Betting on the Middle Kingdom

Macau recently overtook Las Vegas as the number one gambling economy in the world according to gambling industry insiders. Since the laws changed in 2002 to allow foreign casinos to enter Macau, their market has boomed. It doesn't take a Freakonomics guru to figure out Macau's simple strategy: growth. Slot machines are driving much of that increase.

Macau's secret formula has been to allow concessions to gaming providers which are carefully supervised by the Gaming Inspection and Coordination Bureau. In addition, Macau has developed a foreigner-friendly gaming statute. Since the concessions have been released from the sole control of Stanley Ho, the industry has exploded.

Macau's casino operators face a fairly steep tax rate of up to 40% to operate the gaming houses, but the volume has been sufficient to prevent the tax from being a toll booth to fast track.

Mainland China still forbids gambling and most recently cracked down on internet gambling similar to the US. Their gaming legislation seems to be at conflict with a cultural heritage that made gambling a sort of nation pastime.

While gambling is not available in most of Mainland China, it is possible that Hong Kong may be granted Macau-like casino rights. More importantly, hotel owners need to begin to consider creating new gaming properties as they expand to new Asian destinations. In addition, there are no international standards for either land-based casinos or I-casinos. Hotel owners and casino developers should retain competent gaming counsel before risking too much capital in an Asian gaming venture.

The Tao of Chinese Franchise Disclosure for Foreign Franchisors

Article 4 of the Commercial Franchise Information Disclosure Management Measures (“Disclosure Guidelines”) states that a franchisor must provide a written disclosure document to a prospective franchisee thirty (30) days before executing a franchise contract, unlike the current U.S. FTC Rule (“Rule”), the Chinese disclosure law provides a definite time frame of 30 days disclosure prior to executing the franchise contract. The disclosure must be in the written format covering the requisite components of Article 5 of the Disclosure Guidelines.

The elements required for Chinese disclosure purposes are similar to those franchisors already work with under the Rule. The biggest point of departure is that Section 8 of Article 5 requires Chinese franchisors to make mandatory earnings claims. The Chinese Disclosure Guidelines don’t mention whether a foreign franchisor’s earning results based on certain units in a given geographic area in the U.S. would be sufficient to satisfy the mandatory earnings claims requirement in China.

Local Beijing counsel seem to imply that earnings claims based on either company-owned units or franchised units will satisfy Section 8, as long as, an express disclosure is given that such data bears no market relevance to China and all earnings claims in formation was determined on a reasonable basis.

Hopefully, these new Chinese Disclosure Guidelines will offer a calming balance in what previously had been a chaotic regulatory system.

Gnomon and the circular paths of the Chinese “2+1” Rule

It is said by Chinese sources that as far back as 400 B.C. Chinese mathematicians had developed solution to many of mathematics most complicated problems by using physical rods called the “galley method.” One recent regulatory problem that needs to be solved by the Chinese government is the recently enacted “2 plus 1” disclosure rule under article 7 of the new Regulations of Commercial franchising of P.R. China (“Regulations”).

Under these Regulations, a franchisor is obligated to both register to franchise and provide disclosures to prospective franchises. Article 7 further requires that a franchisor must have two company-owned units in operations for more than one year before becoming eligible to franchise in China (commonly referred to as the “2 + 1” requirement).

The Regulations are painfully silent as to whether a foreign franchisor can satisfy the “2 + 1” requirement with units in operations in its home country. The ambiguous language of the Regulations could benefit the foreign franchisors unless the Chinese government establishes a clearly defined “within China” regulatory requirement.

Hopefully, this regulation can be properly clarified and it’s not back to the Chinese bamboo counting rods of the early Han Dynasty.

Sun Tzu on the Art of Franchise Battles in China

Sun Tzu wrote in his classic treatise on war that, "A conquering army cannot enter into alliances until it is acquainted with the designs of its neighbors." Until recently, the last 20 years in fact, China did not recognize franchising as an official form of business, as had many of its trading neighbors. Chinese governmental involvement and a strictly controlled state distribution system was an effective method for determining foreign investment.

Suddenly in 1997 everything changed when China passed its first franchise law. Entitled the "Regulation on Commercial Franchise Business," ("Measures") the law created the first comprehensive legal infrastructure fir franchising in China. Next, as a condition for China's accession to the World Trade Organization, it had to formally agree to implement rules of greater market access and national treatment measures for foreign investors, which it did in 2001.

A year later, China initiated the development of the National Franchise Association and the entrepreneurial hoards went rushing to the People's Republic. Initially, McDonalds and KFC led the invasion with A&W and Subway in quick pursuit.

Today, thanks to China's newly released "Commercial Franchise Information Disclosure Management Measures" ("Disclosure Guidelines") and its fast-paced economic growth of more than 9% in 2006, the country has more than 135 Pizza Huts and 112 Starbucks with the largest chains KEX photo, listing 10,275 franchises in 735 cities. Industry sources state that China has approximately 1,700 franchise companies inside Mainland China with over 85,000 franchisees registered to do business therein.

All that for an emerging entrepreneur sector with limited access to capital and no clear regulatory framework.

With the 2008 Olympics ahead, it is no wonder that franchisers are putting on their short list for global expansion opportunities.

Franchise Journey in China Begins with the First Registration Step!

According to Article 6 of the Chinese Registration Guidelines, " a franchisor shall register the franchise with the governing registration agency within fifteen (15) days of the date of the execution of the first franchise contract with a franchisee in China."

That seems simple enough, until you start tramping deeper into the registration forest. China has an extremely complex administrative structure because it is organized into provinces, autonomous regions, and municipalities directly under the express control of the central government.

From there the trail leads to Article 3 of the Registration Guidelines, which states that "franchising to take place within the provinces, autonomous regions, or municipalities shall be registered in the highest administrative agencies in charge of commercial regulations."

The next trail marker points to franchising that occurs beyond the traditional boundaries of provinces, autonomous regions or municipalities. According to another section of Article 3 of the Registration Guidelines, all cross-boundary franchising shall be registered with the Ministry of Commerce in China.

Just as the Chinese Proverb says, "The journey of 1,000 miles begins with one step." Determining the the proper place to register your franchise could be the critical first step in your registration journey.

FTC Rule versus Art.5: Are Chinese Earnings Claims Mandatory?

If a foreign franchisor already has franchises inside China, according to Section 8 of Article 5 of the most recently enacted China Franchise Law, that franchisor must make "earnings claims" in his disclosure document. This could create an interpretive dilemma if the foreign franchisor does not have any outlets open in China yet. Can you use your US (FTC Rule/UFOC ) earnings claims based on US domestic data and operations to comply with China's earnings claims requirement?

My guess is that would not work in China for a number of reasons. First, Section 8 of Article 5 states that data on Chinese franchisees is required to satisfy the earnings claim requirement. Second, Subsection 2 of Section 8 tends to discount the acceptability for operational data collected outside Mainland China. The Chinese regulations focus on geographical relevance vis a vis earnings claims collected from actual operational results inside China. Third, Article 6 of the new law provides a ban on false earnings claims made in any franchise marketing and advertising of the franchisor in China, i.e. average earnings data for individual franchisees operational results inside China is not considered "propaganda" within the regulations.

Until such time as legislative history or Chinese case law is available discussing the actual disclosure requirements, franchisors will have to hope their filings match the message in the unopened earnings claim fortune cookie.

China Franchise Registration Procedures

Based on information provided by the Ministry of Commerce, a registering franchisor shall follow the following procedures sequentially to properly register.

Step 1
Obtain Username and Password to access the Ministry of Commerce official Website (获取登录号)

1. If franchising is to occur within the boundaries of provinces, autonomous regions, or municipalities, the franchisor or its agent may hand deliver relevant documents to appropriate registering agencies in the province, autonomous region or municipality to obtain username and password. Or, username and password may also be obtained if same documents are mailed to the appropriate registering agencies.

2. If franchising is to occur beyond the boundaries of provinces, autonomous regions, or municipalities, the franchisor or its agent may hand deliver relevant documents to the Department of Commercial Reform and Development located in Dongcheng District, Dong An Meng Dajie to obtain username and password. Or, username and password can be obtained if same documents are mailed to the same office.

Step 2
Sign In at the following URL http://txjy.syggs.mofcom.gov.cn/ (登录系统)

Step 3
Change Password (修改密码)

The initial password assigned to all franchisor are the identical numbers of 000000, so the system will automatically prompt a user to change its password.

Step 4
Fill in the forms and upload documents required under the Registration Guidelines (填报备案资料)

Upon completing the above 4 steps, click on “申报备案” to submit the data and files entered and uploaded.

It is that simple!

Avoiding The "Deemed Export" Dilemma in China

Recently, US franchise companies have run into problems hiring foreign Chinese nationals for their overseas supply and distribution facilities. It seems the "deemed export" licensing regulations have morphed into "deemed reexport" licenses according to industry representatives. Traditionally, the BIS regulation applied to the transfer of controlled technology to foreign nationals from controlled countries residing in the US. Apparently, US companies are now being advised to get export licenses for foreign nationals from controlled countries outside the US borders as well.

This new policy will soon have a chilling effect on US franchisors' hiring practices both in the US and in their overseas facilities. Many highly skilled foreign nationals from controlled countries will not be able to compete for positions in US international franchise companies, which could cause a dilution in service quality if those jobs go unfilled.

As the BIS sorts through the stacks and piles of deemed export applications the process can takes months to process the information and that is only the first filter for an export program. Then comes the implementation of "silos" for the employee from restricted data outside the license. US franchise companies don't need anymore "toll booths" on their way to global fast track.

Does New Chinese Franchise Law Have Feng Shui?

Earlier this month, May 1st to be exact, the long awaited Chinese Franchise Disclosure Guidelines ("Guidelines") went into effect. The Guidelines have brought some clarity to the Regulations as they attempt to add specific details to specific enforcement issues, but there are still traps for the unwary, it appears for foreign franchisors.

Specifically, Article 4 of the Guidelines requires a franchisor to deliver a written disclosure document to a prospective franchisee at least 30 days before the execution of the franchise contract. Nothing is said about the all important "first meeting"; rather, it is the number of days that seems to have the most relevance vis a vis the time of delivery.

Additionally, the new Guidelines are silent as to whether we are talking about business or calendar days. Remember, Mandarin Chinese working days and calendar days are depicted differently. Calendar days are typically shortened to "days", whereas working days cannot be shortened, according to my Chinese colleagues.

I will post more on the potential pitfalls of the most recently enacted Guidelines in the next few days, but for now it appears that we are getting more Qi than water.

Olympic Size Export Risks for Franchisors in 2008

As the US athletes prepare for the 2008 Olympics in China, so should US franchisors. Challenges for both competitors could be substantial. US Department of Commerce and Defense Department officials have announced their intent to tighten controls vis a vis exports to China. Of 1,000 applications for dual use permits for China in the last four years only 700 have been approved under EAR regulations, according to BIS officials.

In addition, according to the DTSA, only a few licenses have been approved by the State Department for items exported to China subject to ITAR. Any US item for export to China controlled by ITAR must receive a presidential waiver before a license can be approved. Check the various US government websites for specific sanctions currently in force against the Chinese government or its various entities.

With a record 35 venues in place for the 2008 Beijing Olympics, the Games could be a gold medal opportunity for both US athletes and franchisors, but to succeed one must prepare early.

China Goes for Gold

With the Chinese government buying a $3 Billion (8%) stake in Blackstone Group, could McDonalds or Starbucks be their next target? It seems as obvious as a Yao Ming dunk. China has traditionally invested in conservative US T bonds, but no longer. Rumor has it that China wants more out of its growing foreign reserves and will even establish a foreign investment agency to enthusiastically chase higher yields in the coming months. As the US dollar continues to decline on world markets, China seems to be poised to begin a US shopping spree. US franchise systems may be the on the list. As the 2008 Olympics get nearer, China may have enough hard ware to make the final medal round.