China has become the world’s leading consumer market and is predicted to grow faster than the West – at 6% annually over the next decade (World Economic Forum). International brands are taking advantage of this, despite increased competition from local competitors and from each other. While e-commerce is now a firm part of the landscape, most international companies remain convinced of the importance of developing a network of brick-and-mortar stores. In this article, we summarize some of the key legal challenges specific to international businesses that plan to open retail stores in China.
Corporate structuring: company set-up
The first step to establishing stores is to incorporate a legal entity. Rules for establishing entities have been liberalized over the years, but it may still take four to six months for a subsidiary to become fully operational. Key issues to decide upon when establishing a retail business are:
- The registered address is the location where the company is legally registered and determines in which district (and under the supervision of which authorities) the company is incorporated. For larger companies, local governments may be able to offer subsidies and tax benefits; smaller retailers may be offered a virtual address. The office lease must be signed before the company can be formally established.
- The business scope determines the activities that the company may engage in and must be approved by the competent authorities. Certain types of products (e.g. food, medical products) may be subject to special licensing. Also, some districts will not allow the inclusion of “retail” in the business scope until an office has been leased for the first branch; this requires a two-step process of establishing the company first, and then expanding its business scope to include retail.
- The company name will be in Chinese and should consist of a location indicator, an industry indicator, and the trade name. For retailers in particular, a good Chinese trade name (and its registration as a trademark) is crucial. Different levels of location (Shanghai vs. China) and different industry indicators may require different levels of approval.
- The registered capital is the amount of capital that the (foreign) investor commits to the company. There is no legal minimum, but companies should consider actual operational needs, since increasing the registered capital later will take three to six weeks. There is no immediate deadline to contribute the registered capital in full, and so some investors prefer to set a higher registered capital. Others prefer to finance partially through foreign debt, which is subject to strict rules.
- The Chinese entity will need to have a board of directors or executive director, a legal representative, one or more supervisors, and rules on the authority of these positions and the shareholder. These issues of corporate governance are a major part of the company’s Articles of Association, which is a legal document and should be drafted with care.
While technically the first branch can be opened at the location of the company, it is much more common to keep the company’s address as an office and establish the first store at a retail location elsewhere. Subsequent stores will normally require the registration of separate branches.
The most common model is to have one company with many branches across the country – there is no limit to the number of branches that a single company can have. An alternative is to establish separate companies in major cities / regions (e.g. Shanghai, Beijing, Guangzhou / Shenzhen, Chengdu / Chongqing) and structure local branches under each of these companies. In that case, an extra option would be to set up a China Holding Company to consolidate all this business.
When establishing a branch and to ensure that it is ready in time, your legal team must coordinate closely with the builder in charge of construction and decoration of the store on related approvals, including store design and fire protection, as these can take weeks or even months to procure (especially where the location is in a new mall). The store should open for business only when all licenses, permits and approvals are in place.
For stores selling food or other products that are subject to special licensing, additional steps must be completed. Examples are the Food Business License (for catering and non-catering), the Public Sanitations Permit, and the Alcohol Retail Permit. The timing and necessity of these licenses varies by location, so professional expertise is crucial.
Signing lease contracts
A good location is one of the key components for the success of a store, even more so for retailers who are relatively new to China and less well-known to Chinese consumers. As in other competitive markets, the best locations are difficult to secure, which means that the landlord is in a very strong position in negotiations over the lease.
On the other hand, signing a very one-sided lease can bring huge risks. It is never advisable to directly sign the landlord’s version. Where the landlord refuses revisions and a company still wants to sign, an analysis of the legal risks can at least establish the tenant’s legal position, especially when it comes to crucial clauses such as term, termination and renewal, competition and confidentiality.
As the retailer’s reputation in China develops, it will become increasingly easy to negotiate more favorable lease terms. This offers a valuable opportunity, especially if background knowledge can be obtained on what the landlord has offered to others and therefore may be willing to accept.
Ensuring legal compliance
China has communicated a clear focus on consumer health and safety issues. These rules and standards also differ significantly from other jurisdictions, and so can have a major impact on retail operations. To give an example, a very successful F&B retailer in Shanghai was closed in 2017, and some of its staff imprisoned, because it was using flour that was past its formal expiration date – while in the U.S. and Europe, flour often has only a best-before date.
Product Quality and Local Standards
China has established extensive standards for all kinds of consumer products, not only for food but also for clothing, electronics, etc. This sometimes results in the ironic situation where products made in China cannot be sold in China without adjustments. For food products, these standards may extend to store organization and supplier management systems.
Failure to meet legal standards can be a serious offense and may lead to large financial penalties and even potential criminal liabilities. The authorities dealing with such matters, especially the Administration for Industry and Commerce, will investigate individual complaints. Responding to an investigation correctly and with the right amount of information is a delicate matter, but it is worth the extra attention, as an unfavorable decision can have huge financial and operational consequences.
Advertising and Pricing
A special compliance risk relates to advertisement and pricing. Areas that are regulated include discounting and minimum pricing. Violations of these rules are often used by professional buyers to extort money from retailers and producers. In the case of complaints, companies must balance between giving in too easily (encouraging more professional buyers to target them), and the cost of defending claims and even lawsuits, whether frivolous or not.
Labeling is another sensitive area. Besides expiration dates, the composition and type of ingredients / materials should be accurately listed on the label to adhere to the stringent rules that apply in this field. Labels must be in Chinese, and meet other specific standards. Violations may result in fines, but also potential lawsuits by professional buyers.
Data privacy is a “hot” topic in China. The legal framework for using private data is still being developed and is not yet as sophisticated as in many Western jurisdictions, but the recently-adopted PRC Cyber Security Law (effective 2017) shows purpose. The law puts the burden on “network operators” (i.e. owners and administrators of networks and network service providers) to protect “personal information” on information networks. Moreover, certain kinds of personal information and other important data must only be stored domestically (i.e. in China). Violations of the law can result in high penalties and even detention of those persons responsible.
When operating stores, employees form an integral part of the company. Chinese labor laws are strict and tend towards protecting the employee. Establishing strong employment contracts and official company rules (in the form of a staff handbook), and adopting these rules in a legal manner, are key steps to lower incompliance risk and create more leeway to manage (and where necessary) terminate employment contracts. A retailer should also consider whether to use standard working hours for employees, or alternative systems (flexible or comprehensive working hours) subject to special approval.
Trademark Protection for Retailers
The protection of intellectual property (IP) such as trademarks is a key concern for foreign businesses in China, because IP helps to determine their identity and distinguish between other brands, in particular domestic ones. For retailers, this is arguably even more important, because retailers are consumer-facing and because reputable landlords, advertisers and especially online platforms will require trademark ownership before beginning cooperation. Reviewing the trademark portfolio and making sure that all relevant brand names are protected in the correct classes and subclasses is not only a prerequisite to the start of China operations, but should be repeated on a regular basis.
For international companies that are new to the country, this can present a huge problem. It is common to find that one’s international trademark has already been registered in China by another party, often a squatter. China’s trademark protection system is first-to-file, and despite exceptions for well-known trademarks and trademarks registered in bad faith, it can be hugely complex and costly to get back a trademark once it has been registered by a third party. Therefore, companies should always register trademarks as quickly and as broadly as possible, preferably directly in China (instead of using the international Madrid system). If too late, then a comprehensive strategy is needed to get back the trademarks.
Another aspect particular to China: not all Chinese consumers speak or read English fluently, so it is important to come up with a good Chinese brand name that can adequately represent the business. This brand name should also be registered in all relevant classes and sub-classes.
China is the land of opportunity for many international retailers. The large, growing and relatively sophisticated market of consumers interested in high-quality international brands, which is increasingly willing to pay for premium products, is a dream for many. Not every retailer that enters the China market is able to take advantage of these factors, but successes are easy to find.
There are plenty of factors that may contribute to success in China, not all of them under the company’s control. When it comes to legal challenges, an international company should be able to avoid big surprises. Company structuring, lease contracts, trademark protection and legal compliance are all subjects that can be managed effectively with timely investment in resources and the right external support.For more on R&P’s retail practice, and on the challenges that you may face selling retail in China, please email your usual contact at R&P or email to [email protected].