China: 2010 and Beyond
January 2010 Franchising World
By Philip F. Zeidman
A year ago, with the world on the brink of what appeared to be a global economic collapse of epic proportions, most eyes were on two countries: the United States and China, the two drivers of growth for the last quarter century. Readers of this article need no reminders of the path being taken by the United States, but what of China?
There was widespread concern that China would suffer a breakdown, dependent as it has become on sales to meet the now much diminished demand of U.S. consumers. And, many speculated, the Chinese obsession with saving would not allow the government to persuade itself to adopt policies favoring consumption and economic growth.
So much for the “informed observers.” Exports have rebounded to where they were in early 2008 (although still well below the levels of previous years), and foreign exchange reserves have hit an all time high of $2.3 trillion. This appears to be part of a pattern in which the Asian economies are leading the global economic recovery.
But a less predictable development has proceeded in parallel: the growth of the economy through increased domestic demand, propelled in part by the bold and uncharacteristic stimulus actions of the government. That package has spurred a remarkable array of building projects, and retail sales as well as industrial output have risen markedly. As a consequence, the Chinese economy rose at an almost 9 percent rate in the third quarter of 2009 (compared to about 3 percent for the U.S. economy); and retail sales in October 2009 rose by 16.2 percent. There is mounting evidence that the growth is no longer so dependent on government pump-priming: corporate revenue and profits are up (Coca-Cola reported sales up 15 percent in the third quarter, versus 4 percent down in North America). And the nature of the government spending is also encouraging: $200 billion on railways in the next two years, much of it for high speed rail, and “clean” or “green” technology far outpacing what we are doing at home. The ambitious goal, a “well off society” in the next 20 years. Economists conclude that in the next 30 years, perhaps much sooner, the size of China’s economy will exceed that of the United States.
600 Million Consumers
Many of these developments, of course, are of direct relevance to franchising. There is now a burgeoning middle class, a large and growing market of those with sufficient disposable income to make discretionary purchases of the products and services which U.S. franchisors sell. While that middle class resists a definition which all can accept (ranging from 100 million to 247 million), there is somewhat more agreement on the future: there could be as many as 600 million middle class consumers by 2015.
They are spending in ways quite foreign to the habitual hoarding of resources (a gross savings rate 40 percent higher than in the United States, at least prior to the recent wake-up call), with younger people leading the way toward more internationalized tastes and spending patterns. And they live where they can be reached by United States franchisors: increasingly, in the urban areas which have benefited from the growth in foreign trade. By 2025, China will have 221 cities with at least one million inhabitants; 23 of them with more than five million. By contrast, no one expects the demographic patterns in the United States to shift much; we have only 50 metropolitan areas of more than one million. The contrast is striking, as are other changes. In the short span of 60 years since the founding of the People’s Republic of China, average life span has increased from 35 to 73, literacy increased from 80 percent to 95 percent, and infant mortality dropped from 20 percent to 1.5 percent. Has any nation in the history of the world ever seen such change in so short a time?
It is not only the growth of consumption which is encouraging to franchisors. As the role of a service economy steadily encroaches into the traditional manufacturing-dominated society, as the education levels rise, as the use of the Internet skyrockets, as the culture of entrepreneurship grows, especially among young people—all of these trends are distinctly favorable to franchising.
Which helps to explain why there are already thousands of indigenous franchisors. The International Franchise Association estimates about 50 U.S. franchisors are doing business in China. In truth, while not all are utilizing the franchise model, it is hard to think of a recognizable franchised name which is not there already. Here are just a few of them: 7-Eleven, Accor, Athlete’s Foot, Budget, Burger King, California Pizza Kitchen, Carl’s Jr., Century 21, Dairy Queen, Days Inn, Dunkin’ Donuts, Econo Lodge, Gloria Jean’s Coffee, Haagen Dazs, Hilton, Holiday Inn, Hooters, Hyatt, KFC, Marriott, McDonald’s, Papa John’s, Pizza Hut, Sign-A-Rama, Starbucks, Starwood, Subway, Super 8, T.G.I. Friday’s, Taco Bell, TCBY, and Wyndham.
And these are not just baby steps: Yum! already has more than 2,500 units, McDonald’s 900.
Plenty of Room to Grow
The room for growth is palpable: franchising accounts for only 3 percent of China’s total retail sales, versus perhaps 30 percent in the United States; and the average system in China so far has only 43 outlets, versus 540 here. The projections for growth are thus understandably eye-catching. In the food arena, CKE Restaurants expects to open 100 Carl’s Jr. stores over the next eight years and Dunkin’ Donuts has secured agreements to open a total of 480 shops in Mainland China over the next 10 years. Dairy Queen expects 500 more in the next five years. And consider the lodging industry: More than half of Starwood’s pipeline in the Asia Pacific region is in Greater China and in addition to the 43 hotels it currently operates there it has 57 new properties scheduled to open. There are currently 60 Holiday Inn/ Holiday Inn Express units under development, and Hilton is scheduled to add another 33 hotels in China in the months ahead.
That’s not because China’s economic horizon is free of clouds. All the issues we have flagged from the outset remain: The need for reliable partners has never been clearer … and finding them is not much easier than it was. The market is diverse, requiring different approaches to consumers and perhaps even different models. The society remains relatively opaque, with corruption an ever-present reality. Even the impressive resiliency in the face of world recession has within it some caution flags: wasteful spending on unnecessary infrastructure has created temporary jobs but may have planted the seeds for future inflation, as well as future discontent.
The Legal Landscape
From the legal perspective, franchisors should never assume that “franchise laws” are their only concern. For international franchisors in China, protecting their intellectual property rights remains a paramount concern. Those who wish to enter the market should take all necessary precautions as early and as comprehensive as possible. While corporate structures for setting up a local presence in China are well established, working with various government agencies and local partners is often a tedious and unpredictable process. Even for those areas of law that have been largely liberalized (e.g., remittances overseas, taxes, etc.), foreign franchisors still need to monitor the laws and regulations closely as they are constantly evolving.
For most franchisors, though, the franchise regulation has been and continues to be the dominating issue. By now, most franchisors with even a marginal interest in overseas expansion are familiar with what has occurred. As early as 1997 a “departmental rule” attempted to regulate franchising. It was primitive (and actually favored foreign franchisors, intentionally or otherwise). But it was recognized to have no lasting effect (it was even referred to as “Interim Measures”). The next iteration, similarly temporary in nature (called “Provisional”) was promptly followed (Dec. 30, 2004) by “Franchise Measures.”
Among several unfortunate features the measures required that all franchisors must have had at least two company owned operations in China for at least one year before commencing franchising, thus barring a large percentage of all franchisors in the world from this market. The next two years were a period of intense lobbying (although there is no recognition of that process as such) by IFA and others, arguing that the country would be illserved by these and other provisions which would slow the introduction of franchising to a crawl. The State Council responded favorably to these overtures, and promulgated the “Franchise Regulation” to be effective May 1, 2007, together with two “implementation guidelines.”
It is now clear that foreign franchisors are covered by the regulation when they franchise directly into China by cross border franchising. The principal consequence is a disclosure obligation similar in many respects to that existing in the United States; and a non-onerous form of “registration,” with relatively modest penalties.
While the franchisor must own a “well developed” business format and be capable of providing necessary support, the lobbying effort was successful: the two company owned operations need no longer be in China. The overwhelming number of franchisors are thus now able to meet that requirement, an about-face which the franchising community has hailed.
The Chinese franchise regulators have also shown their flexibility on another important matter, the “affiliate” issue. Despite the fact that language explicitly allowing units owned by a franchisor’s affiliates to be counted towards the franchisor’s satisfaction of the “two units one year” requirement was taken out by the State Council at the last minute before the Franchise Regulation was promulgated, the officials have been willing to consider the affiliate’s qualification on a case-bycase basis. This has proven crucial for a number of franchise systems in which the corporate operations are conducted through one or more affiliates, instead of by the franchisor. It remains to be seen whether the Chinese courts will hold franchise agreements to be null and void where the franchisor fails to satisfy the “two units one year” requirement, or fails to deliver a disclosure document, or fails to deliver an adequate document. The few courts that have thus far considered the issue have reached different conclusions. Foreign franchisors, however, would be well advised to comply with the Franchise Regulation, as any violation carries a significant reputational risk—the Chinese Ministry of Commerce can publish a list of franchisors that have violate the Franchise Regulation, a far more impactful occurrence in a society such as China’s.
Notwithstanding this and certain other signal ameliorations, there remain some concerns.They include some uncertainty as to certain disclosures, including the length of the mandatory “cooling-off”; some early indications that government officials may be exceeding the contemplated scope of their “review”; and an obligation—not otherwise defined—to conduct franchising “in compliance with the principles of free will, fair dealing, honesty and good faith.”
In short, there are certainly legal pitfalls which the franchisor seeking to enter the Chinese market must avoid—more than enough to keep the franchisor and its counsel occupied. But the Franchise Regulation is no longer high on that list.
Fifty years ago, when IFA was founded, the notion of franchising in China was beyond the contemplation of all but a handful of visionaries. Today many franchisors are already there, and the number of franchise units grows daily. When the history of franchising in the 50th year of IFA’s existence is written, it seems certain that the aspiration to franchise in China will feature prominently in the plans of virtually every franchise company. It will be, after all, the biggest franchise market in the world.
Philip F. Zeidman is a partner with DLA Piper LLP (US). He can be reached at 202-799-4272 or firstname.lastname@example.org . As general counsel to the International Franchise Association, he led the IFA’s successful effort to liberalize the Chinese Franchise Regulation.
NOTE: The author wishes to express thanks to Tao Xu of the ÿrm’s Washington and Northern Virginia offices, and to Richard Wageman of the firm's Beijing office. As a consequence of the firm’s work on the Franchise Regulation, the Chinese Ministry of Commerce has appointed it one of its “preferred law firms.”