As franchising has become an increasingly popular strategy for international brands to enter the Chinese market, recent years have also seen a rise in disputes from when the business relationship goes sour. Tim Meng explains why franchisors and franchisees should clearly define the calculation method and formula for damages arising from the termination of franchise agreements.
Franchising has become an increasingly popular strategy for international brands entering the Chinese market, offering foreign companies a rapid and cost-effective expansion model. However, recent years have seen a rise in disputes stemming from the termination of franchise agreements, frequently tied to unfulfilled profit expectations upon dissolution. Typically, terminating parties face not only claims for unpaid royalties, mandatory inventory buybacks or reimbursement of the franchisor’s initial investments, but also claims for lost net profits that the franchisor would have earned had the business relationship continued. This article addresses key aspects of compensation for lost profits, within the framework of the Chinese Civil Code and relevant judicial interpretations.
Article 577 of the China Civil Code stipulates that a party who fails to perform its contractual obligations or whose performance does not conform to the agreement shall bear liability for breach of contract, which may include specific performance, remedial measures or compensation for losses. Furthermore, pursuant to Article 584, where a party’s failure to perform or non-conforming performance causes loss to the other party, the compensation payable shall be equivalent to the loss actually incurred, including the anticipated benefits that would have been obtained upon due performance of the contract. Nevertheless, such compensation shall not exceed the loss that the party in breach foresaw or ought to have foreseen at the time of the conclusion of the contract as a probable consequence of the breach. It shall also be worth noting that according to Article 591 of the China Civil Code, where one party breaches the contract, the other party shall take appropriate measures to prevent the loss from increasing; if the other party fails to take appropriate measures and thus causes the loss to increase, it may not claim compensation for the increased loss.
In the Second Instance Civil Judgment of Jizhong Energy Zhangjiakou Mining Group Co., Ltd. v. Zhang Peng [(2019) Supreme People’s Court Final No. 1985], the Supreme People’s Court of China has clarified that lost profits denote the anticipated net profit losses suffered by producers, sellers, or service providers due to a counterparty’s breach of contract in agreements involving production, sales, or services. Such losses must possess a reasonable degree of certainty – that is, the profits would likely have been realized had the contract been properly performed. When assessing the recoverability of lost profits, consideration should be given to factors including general trade practices, industry experience, and prevailing market conditions.
Therefore, in judicial practice, the claimant must satisfy two essential requirements to establish a claim for lost net profits: (1) the lost profits must have been foreseeable as a consequence of the respondent’s breach at the time of conclusion of the contract; and (2) the alleged losses must be provable with reasonable certainty, supported by credible evidence. The “reasonable certainty” standard generally requires the claimant to provide proof sufficient to remove the claim from the realm of mere speculation. In most cases, evidence of past performance serves as the basis for a reasonable projection of future profits. However, as reflected in the arbitration case discussed below, the author considers it inequitable to deny the claimant’s recovery due to an insufficient “track record” in the Chinese market, particularly where the respondent's wrongful termination itself prevented the claimant from establishing such a record for the Chinese market.
Typically, in determining the amount of expected lost profits, the court may adopt a method of calculation previously agreed upon by the parties. In the absence of such an agreement, the court shall, at its discretion, determine an appropriate amount based on the submissions presented by the parties. Regarding the methodology for calculating expected benefits, Articles 60 to 63 of the Interpretation of the Supreme People's Court on Several Issues Concerning the Application of the General Provisions of the Civil Code on Contracts provide general guidance as follows:
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The court may calculate such benefits by reference to the production profit, operating profit or resale profit that the non-breaching party could have obtained, after deducting any reasonable costs incurred in connection with the conclusion and performance of the contract.
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If the non-breaching party lawfully terminates the contract and engages in a substitute transaction, the expected benefits shall be calculated as the difference between the price of the substitute transaction and the original contract price – unless the substitute transaction price significantly deviates from the market price prevailing at the time of that transaction.
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If the price of the substitute transaction significantly deviates from the market price prevailing at the time it was conducted, the expected benefits shall be determined based on the difference between the market price and the original contract price.
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If the non-breaching party lawfully terminates the contract but does not conduct a substitute transaction, the expected benefits shall be calculated based on the difference between the market price at the place of performance and the contract price.
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Where the expected benefits cannot be reasonably determined through the aforementioned methods, the court may render a determination based on a comprehensive assessment of factors including the benefits obtained by the breaching party as a result of the breach, the degree of fault, the specific circumstances of the breach and other relevant considerations, in accordance with the principles of fairness and good faith.
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If a party to a fixed-term contract requiring successive performance of obligations fails to pay the price, rent or any other monetary obligation, and the other party requests rescission of the contract, the court may, upon determining that the contract should be lawfully terminated, take into account factors such as the nature of the contracting parties, the type of transaction, changes in market prices and the remaining duration of performance to determine a reasonable period for the non-breaching party to seek substitute transactions. The benefits that could have been obtained shall be determined by deducting the corresponding performance costs payable by the non-breaching party from the price or rent corresponding to such period.
A recent arbitration case administered by the China International Economic and Trade Arbitration Commission (CIETAC), in which the author participated, illustrates the method for calculating expected profits. In early 2018, a European company (the claimant) and a group of Chinese companies (the respondents) entered into a franchise agreement. Under this agreement, the claimant granted the respondents the right to exclusively sell its products within the designated franchise territory in China, using the claimant’s know-how, trademarks, designs and other distinctive signs. As the franchisees, the respondents were obliged to pay the claimant a franchise fee as well as purchase products supplied by the claimant at a discounted price.
Following the execution of the franchise agreement, the respondents began preparations to open stores by entering into lease agreements with shopping malls in several Chinese cities. The claimant, for its part, commenced product supply to the respondents. However, five months later, the respondents formally notified the claimant that the international franchise agreement was being terminated due to unexpected drastic changes in China’s investment and retail markets. Having found that the respondents wrongfully terminated the agreement, the tribunal detailed its methodology for calculating damages for lost expected profits.
First, considering that the franchise agreement included development plans outlining net sales targets over a five-year period – which represented a comprehensive assessment by both parties of the Chinese market and the respondents’ actual sales capacity – the arbitral tribunal concluded that the figures specified in the agreement reflected realistic and achievable estimates, rather than unfounded speculation. Accordingly, the tribunal held that the respondents should have foreseen the loss of the claimant’s anticipated benefits resulting from their unilateral termination of the agreement.
Secondly, in this case, unlike businesses with an established presence in the Chinese market, the parties were still in the preparatory phase of opening stores and had not yet generated any track record in China. This situation substantially increased the Claimant’s burden of proving financial certainty. With this respect, the arbitral tribunal found that, while evidence of past performance in the Chinese market typically forms the basis for reasonable future projections, it would be unjust to give a flat-out refusal to the Claimant’s recovery due to an insufficient track record in the Chinese market – especially since the respondent’s wrongful termination itself prevented the claimant from establishing such a record. Accordingly, the tribunal held that although the estimated annual sales figures stipulated in the contract may not be determinative on their own, lost profits may be established with reasonable certainty through supplementary means such as expert testimony, economic and financial data, market surveys and analyses and business records of comparable enterprises.
Third, regarding the alleged lost profits, the claimant submitted an independent expert report prepared by a globally recognized professional firm. The report establishes specific requirements and principles for valid loss of profit claims and outlines a detailed methodological framework for calculating damages. The arbitral tribunal found that the expert report provided a rigorous analytical structure that prevents speculative claims and conforms to accepted judicial expert standards. Therefore, the tribunal determines that the expert report shall be served as a reference when the tribunal has a discretion to quantifying the loss of profits.
Fourth, the arbitral tribunal determined the period of the loss of profits was one year, after considering the factors that:
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The respondents chose to terminate the franchise agreement during the pre-operational phase, before substantial resources had been allocated. As a result, the legal consequences of such termination are considerably less severe than they would be if termination had occurred during active commercial operation;
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Although the expert report assumed a two-year loss period – based on the premise that the claimant would need that amount of time to secure a replacement franchisee – the original franchise agreement between the parties was in fact negotiated and finalized within six months;
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The claimant has failed to provide any substantive evidence demonstrating its active efforts including seeking an alternative franchisee to mitigate its losses during the alleged loss period; and
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Even if a replacement franchise agreement were concluded, the new franchisee would likely require a reasonable transition period for operational preparations before reaching full capacity.
In another arbitral proceeding in which the author was involved, the dispute was arising from a leading Chinese dairy products company’s terminating a trademark license agreement. Regarding the calculation period for expectable profits, as the licensee, the claimant contended that it should be 12 months, citing the relevant contractual provision: “the licensor may terminate this contract without liability for breach by providing the licensee with twelve (12) months’ prior written notice.” The arbitral tribunal reasoned that the respondent could have terminated the trademark license agreement by providing 12 months’ notice as stipulated in the contract. This would have afforded the claimant sufficient time to wind down partner relationships and derive earnings from remaining inventory, thereby offsetting costs associated with its distribution network. The tribunal therefore held that an award of 12 months’ expected profit was justified as reasonable compensation. The tribunal further calculated the profit rate and determined the lost profits for the remaining period based on the actual sales from previous months, projected sales for the remainder of the period, and deductions for transportation and warehousing costs as well as the imports duties.
In summary, both Chinese law and the cases discussed above indicate a growing willingness among arbitral tribunals in China to award compensation for lost profits. That said, tribunals retain broad discretion in their decisions, taking into account a range of factors. Since Chinese law permits carefully drafted liquidated damages clauses that aim to compensate for lost profits, it is advisable for franchisors and franchisees to clearly define the calculation method and formula for such damages. Doing so would provide businesses with greater legal certainty and allow parties to reasonably anticipate potential outcomes when entering into agreements.
