Franchising issues in China – the story so far

It has been over seven years since China implemented the Regulations on the Administration of Commercial Franchises, as well as two supporting regulations covering franchisor disclosure and franchisor filing. To date, over 2,000 domestic and foreign franchisors have made a formal franchisor filing with the Ministry of Commerce in accordance with the regulations. In addition, many multinational and domestic companies continue to operate as licensors in China, either because they do not meet the regulation’s filing conditions or because they do not want to comply with its disclosure and filing requirements.

The China Chainstore and Franchise Association estimates that over 3,500 companies are operating in China based on a franchise/licensing business model, with many thousands of units in operation. The franchise/licensing business sector is thus large and growing rapidly. However, this growth has also brought with it many challenges for franchisors to develop and protect their intellectual property, particularly their trademarks. In this article we identify some of the issues that franchisors/licensors face in entering the China market and developing their brands.

The regulations define a ‘commercial franchise’ to mean “business activities whereby a franchisor through executed contracts, allows a franchisee the use of the franchisor’s proprietary operational resources, such as registered trademarks, enterprise logos, patents and know-how, to operate a business under the franchisor’s unified business format in accordance with the provisions of the franchise agreement inclusive of the franchisee paying fees to the franchisor”. This definition applies to both domestic and international franchisors that wish to conduct activities in China. Before the promulgation of the regulations on May 1 2007, foreign franchisors entered the Chinese market through a licensing structure that had all of the characteristics of a franchise structure. Due to currency control restrictions, this structure needed to include a master licence arrangement – sometimes called an ‘international licensing agreement’ – a trademark licensing agreement, a technology licensing agreement (know-how) and a service agreement.

When the regulations came into force, franchisors were at last able to identify themselves as franchisors, provided that they complied with the regulations – although they still needed to have the related agreements in place to facilitate the cross-border payment of royalties. This problem was remedied in September 2013, when China introduced a regulation that allowed for the payment of royalties based on a franchise agreement. The franchise document regime was further streamlined earlier this year with an amendment to the Trademark Law that allowed for a simple filing to serve as evidence of a trademark licence arrangement as opposed to needing to file the licencing agreement.

The basic requirements for a franchisor to enter the Chinese market are as follows:

• All trademarks and patents must be registered (ie, registration must have been completed) in China.
• The franchisor must have a defined operating system that it can support in China (cross-border franchising is permitted).
• The franchisor must provide a disclosure statement (ie, a statement that outlines many aspects of the franchisor’s business and its offer to Chinese franchisees) to a prospective franchisee at least 30 days before it signs the franchise agreement.
• The franchise agreement must cover several mandated legal areas and include a short cooling-off period during which the franchisee can rescind the franchise agreement without penalty.
• The franchisor must make a filing (recordal) with the Ministry of Commerce. As part of this, the franchisor must file a series of documents, including evidence that its core trademarks are filed in China and that it has owned and operated two units under the same brand name that it wants to offer in China for at least one year (the so-called ‘2+1 Rule’).
• The franchisor must make an annual filing with the ministry that is in effect a status report of its franchises in China.

In many cases foreign franchisors set up complicated offshore legal structures to enter the China market, such as a China legal entity (foreign-invested enterprise) that will either act as the franchisor (onshore franchise structure) or support the franchisees based on a cross-border franchise structure. In such situations the franchisor needs to set up a licensing structure for its trademarks to ensure that any marks that it wishes to use in China are properly licensed to the legal entity that will act as the franchisor for its China operations.

This trademark/IP licensing structure must be in place before the franchisor begins its franchising activities in China.

Are sufficient trademark registrations in place?

Strictly speaking, a licensor can license unregistered trademarks to a licensee in China, though unregistered marks are generally not protected. Franchisors often assume that having valid registrations in their home country is sufficient for franchising the same brand in China. It is important that they understand that trademark rights are territorial, which means that a US trademark registration does not guarantee the registrant’s legitimate rights or interests in the same trademark in China. A brand owner’s rights and interests in a mark may not be protected under Chinese laws unless and until such an unregistered mark is recognised as ‘well known’ by a competent authority in a trademark dispute, which normally requires a large amount of evidence to substantiate the significance of the mark’s reputation in China.

In practice, it is extremely rare for a relevant authority or a Chinese court to recognise a well-known mark in China, making it even more unlikely that an unregistered mark will be recognised as well known. Due to the franchising filing requirement discussed above, franchisors must obtain valid trademark registrations (which usually takes between nine and 12 months from the application date) before licensing to the franchisee in China. It is thus crucial that a franchisor understands its trademark portfolio in China before entering the market.

Unlike many other jurisdictions, such as the United States, China adopts the first-to-file principle for trademark filings, meaning that grant of registration does not depend on actual use or intention to use that mark. Anyone – even someone who openly intends to hijack a trademark and then sell it back to the rightful brand owner – can apply to register any trademark in China. Thus, franchisors often find that their trademarks have already been registered in China by hijackers before they even consider entering the market.

It is important that franchisors apply to register their trademarks as early as possible and understand the trademark filing system in China. China divides each international class (pursuant to the Nice Classification) into sub-classes. Goods and services fall into the same class, but different sub-classes are generally regarded as being dissimilar.

This sub-classification system creates additional loopholes for hijackers to register identical or similar trademarks in the same class, but different sub-classes. Generally, it is advisable to register trademarks to cover all sub-classes (ie, at least one item with as vague but broad a term as possible in each sub-class) in the core classes in order to obtain the broadest scope of protection. For franchisors in particular, it is also critical to incorporate the specific franchised items in the trademark filings.

As a matter of good practice, we usually recommend that brand owners file important trademarks in the most relevant classes covering all sub-classes in each important class, and for other relevant or slightly relevant classes covering the most relevant or confusingly similar goods and services.

For example, for hotel chain franchisors, the most important services to be incorporated into the portfolio include accommodation services and restaurant services. Depending on the budget and business model, you may also wish to protect the well-known bakery shop in your hotels by covering closely related products, such as cakes, sweets, coffee and tea, or even the mugs, cutlery and napkins that are used in your restaurants. For defensive purposes, it is also advisable to file trademark applications for less important trademarks in the most relevant classes and similar or variations of trademarks in relevant classes. A strong registration that covers a broad range of core and related goods and services, as well as the particular franchised goods, will be helpful when it comes to enforcing your rights against infringers.

A good Chinese name is another key element for a franchisor’s business development in China. Despite the significance of the brand in English or another original language, the local media and consumers will inevitably embrace a local language version. Devising a good Chinese name is crucial to winning recognition among Chinese consumers. This is particularly true for franchisors that wish to enter the market for the first time. The most common way to devise a Chinese name is to use the translation or transliteration of the brand name in its original language.

However, account also needs to be taken of other factors, including the various meanings of the chosen Chinese characters and the pronunciation of the Chinese name in various dialects (eg, Cantonese or Shanghainese).

Franchisee’s trademark licence

Obtaining proper registrations for your trademarks in China is only the start of your battle to protect your trademark. Another big step is to prepare an appropriate trademark licence agreement tailored to your business plan in China. As well as regular licensing and restrictions, a franchisor should consider establishing practical arrangements and protocols with franchisees against potential third-party infringements from a brand protection perspective.

Practical issues involved in such arrangements include:

• how you and your franchisees will cooperate in collecting and storing evidence with regard to use of the licensed trademarks;
• whether franchisees will be granted standing to initiate administrative raid actions or civil litigation; and
• how you wish to control enforcement actions against trademark infringements in China, including the hiring of attorneys and settlement negotiations.

First, both franchisor and franchisee are advised to establish a good policy on the collection of evidence as to the use and reputation of the franchised trademarks in China. This will be of great help in both trademark prosecution and enforcement proceedings to establish prior rights and interests in the licensed trademarks, which also serves as the basis to claim damages against third-party infringers. Useful evidence and information include:

• your investment in promoting and advertising your products;
• media reports on your promotional events;
• consumer recognition of your products;
• sales records;
• any awards that you or your franchisees have won; and
• any track record of successful actions taken against infringements.

If external PR companies are engaged in promotional events, the franchisor and franchisees should also obtain and preserve records of payments to these, as well as any pictures, videos or news reports on such events.

Keeping and recording such evidence on a regular basis is highly recommended; otherwise, it can be extremely difficult to produce sufficient proof to a tight deadline. For example, if a franchisor files an opposition against a similar trademark filed by a third party, the relevant regulations grant it only three months to collect, organise and submit evidence to support the use and reputation of its prior marks. Given that the franchisor will have no opportunity to file a further review or appeal against an unfavourable opposition decision, it is crucial to be ready to produce sufficient evidence in a timely manner.

In the event of actual infringement, it is also advisable to establish appropriate protocols to share information on third-party infringements in the market. In practice, franchisees – which have people and operations on the ground, as well as a good understanding of the local market – may be in a better position to identify third-party infringements and collect information on the infringers. Franchisors should thus consider encouraging franchisees to actively monitor the market (eg, asking them for timely reports of any suspected infringements and granting them standing to bring enforcement actions against infringers).

Under the relevant laws, a non-exclusive licensee may file suit under an explicit authorisation granted by the trademark registrant. Before deciding whether to let a franchisee gain full control of any trademark dispute on your behalf, you must consider:

• whether it has the resources and ability to enforce its IP rights in China;
• whether the master franchisee is capable and sophisticated enough to understand the value of these IP rights; and
• whether it wishes to take control in any settlement negotiations with third-party infringers (which might become sub-franchisees in exceptional circumstances).

Other issues

Signing the franchise agreement/trademark licensing agreement with your franchisees is only the start of your China business journey. Additional maintenance work must be carried out during the operation of the franchise. In particular, franchisors should have monitoring programmes in place to ensure that franchisees are complying with the licence agreement and using trademarks as directed, and are not applying to register similar trademarks or any combination of your trademarks.

Franchisors also need to keep an eye on the market to see whether consumers have developed any nicknames for their brands or certain products, or whether franchisees have developed any catchy names, slogans or logos while promoting their products. Along with the development of their business, franchisors may need to expand the scope of their trademark registrations to cover more trademarks, combinations of marks/logos or other relevant classes of goods or services.

In addition, franchisors are advised to monitor for infringement in the market to protect franchisees, as well as their own interests in their brands and the business.

Every successful business may face IP infringement to a certain extent in China. Depending on your business model, you may encounter infringements online (eg, a chocolate maker found its brand printed on gift boxes offered online and a hotel chain found a copy-cat hotel promoting itself on a local booking website). For other business models, you may find confusingly similar stores to your brand (eg, a famous fast-food chain found a ‘sister’ chain operating in a third-tier city in China; a popular ice cream brand found a similar ice cream booth using almost an almost identical brand, with only one letter different; and a unique toy shop found a copy-cat shop with the same business model and concept, but different brand). Only if you are aware of infringements can you investigate and devise an action plan. Therefore, it is important for franchisors to gather market intelligence on infringement on a regular basis and to motivate franchisees to participate in intelligence gathering.

Franchising activity in China has come a long way over the past seven years. There is now a firmly established regulatory framework for franchising, most restrictions on foreign investment in those business areas in which the franchise model is commonly used have been eliminated and the enforcement of IP rights has been considerably tightened up.

These developments have not only prompted foreign franchisors to enter the China market in greater numbers, but also assisted in the development of home-grown domestic brands, which are now located in every province in China. With such rapid development of the franchise business sector, as well as the contribution it makes to local consumer spending and its importance to China’s long-term fiscal policy, brand development and protection will be a key focus of both franchisors and regulatory authorities going forward.