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CHINA: Non-competition clause and agreement in a franchise business.

Having non-competition terms in a franchise agreement is very common when negotiating a franchise business, however, how to draft such a clause or even inserting such provisions in an individual agreement on it could be tricky in China.

Paul JONES - 15.02.21
Country expert

A recent appeal case, Xinjiang Maya Housing Brokerage Co., Ltd. v Zhao Shilei, Urumqi Intermediate, Civil Final No.495[1], provides some useful guidance for franchisor on how to secure their rights on business resources when preparing franchise agreement.

In this case, Xinjiang Maya Housing Brokerage Co., Ltd. (hereinafter as “Maya Housing”), as the franchisor, entered into a franchise agreement (hereinafter as “Agreement”) with Mr. Zhao Shilei, which allowed Mr. Zhao to operate real estate business under the name of “Maya Housing” and using Maya Housing’s business resources in the city of Urumuqi. The Agreement was a standard form contract prepared by Maya Housing. The granted territory was No. 425 Cangfanggou Road. In the main body of the Agreement, the non-competition clause set out that during and within two years of termination, the franchisee and related entities were prohibited from operating or investing similar businesses within 50 kilometers from the granted territory. However, in a separate non-competition agreement, also a standard form contract provided by Maya Housing and attached to the main body of the Agreement, the prohibited territory was established as the granted territory of the Agreement, being only No.425 Cangfanggou Road.

The first issue that led to conflict between Maya Housing and Mr. Zhao was whether it was fair to have a non-competition clause in a standard form contract. Mr. Zhao argued that since the Agreement was a standard form contract prepared by Maya Housing which gave him little ability to negotiate more favorable terms, such non-competition clause was favoured the franchisor and should be deemed as void. The court did not support his stand. Having non-competition terms in franchise agreement is a common mechanism utilized by franchisors to secure their exclusive rights on the business recourses developed by them. Violation of non-competition obligations could infringe on those exclusive rights and even cause severe breach of business ethics. The appellate court also emphasized that real estate is a type of business which heavily relies on information communications. Once the franchise agreement is established, it is of high possibility that the franchisee will receive “know-hows” from the franchisor. Non-competition clause is a legitimate tool for franchisor to prevent franchisee from improperly disclosing those “know-hows”. Moreover, the court did not find direct cause-and-effect relationship between enforcing fair non-competition terms and market monopolies. The court concluded that the non-competition clause as well as the separate non-competition agreement are both valid.

Another interesting point related to the first issue was that Mr. Zhao also argued that a non-competition clause was valid only if it was in an employment agreement and it only applied to certain persons such as directors. Mr. Zhao claimed that it was not fair to impose non-competition obligations on him without providing compensation. The trial court turned this claim down and the appellate court supported the trial court’s decision that it was not rational to refer and apply legislations on Labour Contract law to a franchise relationship. Article 23 and 24 of the Labour Contract Law prescribe that an employer may impose non-competition obligations to certain types of employees for the term of employment and up to two years after the termination of the employment.[2] During the term of non-competition, the employer shall provide the employee with compensation on a monthly basis. As reaffirmed by the court, the aforementioned clauses only apply to employment relationship. In a franchise business relationship, the franchisor is not obligated to pay compensations to a franchisee for having non-competition terms in the agreement.

The second issue of this case was the question about which prohibited territory applied. Apparently, the prohibited territory in the main body of the Agreement is larger than the prohibited territory in the separate non-competition agreement. The court referred to Article 41 of the Contract Law[3] and decided that the prohibited territory in the separate non-competition agreement which was more favorable for Mr. Zhao should prevail. Such mistake is avoidable. Firms usually build up customized franchise documents for their clients based on previous cases and templates collected from the past. While the “bones” of a franchise agreement could be borrowed from case A, a separate non-competition agreement could be from Case B. While modifying the terms of the franchise agreement based on the actual circumstances is like putting “blood” into the deal, ensuring that those terms consist with each other is making the “blood” circulate smoothly and not get stuck. One of the methods is to create a term sheet presenting all the figures, times, territories and compare all the relevant clauses before finalizing the agreement.

 

[1] http://wenshu.court.gov.cn/website/wenshu/181107ANFZ0BXSK4/index.html?docId=96c5ccfb241848399ce2abd601219720

[2] Article 23 An employer may enter an agreement with his employees in the labor contract to require his employees to keep the business secrets and intellectual property of the employer confidential.
For an employee who has the obligation of keeping confidential, the employer and the employee may stipulate non-competition clauses in the labor contract or in the confidentiality agreement and come to an agreement that, when the labor contract is dissolved or terminated, the employee shall be given economic compensations within the non-competition period. If the employee violates the stipulation of non-competition, it shall pay the employer a penalty for breaching the contract.

Article 24 The persons who should be subject to non-competition shall be limited to the senior managers, senior technicians, and the other employees, who have the obligation to keep secrets, of employers. The scope, geographical range and time limit for non-competition shall be stipulated by the employer and the employee. The stipulation on non-competition shall not be contrary to any laws or regulations.
After the dissolution or termination of a labor contract, the non-competition period for any of the persons as mentioned in the preceding paragraph to work in any other employer producing or engaging in products of the same category or engaging in business of the same category as this employer shall not exceed two years.

[3] Article 41 If a dispute over the understanding of the standard terms occurs, it shall be interpreted in accordance with common understanding. Where there are two or more kinds of interpretation, an interpretation unfavorable to the party supplying the standard terms shall prevail. Where the standard terms are inconsistent with non-standard terms, the latter shall prevail.

 

Paul Jones, IDI Country Expert for franchising in China

Zoe Huang (黄子峨)

Leo Xu (徐鑫)

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