China has become the world’s leading consumer market and is predicted for faster growth than in the West – at 6% annually in the next decade (World Economic Forum). International brands are taking advantage, despite increased competition from local competition and from each other. And while E-Commerce is now a firm part of the landscape, most international companies remain convinced that the only way to succeed in the Chinese market is to develop a network of offline, 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, including relating to the corporate set-up, lease contracts, trademark protection and legal compliance.
1. Corporate Structuring (1): Company Set-up
The first step to establishing stores is to incorporate a legal entity. Where this company is a wholly-owned subsidiary of a foreign entity, it is often referred to as a wholly foreign-owned enterprise, or WFOE. Rules to establish entities have been liberalized over the years, but it may still take 4-6 months for the subsidiary to be fully operational. Key issues to decide on when establishing a retail business:
- 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 that do not need an office can consider using a virtual address. Note that the office lease will need to 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. A careful review should be made of the categories of products that the retailer will be selling, especially if this includes types of products (e.g. in food, medical products) that 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, see below) is crucial, but the location and industry indicators can also contribute to the success of the business. 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 needs – if the company needs funding beyond the registered capital, then the registered capital will need to be increased which may take 3-6 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 thin capitalization 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 carefully.
2. Corporate Structuring (2): Branch Establishment
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 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.
The legal steps in the set-up of a branch are relatively straightforward. However, after the Branch Business License has been obtained, post-registration procedures will include stamp carving and tax registration, and if the branch is in another city, applying for general taxpayer status and opening the bank account. To ensure that the Branch is ready in time, it is also important to coordinate closely with the company 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 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. Some examples of licenses that may apply are the Food Business License (incl. for catering and non-catering), the Public Sanitations Permit, and the Alcohol Retail Permit. Some of these are easier to obtain than others and may or may not be needed depending on the circumstances of the store, and the opinions and practices of the local authorities. In any case, it will take time to obtain relevant licenses and so professional expertise is crucial.
3. Signing Lease Contracts
A good location is one of the key components to the business success of a store, and this may be even more the case for retailers who are relatively new to China and unknown to the average Chinese consumer. As in other competitive markets, the best locations are difficult to secure, which means that the landlord has 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 – at least some level of negotiations is recommended. Where the landlord refuses revisions and a company still wants to sign, an analysis of the legal risks should be made to understand 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 reasonable 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.
4. Protecting Trademarks
The protection of intellectual property such as trademarks is a key concern for most foreign businesses in China, because it 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, but also because reputable landlords, advertisers, and especially online platforms etc. will all ask for proof of a trademark’s ownership in China before the start of a cooperation – so that they themselves can avoid falling foul with regulators. Reviewing the trademark portfolio for China and making sure that all relevant brand names are protected in the correct classes and subclasses is therefore an important part of a retailer’s due diligence when operating in China.
For international companies that are new to the country, this can present a huge problem if the international trademarks are not yet registered in China, or worse, if another party has registered them first. China’s trademark protection system is first-to-file, and although exceptions are made for well-known trademarks and trademarks registered in bad faith, it is not easy nor quick to get back a trademark. If not yet registered, it will take 9-12 months to get certainty whether a newly-filed trademark will be approved.
While obtaining the exclusive rights to the international trademark is crucial, most Chinese people do not speak or read English fluently and so it is arguably just as important to come up with a good Chinese brand name that can adequately represent the business. To be protected against both infringers and trademark squatters, the brand name should be registered in all relevant classes and sub-classes. As this involves trademarks with Chinese characters, it is best to complete these registrations in China (instead of using the international Madrid system).
5. Ensuring Legal Compliance
It will not surprise that compliance with the laws, regulations and rules applicable in China is a good idea. For retailers, this is especially important given that China has communicated a clear focus on health and safety issues that may impact consumers. The first aspect to this is to understand that the rules and standards that apply in China may be different from elsewhere. 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 Europe, flour often does not have an expiration date (only a best before date).
Product Quality & Local Standards
China has established extensive standards for all kinds of consumer products, not only for food but also for clothing, electronics etc., and these standards may be stricter than in other jurisdictions. This sometimes results in the ironic situation that products made in China are not allowed to 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 (in the most serious circumstances) criminal liabilities. The authorities dealing with such matters, especially the Administration for Industry and Commerce, will respond to individual complaints by starting an investigation. Responding to an investigation in a positive way; providing correct and the right amount of information is a delicate matter but is worth the extra resources, as an unfavorable decision can have huge financial and operational consequences.
Advertising & 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 it), and the cost of defending claims and even lawsuits, whether or not of a frivolous nature.
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. 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 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 laws are strict and tend towards protecting the employee, which means that incompliances are an imminent threat and lawful termination of employees is challenging. Establishing strong employment contracts and official company rules (in the form of a staff handbook), and adopting these rules as per legally-established processes are key steps to lower incompliance risk and create more leeway to manage (and where necessary terminate) employment relationships. One area that requires a retailer’s special attention is whether employees will be subject to standard working hours, or whether flexible working hours or comprehensive working hours should apply (which are subject to conditions and special approval).
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 and increasingly willing to pay for premium products, is a dream for many. Not every retailer that enters China is able to take advantage, but successes are easy to find.
One thing is clear though: competition is strong. 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 though, 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 the timely investment in resources and the right external support.
As a full-service firm, R&P assists with corporate/M&A, litigation, arbitration, IP, employment, tax, compliance, and commercial matters. R&P China Lawyers has a thriving retail practice, supporting numerous international companies on selling to Chinese consumers through e-commerce, cross-border e-commerce, and brick-and-mortar stores in China. For more information on our practice, or to discuss strategies on taking advantage of the latest legal developments, please contact [email protected]