China Law Insight : China Business and Intellectual Property Lawyers & Attorneys : King & Wood Law Firm : IP, Arbitration, Litigation, Securities, Foreign Investment

Without the Measures, the existing Partnership Enterprise Law itself does not allow foreign investors to directly invest in partnerships due to a provision which says such circumstances will be subject to administrative measures to be issued by State Council. Though with such restrictions, international PE/VC firms still appear to prefer using limited partnership as the form of RMB fund, and try the approach of setting up a foreign invested company acting as the general partner and raising fund from domestic investors, which proves practicable in some areas of China. Nonetheless, due to the foreign exchange control in China, a limited partnership cannot receive substantial funding from foreign investors even in such an indirect way.

The Measures generally allow a foreign investor to act as a general partner or limited partner of a limited partnership, but it is still too early for PE/VC firms to celebrate the opening of door. The Measures indicates that for foreign enterprises or individuals setting up partnerships in China with the main business of investment, special laws or regulations in this regard could apply. According to the answers of the Legal Affairs Office of State Council explaining the Measures to journalists, the authorities has not figured out a clear position on partnerships with the main business of investment, such as venture capital enterprises and private equity funds etc., and thus the relevant wording in the Measures is flexible. As a general practice in China, the implementation of the Measures will require detailed rules, which may address this issue further.

The Ministry of Commerce and its local counterparts (“MOC”) has been the main approval authority for foreign invested enterprises for decades, but the Measures take a different approach for foreign invested partnerships (“FIP”). An Application for the establishment of an FIP shall be submitted to the local administration of industry and commerce as authorized by the Sate Administration of Industry and Commerce (“AIC”). MOC will only be notified of the registration information upon the establishment of an FIP. An FIP is still subject to foreign investment industrial policies, including the Foreign Investment Industry Catalogue, and the AIC will review an explanation on compliance with foreign investment industrial policies as part of the application process. We would like to put a question mark on the consistency between AIC and MOC in applying industrial policies to FIPs and other foreign invested enterprises respectively, and speculate that this could trigger the involvement of MOC in approving FIPs.

I. Franchising Trends in China

A. Trend 1: Franchising of Services Derived from Product Trademarks

Generally, franchising is a complete and compact business model that focuses in one particular limited industry area. For example, "Ten Fu' s Tea," is a tea shop where people may taste tea before they buy, but it is not a tea house with tea tasting “services". In franchising, very few companies mix product trademarks with service marks. Mostly, companies prefer to distinguish between the two, for example, IBM was mainly a computing brand, but its after-sale service brand is "Blue Express."

However, franchising in China recently saw the development of a new trend which extends the product trademark to the service sector. In other words, franchising may extend from the manufacturing industry to the service industry. For example, Shanghai Jahwa's mark "HERBORIST" is a trademark for high-end cosmetics that can only be bought in company-owned stores. This limitation on the brand is a clear message to consumers that only company-owned shops sell that product line, and any other channel where the product line is available is not officially authorized. By doing so, the company greatly reduces the possibility of its products being counterfeited and crosses from the manufacturing phase to the retail phase. Moreover, it ensures the quality of the product line, and that the brand will always be connected with "high-end" products. Once this brand acquired market recognition, Shanghai Jahwa opened the "HERBORIST SPA" salons through franchising, which extends the brand from a product brand to a service brand as well.

B. Trend 2: Franchisees dissatisfaction with dependency

In order to maintain quality, franchisors often intervene into operations of the franchisees and take strict control of the franchisees' management. The franchisors often set various restrictive provisions in their franchising agreement and franchisees are often controlled or restricted by the franchise agreements with respect to branding activities, management models, supplies and so on, and must give up control in strategic decisions. For example, franchisees do not have flexibility to adjust its operational model to suit local customers' needs. As a result, although a franchisee is legally an independent owner, it is in fact a subordinate of the franchisor. As the franchisee improves over time, it becomes obvious that the franchisees will feel uncomfortable with their obligations on payment of royalties, advertising fees, and training fees to the franchisor.

During the current economic downturn, when a company wishes to expand, the first and foremost issue is looking for capital. Many multinational companies have since decided to expand into the Chinese market. Under such circumstances, multinational corporations often try to work with strong local Chinese companies under franchising arrangements. However, a franchisee who only obtained territorial authorization is often dissatisfied with its subordinate position. This is particularly apparent if the franchisor has to rely on a franchisee' s financial support and distribution networks. The franchisee will then desire a stronger position which may lead to future conflict.

This situation is more likely during the current financial crisis as more franchisors need to rely on the franchisees' financial support. This new imbalance may cause a franchisee to gradually deviate from the franchisor's control, the unified management standards, and quality requirements. The faster a franchisor expands his franchising businesses, the bigger a franchising territory is, the harder for the franchisor to control franchisees. Any deviation from the spirit of franchising will ultimately damage the franchised brand, and result in losing its market completely.

As this series continues, we will examine how franchisees exert influence on franchisors and provide suggestions for franchisors to maintain control.
 

Before the issuance of such a Circular, the above-mentioned question has for a very long time confused not only foreign investors, its lawyers, and other consultants, but also some local officials of SAFE partly due to the reason that SAFE did not clarify this question by issuing an official and universally-applicable rule. As a result the answer to this question has to depend, to large extent, on the local regulatory practice. Not surprisingly, in practice, some local offices of SAFE held a view that a FIE should not be allowed to exchange the foreign currency from its capital account into RMB for purposes of re-investing in China on the grounds that the foreign currency deposited in such account had been specially approved to satisfy the defined project as described in the business scope. In the meantime, some others officials held different views and allowed the FIE to settle the foreign exchange into RMB to satisfy the needs of re-investing in China. This is particularly the case where a local government is thirsty for foreign investment and it may be driven to take a more flexible policy.

Now, with the promulgation of the Circular, the door to direct re-investment by FIE(s) using the RMB settled from its foreign exchange capital account in China is closed. If a FIE happens to come upon a good investment opportunity, it will have to use its accumulated RMB profits or income or borrow RMB from domestic banks.

As is known in recent years, international “hot” money has unnerved the Chinese government which has thus taken a series of measures to cope with the issue. Without doubt the new rule is intended to strengthen the administration of foreign exchange flow and curb the inflow of hot money. However while it may contribute to the strengthening of its foreign exchange administration and the stability of its economic growth, it may also add the cost of making re-investment by foreign investors through their FIE(s) in some cases more difficult from a commercial perspective.
 

Conditions to be Considered - the regulations introduce factors for the authorities considerations such as whether an import will unfavorably influence the PRC domestic industry’s development, adverse affect upon public morality or environment.

Validity Period - the amended Article 9 states that the validity period for the Proposal for Technology Import License will be set within the range of one to three years. As the previous law did not set limits it is not clear what this restriction will mean in practice.

Procedural Changes – the new regulations require on-line registration with a MOFCOM website before an applicant can collect a Technology Import License. More importantly, contracts which include royalty payments require the technology importer/exporter to make a recordal within 30 days after the base figure for the royalty has been determined. This requirement appears to be an on-going requirement for subsequent years.

Requirements in respect of free technology transfers have been relaxed. Under current law the technology importer or exporter should re-register any amendment to a free technology import or export contract. The June 2008 amendments simplify this by requiring the technology importer or exporter to comply with an amendment recordal procedure rather than re-registering. However, the current practice of the vast majority of companies in China – i.e. doing nothing – is simpler still. However, a failure to follow up properly will make taking legal action against a breaching importer more difficult still.

By Mark Schaub, Partner