of the intricate framework of laws and culture that shape the retail market in the country.

   This paper provides an overview of China’s business, legal, and cultural environment and examines the current framework of China’s franchise laws. Particularly, Part II provides a background of the economic development of China’s retail sector; Part III provides an overview of certain fundamental business, legal, and cultural issues that foreign franchisors should consider when entering China’s retail market; Part IV examines the 2007 Regulations on Administration of Commercial Franchise, highlighting parts of the regulations that may be of concern to foreign franchisors; and Part V provides a prediction for the future trend of the legal environment for franchises in China.

2. The Economic Development and Structure of China’s Retail Sector

   In 2003, local and national Chinese franchise sectors together generated 85 billion U.S. dollars (USD) in sales in China, which was an increase of 40 percent over the prior year. Despite this impressive growth, sales from franchised outlets constituted a mere 2 percent of the retail sales. However, ever since China opened up its retail market to foreign investors, foreign franchises increasingly invested and became involved in China’s retail market, and it is estimated that franchising will account for at least 30 percent of total retail sales in China by 2010. In other words, foreign investments play a major role in the growth of China’s retail franchise market. To understand how foreign franchises fit into the current structure of China’s retail sector, it is important to understand the history of the development of China’s retail sector and the underlying policies that carefully limit and restrict the foreign investment activities in China.

   In the late 1940s, China’s governmental control over the retail sector transitioned from centralized to localized in nature. During this period, the retail sector was highly fragmented due to the deficient transportation infrastructure and lack of nationally organized distribution channels. The Chinese government neglected much of its retail market, focusing on providing only the basic necessities of life because the government’s priority was to expand the heavy industry sector. Thus, shortages of even the most basic consumer goods, such as clothing and food, were prevalent until the late 1970s.

   In late 1970s, China experienced an economic inflection point when Deng Xiaoping introduced liberal economic reforms that allowed a number of China’s provinces to engage in foreign trade autonomy. Chinese export rates rose from 6 percent per year in the 1980s to 6 percent per year between 2000 and 2003, which was seven times higher than the world’s growth rate. In dollar amounts, China’s exports amounted to 148 billion USD in 1995 and 762 billion USD in 2005 with a 200 billion USD trade surplus with the United States. Furthermore, foreign direct investments (FDI) soared to over 1 billion USD per week in 2007.

   Despite the huge influx of foreign investments, foreign participation hardly existed in the Chinese retail market during the early period of the economic reform. It was only during the last fifteen years that the Chinese retail market opened up for foreign franchises. In 1992, China first opened its retail sector to foreign investors through the promulgation of equity joint venture regulations limited to certain special economic zones. Among the first to jump on this opportunity was the French retail giant, Carrefour. But, Carrefour and other foreign retail giants in similar situations faced regulatory roadblocks making the operational environment very difficult. The situation, however, improved dramatically after China had joined the World Trade Organization (WTO) in 2001.

   From 2001 to 2006, China’s total retail market grew 157 percent–or translated in current terms, to 4.16 trillion Renminbi (RMB)–representing an annual growth rate of 19.7 percent. In 2007, the total retail sale of consumer goods in China was 7.7 trillion RMB–representing a growth rate of 17 percent compared to 2006. It is estimated that China is home to more than 230 million middle-income consumers and approximately 415 million consumers under the age of twenty-one. These numbers indicate the existence of a strong middleclass base and the rapid gain of affluence in China’s population.

   Much of the economic boom was due to the recent development of foreign investment laws. As more laws passed to protect their rights, more foreign investors were willing to enter the Chinese market. In practice, however, foreign investors still suffered from the government’s inconsistent enforcement and application of such vague laws. Thus, it is vital that foreign investors entering the Chinese market work diligently beforehand to understand China’s legal and business environment. For many reasons, this can be a daunting task. The next section provides an overview of issues that a foreign investor ought to consider, followed by an in-depth discussion of the recently promulgated franchise regulations.

3. Overview Considerations

   1. Foreign Invested Enterprise Types

      If foreign investors decide to set up a foreign invested enterprise (FIE) in China to engage in franchising activities, they should carefully evaluate their needs and goals before choosing the type of enterprise. The three main types of entities are: (1) wholly foreign-owned enterprise (WFOE), (2) equity joint venture (EJV), and (3) contractual joint venture (CJV).

      1. Wholly Foreign-Owned Enterprise

         A WFOE is by far the most popular investment vehicle for foreign investors in terms of contracts signed and projects developed. In 2000, the number of signed contracts and the value of contracted investments were over 40 percent and 70 percent more, respectively, in WFOEs than joint ventures (JVs). While the approval process for WFOEs is stricter than JVs, the benefits of WFOEs far outweigh the time and costs of obtaining approval. WFOEs are typically formed as limited liability companies and are entirely owned by foreign investors. Thus, the main advantage of a WFOE is that foreign investors have full management control over the company, and the foreign investors do not have to share valuable confidential information with any Chinese partners. Further, because WFOEs are “legal persons” under the 1986 Chinese Civil Law, they may possess the “corporate characteristics of continuity of life, centralization of management, and … transferability of interests.”

         But, this comes with limitations and restrictions. For example, the relevant Chinese authorities must approve important changes or decisions in WFOEs, such as, mergers. Also, the Chinese government heavily discourages or bars WFOEs from entering certain sectors, for example, transport facilities, public utilities, real estate, leasing and trust investment, newspapers, publishing, broadcasting, television or films, domestic commerce, foreign trade or insurance, postal services and telecommunications sectors. Thus, foreign franchises that are interested in entering China should take extra caution if their businesses are related to those restricted ones above, because...