By Alan Adcock
Intellectual property (IP) forms an important part of the franchise relationship. Acknowledgement of this by both the francisor and the franchisee is a key issue for franchisors that wish to enter the newly opened Chinese market as well as the long established Hong Kong market. Most people are aware of the fact that China and Hong Kong are separate legal entities, but may not be so clear on the fact that their IP needs to be registered separately in both. Differences in enforcement also exist. With the recent liberalization of China’s franchise system, foreign franchisors are now considering the People’s Republic in their business plans and adding Hong Kong to that list at the same time.
Franchise overview in China
On 1 February 2005, the PRC Ministry of Commerce’s (MOFCOM) Administrative Measures on Commercial Franchising (“New Measures”) took effect replacing earlier interim regulations and now allowing foreign invested companies to enter into franchise relationships in China.
Franchising in China has exploded in recent years mainly driven by domestic companies. Until the New Measures took effect, most foreign franchised outlets such as fast food chains and convenience stores, were owned by the franchisor corporations for a number of reasons. Foreign franchisors wanting to enter the Chinese market had to work with the laws governing joint ventures (JVs) and wholly owned foreign enterprises (WOFEs) to structure their Chinese ‘franchisees’. These laws are complex and were not really intended to cover franchising. Also, the value of a franchise is the intellectual property owned by the franchisor – brands, trade secrets, manuals etc. Lack of confidence in China’s IP protection regime has also contributed to the concerns of foreign franchisors being willing to give up close control of their brands in China to a franchisee.
A successful franchise operation requires a sophisticated legal system to define and protect the rights and obligations of both franchisors and franchisees. With the implementation of the New Measures, more foreign franchisors are starting to adopt the traditional franchise method in China and the authorities who implement them are starting to come to terms with franchising as a valid business model. This is the cusp of China’s franchising growth which is predicted to grow significantly over the next few years.
Franchise overview in Hong Kong
As franchising becomes more common in China, many master franchisees in Hong Kong are considering expanding their territories into mainland China, making Hong Kong’s franchising regime also important. There is no specific legislation or regulations governing franchising operations in Hong Kong. There are no exchange controls, anti-trust laws or foreign equity participation or local management participation regulations. Disputes arising from franchise agreements will be subject to the common law (and specifically the principles of contract law) and to the legislation relating to the registration, licensing and protection of intellectual property rights. Such legislation includes the Trade Marks Ordinance (Cap. 43), Trade Descriptions Ordinance (Cap. 362), Copyright Ordinance (1997), Registered Designs Ordinance (Cap. 522) and Patents Ordinance (Cap. 514).
Many companies operate in China successfully and are able to exploit their IP effectively. Careful and early planning is the key to an effective IP protection strategy in China. The following checklist provides a useful guide of things to consider when operating in China:
Franchising IP checklist
Register your IP
China and Hong Kong follow a first-to-file rather than a first-to-use principle in relation to registration so it is important to register IP as early as possible.
Trade mark registrations tend to be the most straightforward rights to enforce in China and Hong Kong. Authorities are familiar with the process and the registration certificate clearly shows the rights involved.
Franchisors should also register their brands in Chinese characters (as appropriate), otherwise run the risk of it being registered by someone else. It is no secret that piracy is common in China, and enforcement of IP rights a daunting challenge. Recovery of a trade mark, once it has been used or registered by another party (including a franchisee) in China, can be costly and time-consuming, as evidenced by Starbucks Corporation’s fight to recover its Chinese name in 2004. The name, Xingbake, was already registered as a trade name by a Shanghai-based company, which resulted in an expensive and drawn-out litigation process. Although Starbucks initially won the case, the Chinese party filed an appeal with the Shanghai Higher People’s Court in January 2006.
Trade name registration is separate to trade mark registration and securing your brand as a trade mark will not prevent a third party securing that mark as a trading name. In Hong Kong, many times mainland companies will register famous trade marks as business names and use this platform from which to conduct unauthorized trade. In China, business enterprise name registrations are a matter of local registration rather than national. Taking action to get these stricken must be done at the local level. As more and more famous brands begin their China rollout, unauthorised business enterprise registrations will increase. The best way to combat these is for your trade mark gain well known status-a procedure allowed under new State Intellectual Property Office rules.
Although copyright arises automatically on creation in China, (i.e.: in software, manuals, drawings, specifications, etc), there is a voluntary recordal system which can assist with making enforcement of copyright more straightforward and provides a public record of the existence of the copyright. As in the US, this voluntary recordal system is prima facie evidence of subsistence and ownership and the defendant is left to prove his otherwise independent creation and non-copying.
Trade secrets/know how
Trade secrets such as technical or operational information which is unknown to the public is the most difficult type of IP to protect as it relies on the ability to maintain confidentiality. The regulations place a very high onus on the plaintiff to prove the steps they have taken to ensure the information was kept confidential. At a minimum, companies need to mark confidential terms, restrict access to trade secrets by controlling reference/access groups and implement confidentiality policies and agreements with employees.
Checks on potential franchisees
Companies need to carefully select any partner they use in China and Hong Kong. It is critical to conduct due diligence on these potential franchisees to identify their level of IP awareness as well as any weak points which create a potential risk for the franchisor’s IP. It is necessary to confirm that your potential partners have a proven record with protection of IP, including their own brand and reputation (if any).
Once a partner is selected, the franchise agreement needs to contain very specific IP protection clauses. You must exercise your audit rights under these agreements to maintain the awareness with the partner.
Manage the production and supply chain process
The production and supply chain are key risk areas for leaks of confidential information and for infringement of IP. There are regular examples of waste materials from authorized factories being used to create counterfeit products. There are also numerous examples of genuine product leaking ‘out the back door’ of the authorised factories and ending up in the market as grey goods (genuine, but unauthorised). Unauthorised sub-contracting in the food and personal care inductries can lead to public health issues and loss of brand value. Production and supply chain management can help to alleviate sucks risks.
One of the main risks for infringements of IP is employees. Companies must ensure that their HR processes contain express IP protection policies including: (i) strong employment contracts (with non-compete, confidentiality provisions and other restrictive covenants); (ii) policies for exit interviews and processes; (iii) education of employees about the importance of and policies for IP protection; and (iv) trade secret protection policies, including restricting access to confidential information. Companies must actively control what walks out the door with exiting employees and ensure that non-competes are enforced against key employees.
Strong franchise agreements
The franchise agreement you use in other jurisdictions is likely sufficient for China and Hong Kong purposes. However, certain areas may need particular attention and amendment for local legal compliance and practical considerations. It is advisable to prepare confidentiality agreements for pre-franchise negotiations. If a potential franchisee is not willing to sign such an agreement, then he is probably not going to be trustworthy franchisee. IP protections can normally be strengthened for China purposes including clear restrictions on what the franchisee is not allowed to do. You should not be afraid of deviating from your ‘master’ franchise agreement which was probably prepared for more mature jurisdictions.
With the growing understanding and proliferation of international franchising, China and Hong are seeing significant increases in franchising opportunities. While the IP environment may remain challenging, systems of enforcement are becoming much more sophisticated. A franchisor with a well executed IP strategy can successfully exploit these opportunities.
Alan Adcock works with Yu & Partners, a Hong Kong law firm associated with Rouse Legal, a member of the Rouse & Co International Group. www.iprights.com