PEOPLE'S REPUBLIC OF CHINA: A recent judgment of the Beijing No. 1 Intermediate Court of the implications of the failure of a franchisor to make all the required disclosures.

Paul JONES | CHINA | 2011-02-16

Paul JONES

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The franchisee, ?? (Zou Jun), entered into a franchise agreement on April 24, 2010 with the franchisor, (Yicai International Business Management (Beijing), Inc.) to operate a shop selling Korean cosmetics.

Under the agreement, the franchisee paid an initial fee in the amount of 39,800 RMB for the products and equipment provided by the franchisor. The location of the franchisee’s shop has to be approved by the franchisor and the franchisee was not authorized to sell the franchised products outside the authorized area. And the franchisee could not purchase products from other sources. The selling price was to be fixed by the franchisor. The franchisor was to provide the construction specifications, brochures, uniform marks and logo, instructions on management, technical support etc. The franchise contract was to be effective from April 24, 2010 to April 23, 2011.

But the franchisee appears to have changed his mind and shortly after commenced an action against the franchisor for termination and rescission, claiming that the franchisor had failed to provide the audited financial statements for the previous two years as required by Article 22(9) of the 2007 Franchise Regulation. Based on the provisions of Article 23 of the Franchise Regulation, the Haidian District court agreed.

The franchisor appealed this decision, claiming that the franchisee did not request a copy of the audited financial statements. For disclosure based simply on the doctrine of culpa in contrahendo, which is common in civil law jurisdictions and requires that negotiations and the formation of a contract be in good faith (in China it is in Article 42 of the Contract Law) , this is often a good defense. It provides a judicial limit on the scope of the disclosure required when negotiating in good faith.

However in China there are the specific provisions of the franchise regulation that require disclosure of the audited financial statements. Beijing No. 1 Intermediate People’s Court said that the regulations created an obligation to disclose the required items, whether the franchisee requested them or not. The missing audited financial statements provided sufficient grounds for rescission.

It should also be noted that the franchise agreement provided for re-sale price maintenance. Article 14 (1) of China’s new Anti-Monopoly Law (‘AML’) makes it quite clear that business are prohibited from fixing re-sale prices with their counterparties unless they fall into one of the exceptions in Article 15. These are where the behavior would be efficiency enhancing or overall achieve public interests. It is unlikely that fixing the prices of cosmetics would fit into the exemptions.

Rather the enforcement of the AML is really just getting under way. In the last week of January there was a press report of the first enforcement that was not a merger review or an action against a pure price cartel amongst competitors. And the investigators are still discovering price fixing cartels by watching for their announcements in the newspapers or on TV. In other words many business people in China see such actions as acceptable commercial behavior and do not even try to hide it. No wiretaps are needed yet.

And in negotiating a master franchise agreement the author has had a Chinese lawyer tell him that while the franchisor in North America may not be able to fix prices, they could do it in China.

So this franchise agreement was in breach of Chinese law in another way. It is suspected that there are a few master franchisees or distributors in China who have made the same mistake. Enforcement with respect to prices is increasing in China. In January Carrefour and Wal-Mart were fined for having improperly priced products in their stores.

 

Citation: Zou Jun v. Yicai International Business Management (Beijing), Inc., Beijing No.1 Intermediate People’s Court, (2010).

 

 

Paul Jones, IDI franchising country expert for China.

 

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