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China’s Legal Landscape

Posted in China Business, Legal News
A real landscape.

A real landscape.

One of our China lawyers, Dan Harris, was recently interviewed regarding China law and lawyering in general in this article, entitled Legal Landscape. Large portions of this interview are China relevant, particularly for foreign companies doing business in China, and so if you are one of those companies, we recommend you read it. The below is an excerpt from the article and we urge you to read the whole thing.

 

Looking at your practice area, what has been the biggest development in the last five years?

Things that American companies could get away with in China five years ago, they can’t anymore. China now has sophisticated tax and tax collection systems. China has gotten a flavor of what it means to collect taxes, and they love it. Like all governments, they want your money. And if you’re not going to pay them the money that they believe they are owed, they will make your life miserable beyond any conception of the word miserable.

Americans are getting in major trouble for this. We see it in two areas constantly.

An American company will hire, say, three “independent contractors” in China. The Chinese government will come to the American company three years later and say, “What are you doing? You have three employees but haven’t paid employer taxes for the last three years or withheld employee taxes. We’re going to say that you’re doing business in China because you have these three employees, so you owe company income taxes. And by the way, employer taxes and benefit taxes equal, like, 40% of what you paid them in salary for the last three years. And we’re going to charge you interest and a penalty. And if you don’t pay, we will shut down your business here and we may not let you leave the country.”

“What? They’re just independent contractors,” the Americans argue. Well, guess what? If they’re not your cleaning person, or your plumber who’s coming to fix your sink for two days, and you’re paying them money and they don’t have a company, they are your employees.

The other thing is that Americans will set up a company in China that sells a service or a product back to the parent company in the United States. They set it up so that the company in China makes no profit. It is called transfer pricing. But the Chinese government will come in and say, “People don’t run businesses for no profit. We’re going to impute a 30% profit, and you need to pay the last three years’ taxes on that plus penalties, plus interest.” And the Americans freak out.

What you should do is bring on accountants who understand transfer pricing and they will figure out that the typical profit margin is, say, 6-10%, so maybe they put you down for 8%. The Chinese tax authorities will look at that and won’t mess with you. But if they have to come in and you’re making no profit, they don’t start at 8%. They come in at 30%.

That’s how governments always work. Americans need to start realizing that what American companies got away with five years ago, that era is no more. And the things Chinese companies down the street are getting away with? Well, you’re not a Chinese company.

Are You Operating Legally In China? Now Is The Time To Be Sure

Posted in Basics of China Business Law, China Business
We've been accused of trying to scare people. This time we cop to that.

We’ve been accused of trying to scare people. This time we cop to that.

We have been through many China downturns and they all have one thing in common: they cause the Chinese government to get even tougher with foreign companies. But when it comes to getting tough with foreign companies not complying with China’s laws, our China lawyers have never seen anything like the current one. We think it is due more to China’s better capabilities at catching the non-compliant than to an increased desire to do so. Either way, it is happening out there, and in buckets.

Today’s post will focus on the foreign companies that are getting called out on employment matters. In a subsequent posts we will discuss foreign companies getting in trouble for operating beyond the scope of their formation documents.

In the last couple of months we have received more emails and phone calls regarding companies being “summoned” to their local labor bureaus than we received in the last few years. Though these phone calls and emails are coming from all over China, we have no way to know whether the summons are based on local initiatives or whether they are being directed from Beijing.

The below email is an amalgamation of some that we recently have received:

We are in the ________ industry and I have been coming to China for about 10 years. Our business in Europe kept growing at a good rate and so to improve quality, get better prices and avoid agents getting a percentage from us plus a percentage from the factories and making our goods too expensive we decided to start a company in Guangdong 5 years ago and last year we opened a factory to do most of our production.

We have been using a Chinese accounting firm to help us with our accounting and labour matters. The accounting they do is very strange to me, but they insist this is how all Chinese companies work. On labour contracts they told us that we do not need contracts with all of our workers, but just with a few key members of our staff. So out of our 75 workers only 16 have contracts.

Last week we got a letter from a government labour department, summoning us to their offices in two weeks time because they had received a complaint. One of our workers reported us for firing him for no reason. The letter from the labor bureau says that they are claiming ________ rmb for the dismissal and for not having a contract and for making this person work overtime.

Our response to these is typically along the following lines:

ALL of your employees should have had written contracts (in Chinese). Failing to have a written contract opens your company up to substantial penalties. Are you paying all of the required employee taxes on ALL of your employees? I am very concerned that you are not. Here is an article I wrote recently for detailing how (and why) China is going after foreign companies so strongly on labor tax issues. I would not want to see this one problem escalate into a massive tax issue for your China company and I am very concerned that the labor bureau is just using this one case as an excuse to force you to open up all your books on all of your employees. Trust me when I tell you that we have seen this sort of thing happen countless times before.

We like to nip in the bud situations like the one you describe before they reach the government stage, where pretty much nothing good is going to happen. By “nip in the bud,” I mean that we would try to settle with this employee to try to end the government proceeding entirely. Our goal would be to end government involvement as quickly as possible and then clean up your company so as to prevent future problems. We may be too late for that, but there is at least a decent chance that we are not. The first thing we would try to do is to seek to move the meeting with the government back a few weeks to give us time to try to negotiate a settlement with this one employee.

Internally at our firm we had a discussion among some of our China attorneys regarding this sort of situation and one of them (via a long series of emails regarding multiple companies) wrote something like the following:

Yes, this company is in big trouble. And that is because it took advice from a Chinese accounting firm. But what are these guys supposed to do? It should be completely safe to take advice from Chinese lawyers and accountants. But the opposite is too often true, especially outside Shanghai and Beijing. These firms believe that they are doing right by their foreign clients by telling them to do what their Chinese clients do. Do they not know that foreign companies will be treated differently in China? Do they not care? Or is this a situation where both sides (the accounting firm and the client) are deliberately wallowing in silence when both must know that what has been proposed makes no sense and cannot be legal?

Consider, however if this company had operated legally from day one. It probably never would have opened a factory because it would have been clear that it would not be profitable. We can add this to the examples of operating outside the law in China. But what is the advice we give here? We always advise ignoring these sorts of Chinese professionals and stress the need to operate 100% legally. This advice is sound, but for many companies operating 100% legally means not operating at all in China. This accounting firm helped to bring jobs to China that would not otherwise have gone to China and, more importantly, it brought itself years of good fees. Did the company benefit from this “bad” advice? We don’t even know. But we do know that we have seen many foreign companies that have benefitted by operating illegally for three, five and even ten years before they got called out and shut down. This is just another example of how China makes it easy for you to come in with your money but difficult to leave with it.

But again, it is hard to have a lot of sympathy here because these companies did operate illegally and should have known that they were operating illegally. Some of them have to have known that they were operating illegally, but were happy to use their Chinese “professionals” as their cover because they profited handsomely by doing so. And of course they did benefit by operating illegally and we should not forget that either.

But this sort of thing is part of the new anti-corruption moves and so foreign companies are going to need to change their thinking and fast. Three years ago, this sort of company would not even have contacted us. They would have just gone to their Chinese accounting firm and the Chinese accounting firm would have asked for $5,000 and “presto” the problem is solved for a few more years. For all we know, that has been exactly what this company has done many times before. But doing that now would be the worst thing it could possibly do because it then puts it and its top people at great risk of expulsion and even jail time. But do they even have sufficient funds to really try to clean it all up? And is that worth it to them at this point even if they do? So what can they do? If this is as big an issue as we think it is, their best strategy may just be to pack up their bags and leave today. Just another company caught in yet another China paradigm shift.

Bottom Line. If you want to stay in China, now is the time to make sure that you are operating legally there and to take immediate action if you are not. The Chinese government goes considerably easier on companies that self-report their problems and propose solutions than on companies it discovers with problems.

Getting Your Product Into China With China Distributors: The Yin And Yang

Posted in China Business, Legal News
China distributor relationships can be a muddy (or a clear) path to China success.

Don’t let your China distributor relationships muddy your path to China success.

We are big fans of Western companies using China distributors to market and sell our client’s products in China. Our thinking on this goes as follows:

1. We have seen far too many Western companies spend way too much time and way too much money trying to sell their products into China.

2. We have seen far too many Western companies fail in selling their products into China.

3. China is a difficult country. Most of the marketing clichés about it are true. It is not one market. For instance, you can succeed in Shanghai and never succeed anywhere else. You can succeed in one province and never succeed anywhere else. China is big and China is diverse. And for many products, its distribution and retail or wholesale networks are a mess. Add in the cultural and language unfamiliarity that accompanies all of this for most Western companies and. . ., well you get the point.

4. From a legal prospective, China distribution agreements are relatively easy in the sense that we can draft a distribution agreement that works for China and for our own clients. As can be seen in the following posts, we have for years we have been extolling the ease of “doing” China distribution contracts and of setting up a sound legal foundation for a successful China distributorship:

China Distributor Agreements: A Relatively Easy Way To Sell Your Products Into China

Selling Your Product To China Through A Distributor. Just The Basics.

Selling Your Product In China Through A China Distributor. Easy-Peasy.

Getting Your Product Into China Via Distributorship. A Legal Piece Of Cake.

But….

Getting the right distributor and then establishing the right distribution relationship is not so easy. Not so easy at all.

I was reminded of that today when a food client of mine sent me an email with a link to a Shanghai Scrap post, entitled, The More Things Change in China – Hershey’s Chocolate Edition. The post seeks to dissect what is going wrong for Hershey’s in China, as evidenced by its most recent earnings report showing that sales are “suffering” in China:

Was this just another case of China’s souring economy dragging down another venerable American company? Or was there something else at play here – something more subtle. In search of an answer, I emailed a gentlemen whose judgment on foreign investments in China I trust, and who asked that – for the purposes of this blog – he be referred to as “Cocoa.” He took a look at Hershey’s attempt at an explanation, and used it to form his own. So, with Cocoa’s permission, I reprint Cocoa’s sound explanation for why Hershey’s is tanking in China.

“I think Hershey’s problems in China – and as judged by China – have nothing to do with Hershey’s chocolates taste which is acceptable, design and packaging which is okay, price which is reasonable and all in all an acceptable value (I pointedly dismiss all other products but the chocolates no matter in what form; peanut butter cups probably make the average Chinese gag). Rather, the company bought a pig in a poke, to wit Shanghai Golden Monkey which Hershey now understands has an “unstable distributor network” (call that distributors disloyal to the brand who can’t be won over to push sales without hefty rebates coming into their pockets) and so the “retail customer reach is not as broad as we (Hershey) believed it to be” (meaning the customer base is much, much smaller than was presented to Hershey) and so the consequence that sales in 2015 are US$90 million less than the US$200 million they expected – well, that’s 45% below projections which to anyone in industry is a sure-fire pink slip to all involved. In short, Hershey’s problems in China have nothing to do with chocolates but everything to do with newbies coming to China and being sold a bill of goods. Yep, it’s that simple.”

I have nothing to add to this except to say that, a) I agree, and b) it’s remarkable that after three decades, well-heeled, established companies continue to allow their enthusiasm to run past their common sense when seeking growth in China.

Let me say that I have no idea as to why Hershey’s sales in China are hurting, but both I and the other China lawyers at my firm have most definitely seen our own clients have their China sales stymied due to their distributor. Of course, on the flip side, we have also seen our clients’ China sales soar due to their distributor in China.

So now that you understand the issue, how can you as a Western company choose the right China distributor and then make your arrangement with that distributor work. Two answers, neither of which I realize are going to be terribly satisfying. One, engage in extensive due diligence when choosing your China distributor. That does NOT mean automatically choosing Chinese Company A simply because Chinese Company A called you. That means first understanding your industry and your market in China and then choosing a reputable distributor best equipped to service your industry and your market. Two, think long and hard about what you want your distributor to do in China and about what you want your distribution relationship to look like in China and about all of the things you need to do to protect yourself in China. And then have a contract drafted that advances all of these things.

Not so hard/hard.

The China Bank Switch Scam: It Gets Hotter When China’s Economy Cools

Posted in Uncategorized

Our China lawyers have received at least five emails this past month from companies that have fallen victim to the China bank switch scam, in amounts ranging from USD$12,000 to $383,000. We are getting these at such a pace of late that I have formulated the following automatic response:

Your chances of getting back all of your money are very low.

How to protect yourself from the China bank switch scam and what to do if it happens to you.

The China bank switch scam and what to do if it happens to you.

If you were to retain us, we would do the following:

1. Work with your insurance broker and your insurance company to see if it will cover you for this loss. This is pretty much your only real chance of recovering all that you have lost.

2. Try to get some monetary contribution from your Chinese supplier by pointing out to it that it was their computer system that the scammer hacked and therefore it should pay at least some of your loss. This works maybe half the time in getting maybe half of the money back, usually over time. Much will depend on your existing relationship with your Chinese supplier and on what it perceives its future relationship with you will be.

3. Try to determine if there is any chance in recovering anything from the perpetrator. This virtually never leads to any recovery.

As we have frequently written on here, this bank switch scam is the most common, most pernicious and most difficult to detect China scam of which I am aware, and it just unrelentingly keeps happening.

This scam usually involves your regular Chinese supplier asking you to make your next payment to a new bank account, though it sometimes can involve your very first payment to a new Chinese supplier. Then even after you make the payment, your China supplier insists that you still owe it the full amount (oftentimes with added fees) because it never received your payment. When you explain to your China supplier that you in fact did pay it, your supplier points out that the bank account to which you sent the funds is not theirs and that you still owe the money.

What happened? Your Chinese supplier got hacked, either by someone outside or within the company and you indeed have yet to pay it.

Here is the latest one, with all identifiers changed so as to disguise identity:

Dear Harrismoure,

My name is ____________, I am the president of __________, a manufacturing company in Spain.

We had a supplier in china that is selling ________ to us (for over 5 years) and we got a recent request from our supplier asking us to do the deposit on a different account in China and we did for over 230,000 USD.

Then we found out that our supplier did not have the money. Now we do not know who has our money.

I saw your article in Forbes about this and I would like to know whether you can help us.

I wish that I had some new method of preventing this scam (just as I wish that everyone who does business internationally would read this post so that this scam never happens again). But I must resort to saying what we have been saying all along.

This is a scam that can happen to YOU. We have seen many smart, worldly, sophisticated companies of all sizes get caught up in this scam.

What then should you be doing to prevent it from happening to you? Do the following (h/t to Renaud Anjoran for these):

1. Get to know your suppliers who speak English (if you don’t speak Chinese) and get your supplier’s landline phone numbers as that cannot be hacked. Call if you have any concerns.

2. Get your supplier’s bank account information in advance and ask them to refer to “bank account information document” on their invoices, rather than listing out full bank details every time.

3. Ask your suppliers to fax you their invoice and make sure the sending fax number belongs to your supplier’s company.

4. Do a first small wire to confirm the account.

5. Have a special procedure for confirming the company name. Note also “that paying a Chinese company in mainland China is safer for you” than paying them overseas in Hong Kong, Taiwan or elsewhere.

6. Have a special procedure for confirming bank account changes. “Follow the same procedure as point 5, but also call several people in the company. They will understand your attitude if you tell them you are worried about the “different bank account scam” — they are also a victim when it happens to their customers.

And please just be careful out there.

China Employee Non-Compete Agreements: What’s Your Geographic Scope?

Posted in Legal News
When drafting your employee non-competes, don't just assume the world is your oyster.

When drafting your employee non-competes, don’t just assume the world is your oyster.

When drafting China employee agreements, I often have to deal with the issue of non-compete provisions. One of the recurring non-compete issues is the geographic scope appropriate for the employee. The general rule for China on this is quite simple: China will enforce a “reasonable” geographic scope.

But what does that even mean?

The analysis is entirely factual. In determining whether the geographic scope of a non-compete provision is reasonable, Chinese courts will consider all facts, including, the employer’s business scope, the employer’s size, the employer’s industry, and the employee’s position. Note that the courts will look at the employer’s actual territory on the date employment is terminated, not the territory in which the employer was contemplating doing business back when its employee signed the employment contract.

In a situation where the employer is part of a bigger enterprise, the only thing that matters is the entity with which the employee has his or her labor contract. The worldwide operations are not considered territories for purposes of your China employee non-competes. This is an important thing for foreign companies to realize because this means that if your China employees are part of your China WFOE (which is what should be the case virtually all the time) and your China WFOE makes or sells its widgets only within China, the reasonable geographic scope of your employee’s non-compete will be confined to only China, regardless of whether your Hong Kong or your New York operations sell widgets all around the world.

But if the employer’s territory includes countries outside China, theoretically, these countries can be added to the territory of the non-compete agreement. However, enforcement of your non-compete provision is another issue your should consider. Suppose your employee leaves your employment to work for a Chinese company with a market in one of these foreign countries; your agreement would in principle be enforceable. However, Chinese courts have historically been very reluctant to enforce contractual provisions dealing with situations not within China and we are not aware of a Chinese court ever having agreed to enforce a non-compete in this sort of situation.

Nonetheless, it can still make sense to make the geographic scope of your employees’ non-compete provisions as expansive as you think appropriate. Even if you make the territory too big or the non-compete agreement is unclear on its geographic scope is, it does not invalidate the entire agreement. It only means the court may reduce the geographic scope if it sides with the plaintiff on the territory issue. However, if your agreement provides for a narrow scope, it would be very difficult for you to argue later that the scope should be broadened.

But, as is so often true in this sort of situation, there is a psychological issue that you should consider when contemplating the geographic range of your non-compete, which makes these provisions equal parts art as science. An example of how this might work would be helpful here. Suppose that 99% of your sales are in Qingdao in the Province of Shandong, and the remaining one percent of your sales are in the rest of Shandong Province and in a few provinces nearby. Now suppose that your non-compete specifies the entire world. A judge looking at that will instantly know that there is no real connection between the geographic scope of your employees’ non-compete provision and where you conduct your business and he or she will no doubt severely reduce the scope of the non-compete, probably limiting it to just the city of Qingdao.

Now suppose instead that your non-compete forbids competing within all of Shandong Province. In that case, the judge would be a lot more likely to “let slide” the geographic scope in the contract because it does at least have some reasonable connection with the scope of your business.

For more on China employee non-competes, check out How To Terminate A China Employee Non-Compete Agreement. Very Carefully.

 

China’s Ten Favorite Industries

Posted in China Business
China's ten favorite industries

China’s ten favorite industries

You probably think it a bit strange for me to be writing at all optimistically about China’s economy today and I get that. But as someone who has lived through a whole host of downturns, I sort of look at “these things” as us not having any choice. I also think it important that we all keep China’s economic downturn in perspective and as an example of that, take Japan.

I was in Tokyo and Osaka and Kyoto a few months ago and — just as is the case every time I go to Japan — I was struck by how wealthy that country is, especially Tokyo. You cannot be out in Tokyo for more than a minute without seeing an S-class Mercedes or a 7-series BMW. And yet Japan’s economy has essentially done little for decades. Assuming China’s economy flatlines (which is really quite a stretch because even the pessimists are talking about 3-5% yearly growth), China will still have tens of millions of extremely wealthy people and hundreds of millions (dare I say a billion+?) consumers. Maybe sales of $4000 handbags will go down, but people are still going to need handbags. And cars and food and clothing and…. Not to mention that the downturn will likely be a boon to most foreign companies that manufacture in China or are looking to do so. So unless I see something to indicate otherwise, I feel that slogging on is the way to go.

And in that spirit, I mention an excellent article I read by Gordon Orr, a Director and Chairman of McKinsey Asia, based in Shanghai. The article is China Is Betting Big on These 10 Industries, and it sets out — you guessed it — the ten industries China is favoring and explains why each of these should do well over the next ten years. As Orr so nicely puts it in describing what we can expect with these ten industries:

We can be certain that behind these priorities will be a wave of cash and incentives to manufacturers and to consumers. We can be sure that many Chinese companies, private and state-owned, are revising their strategies to align with the government’s priorities and that local capacity will rise exponentially.

And while experience reminds us that success will be elusive in some sectors, in several it is likely that Chinese companies will become much, much stronger global leaders by the end of this period as a result of very Darwinian competition.

Customers may be the biggest beneficiaries in the decade ahead as the government’s strategy drives companies down the experience curve much faster than would otherwise have been the case.

The following constitute Orr’s top ten:

  • Information technology. “Especially where Beijing has emphasized the need to wean China off foreign technology, and for China to become a “cyber power” in its own right.” Orr counsels us to expect more investment in semiconductors and acquisitions of international technology companies by Chinese companies. I 100% agree, based in large part on the rapidly increasing work our China lawyers are seeing in this sector over the last 2-3 years.
  • Numerical control tools and robotics. According to Orr, “China is already becoming a leader in low and mid-range numerical control machines. “
  • Aerospace equipment. According to Orr, “China seeks to become a leader in satellite technology and is hoping to move beyond its first domestically made passenger jet, which is heavily dependent on foreign technology.” I doubt anyone would dispute that and we are seeing the same thing via U.S. aerospace companies contacting us after having been contacted by Chinese companies wanting to buy or sell their products or seeking to form a China Joint Venture.
  • Ocean engineering equipment and high-tech ships. Though our firm has a long history of representing companies in the international maritime sector, we have not seen any uptick on this front. At least not yet.
  • Railway equipment. Make sense.
  • Energy saving and new energy vehicles. China definitely does want to improve its capabilities on this front, but this has proven to be a tough industry for foreigners.
  • Power equipment. “Smart grid and smart city technology are the central priorities.”
  • New materials According to Orr, if “China can become a leader in inventing and commercializing new materials we will have fewer conversations on ‘does China innovate.'”
  • Medicine and medical devices. We are certainly seeing growth in U.S. companies getting involved in these industries in and with China.
  • Agricultural machinery. “Yet another sector where China is looking to enhance efficiency and create a platform for exports. Yet as we have seen with the auto sector, it may not be easy.”

Please also check out China’s Five Best Business Opportunities, Revisited, where I discuss some of these same industries, but more in the context of how foreign companies seeking to do business in China can benefit.

What are you seeing out there?

China’s Stumbling Economy And You

Posted in Basics of China Business Law, China Business, Legal News
Doing business in China is getting even tougher

Doing business in China during a downturn

If this post seems familiar, it’s because I run an updated version of it whenever China’s economy starts shifting downward.

Lately, the China lawyers at my firm have been receiving emails like this:

Hi. I am an avid reader of China Law Blog. I run a small _________ company in Shanghai and have come upon my own situation in which I would like to ask for a legal opinion. It’s not a very big issue and maybe not even worth pursuing it but since we are a very small company with limited funds it’s still of relevance for us.

A part of our business is renting out _________ machines to customers such as restaurants. One of these restaurants has just gone out of business. Since several months of rent are due to the landlord, the landlord has locked the shop down with all equipment (our _______ machine, the restaurant’s employees’ personal things, etc.) all still inside. The landlord is saying that they will release everything inside the restaurant only after discussing with the restaurant operators, all significant employees of which have now left town.

I am not exactly sure what will happen, the situation is vague as many things are here, but we would like to get our machine back (wholesale cost of about 20k RMB).

My questions now are if the landlord has the right to keep our property (e.g., the machine) and if not, if there is anything worthwhile that we can do about it?

Thank you.

Here was our response:

Without reviewing your contract with this restaurant, I have no way of knowing what you can and should do. If you have a really good contract (preferably in Chinese and chopped by the restaurant) that makes clear that the ______ machines belong to you unless and until they are fully paid-for, then you should show that to the landlord and the odds are good it will let you walk off with your machines. If you don’t have such a contract, I wish you good luck because at that point it is not likely to be very clear who owns what.

Emails like these reflect a larger issue. In 2012, I wrote a piece for the Wall Street Journal entitled China’s Slowdown and You, on the impact China’s slowing economy was having on foreign companies doing business with China. In it I asserted the following:

  • The Chinese government “is more concerned with social harmony than with economic numbers” and that is why it continues to encourage wage growth even though higher wages make China’s factories less competitive.
  • China’s prioritization of its citizens’ contentment means China will continue getting tougher on foreigners, just as it has always done when times are tough. Everything foreign businesses do will be under heightened scrutiny.
  • The Chinese authorities are throwing new roadblocks in the way of foreigners seeking to form businesses in China. Beijing and local governments are increasingly eager to distinguish between “contributing” and “noncontributing” foreigners, which means it has never been easier for well-funded, nonpolluting foreign companies to secure approval to operate in China — and it has never been tougher for foreign companies that pollute, pay low wages, or have no plans to hire Chinese employees.
  • Chinese exporters, particularly those that compete with companies from lower-wage countries like Vietnam and Bangladesh, are suffering — in particular in low-tech, low-wage industries such as manufacturing of textiles, clothing, shoes and low-end electronics and toys. Foreign companies that do business with Chinese companies in these industries must keep up their guard.
  • The key to weathering China’s slowdown will be for foreign companies to go back to basics: think afresh about what your company contributes to China’s economy and how that is likely to shape policy makers’ opinions; focus on scrupulous regulatory compliance; and renew your focus on due diligence at a company-to-company level.

Though all of the above is still true today, the news isn’t all bad. A greater number of China businesses are getting savvier, more sophisticated and more international. Even though China’s low-end companies are suffering, the high-end companies are getting bigger and deeper, as they strive to provide a product or a service (or a product and a service) that can compete anywhere. The existence of such Chinese companies is not new; my point is that these are the companies that are proliferating and growing in strength, and more Chinese companies are realizing that stepping up their game is the best way for them to survive. Co-blogger Steve Dickinson hit on this trend in his post The New Role Of Written Contracts For Product Purchases In China. In other words, the importance of choosing your China partner — which was always critical — has become even more so.

China’s most recent economic hiccup is a double-edged sword for Chinese manufacturers. On the one hand, the renminbi’s devaluation improves the competitiveness of Chinese manufacturers that don’t source many components from outside China. On the other hand, Chinese manufacturers are increasingly cut off from funding sources, and those that were undercapitalized to begin with are headed for trouble. And foreign customers are the last to know, and the first to get taken advantage of. With this in mind, our best advice to protect your financial interests is (1) document all transactions in simple, concise language (so that if there is a fight over the failing Chinese company’s assets, it will be clear what actually belongs to you), and (2) do your utmost to determine the financial wherewithal of your Chinese counter-parties before you pay one cent. These two steps aren’t foolproof, but if you do both you’re a lot less likely to get burned, slowdown or not.

Do you agree? What are you seeing out there?

Self Enforcing China Contracts With Powerful Companies

Posted in Basics of China Business Law, China Business, Legal News
When it comes to your China contract, make it work.

When it comes to your China contract, make it work.

In China Contracts: Make Them Enforceable Or Don’t Bother, I talked about what should go into your China contract to make it enforceable. In this post, I go deeper into the issue of contract enforcement in China.

Foreign businesspeople doing business in China often tell me that “contracts with Chinese companies are not worth the paper they are written on.” When told this, I usually ask whether they had any first hand experience where this was the case. In the rare instance where they did, I ask to see the contract that did not work for them. Recently, a German investor told me of a situation where the Chinese side of his joint venture deal violated the terms of all the contracts and he was unable to find any remedies.

After looking at his contracts, I agreed that his contracts were all completely unenforceable; they were the type of contract I discussed in my previous post on this issue. I told him: “you are correct, the contract you executed is in fact not worth the paper it is written on. Some contracts are very valuable, some are not. Enforceability depends on a number of factors.

In my previous post I stated that when you enter into a contract with a Chinese company you must ensure that the contract is actually enforceable in China, and I set out the basic rules required to achieve that goal. However, I also noted that you should consider who the Chinese party is on the other side of your deal. The China lawyers in my firm have had good success in using China’s court system to enforce contracts. However, China’s court system works for enforcing your contract against a Chinese company only if one absolute rule is met: the Chinese court sees the parties on both sides as being equals.

When we succeed in China’s courts, both parties are WFOEs (Wholly foreign owned entities) or the dispute is between a WFOE and a foreign company. In this sort of situation, it is natural for the Chinese court to see the parties as equals. Most of the disputes we handle, however, are between foreign companies and privately owned Chinese companies. This is the typical situation where a foreign purchaser of Chinese manufactured goods makes a claim against a Chinese manufacturer based on quality or intellectual property infringement.

Surprisingly, in these cases, the Chinese courts tend to treat the parties as complete equals. In fact, in the intellectual property infringement area, many Chinese companies complain that the Chinese courts actually favor the foreign side over the Chinese entity. That is, the Chinese courts just assume the Chinese company is an infringer and then move on to determining what to do about the infringement.

But what happens when the Chinese party to the contract clearly will not be treated as the equal of the foreign entity? For example, what if the Chinese party is a major state owned enterprise, or the sole large employer in a provincial town or (most dangerously) is private but is owned or controlled by a family member of a powerful government official or is owned or controlled by the Chinese military or police. For this type of party, it is likely that a Chinese court will treat the Chinese party far better than it treats the foreign party and the likelihood of your securing a favorable court decision against the Chinese party is low.

So then what should you do when entering into a contract with the above sort of “powerful” Chinese entity? American and European companies when faced with this sort of situation far too often simply ignore the true risks and enter into exactly the kind of unenforceable contract I described in my previous post. That is, the foreign party reasons: it will be impossible to enforce this contract in China, so I will provide for some fanciful solution such as arbitration in New York as an alternative. But this is a mistake: if the contract is not enforceable within China, it certainly will not be made enforceable by avoiding Chinese jurisdiction and then having to come back to China to get it enforced there. All this does is make it even easier for a Chinese court not to enforce. Smaller companies often simply abandon all hope of any sort of contract protection and draft their own or just use purchase orders. These approaches are usually a mistake.

When doing a deal with a powerful Chinese company, your first step should be to enter into a contract that follows the basic rules for developing an enforceable contract in China. China has great respect for the written word. Even in difficult situations, it is often surprising how effective it can be to threaten a law suit in China based on an enforceable, Chinese language contract. However, for the threat to work, it must have at least some teeth and that requires a contract that will work.

In contracting with a powerful Chinese party where you know contract enforcement will be difficult, you should think carefully and develop a way to make your contract self-enforcing. You should use the contract as a device to structure the business relationship in a way that allows for you to enforce it yourself. This can be done in many ways, including the following:

  • The best way is to do nothing under the contract without being paid first. If the deal involves your company delivering product to the Chinese company, write a contract that provides that you don’t ship a thing until after you have received payment. If the transaction involves your company providing services to the Chinese company, don’t provide any services until after you have a substantial deposit from the Chinese company. Chinese companies will fight this kind of structure and requiring it oftentimes will put a kibosh on the deal. But so what. If the Chinese company refuses to pay you sufficiently in advance, you should just figure it is because they have never had the intention of making full payment to you in any event. Possession is indeed nine tenths of the law and in dealing with Chinese companies you should not forget this.
  • Where there is inherent risk in your transaction (payment risk, quality risk), cover the risk with standard risk management products such as a letter of credit, a bank guarantee, escrow or insurance. The key to protecting yourself in one of these ways, however, is to use a truly neutral third party professional not located in China. Any risk management product offered by a Chinese entity such as a bank or insurance company is of little to no value.
  • Design the product you provide to your Chinese company so that you can and do retain a key component of it until you are paid in full. For example, make your manufactured product in such a way that you can hold on to a key chemical or physical component required for it to work and that not provide that key component until paid. For a software product, require the use of a password or software key that you can change each time a new payment is due. Sometimes this sort of thing can be done with a service as well, if you can hold back on the critical elements of it until the end.

There are many other techniques you can use to all but guarantee payment, depending on the nature of your business and the transaction. The interesting situation in China is that Chinese companies fully understand what is going on when they are presented with a self-enforcing contract. It often surprises foreign business people to find that Chinese companies will willingly sign off on an onerous, 30 page long common law contract but adamantly refuse even to discuss a China-enforceable, clearly written Chinese language seven page long self-enforcing contract.

The reason for this dichotomy is simple. First, even the most powerful Chinese companies are afraid of Chinese courts when the legal issue involves business rather than politics. Second, in the case of a self-enforcing contract, the Chinese company recognizes that such a contract takes away their power to to be arbitrary and unfair. Since the kind of powerful entities that I am discussing here are accustomed to being arbitrary and unfair, they (rightly) view self-enforcing contracts as risky and threatening.

Well connected Chinese companies often will simply refuse to execute a fairly written, self-executing contract. In that situation, the best response for the foreign party is to weigh its risks and seriously consider just walking away from the deal.

What To Read On China: The End Of Our Blogroll

Posted in China Business, Legal News, Recommended Reading
Doing Business In China

Please send us your list of recommended China reads. Email will work just fine.

Our blog consultants (a very loosely and ill-defined group of friends who know what’s what on blogging) have been telling us for years that blogrolls are passé. They say that we should delete our blogroll to “catch up with the times.” The thinking is that few people go to blogs any more. Instead, they mostly get their blog content via readers and other sources. And when they do actually go to a blog, they virtually never look at the blogroll.

I have come to believe “they” are right. We used to receive countless emails from readers listing out their favorite blogs and asking us to review their list and consider revising our blogroll accordingly. I loveed those emails because they would enlighten us to really good China blogs of which we previously were not aware. Those emails stopped coming years ago. I now just get a fairly steady stream of emails from blogs wanting us to add them to our blogroll or complaining that they are not on our blogroll. Most of these blogs are either brand new or just not so good.

The above is my way of saying that keeping up our blogroll has become more trouble than it is worth and so we will be slowly shutting it down. But instead of just turning off a switch and immediately sending our blogroll into blog oblivion, we will be shutting the list down three blogs at a time, in alphabetical order. But to give the blogs on our blogroll a fitting send-off, we will write a post on the three blogs being deleted from our roll, each time we do so.

Throughout this “deletion period” we will be gathering up any and all good reads on China, consisting of the following:

1. Good China blogs. This is defined as any blog that is helpful to those doing business in China or just interested in China.

3. Good podcasts related to China.

4. Good websites related to China.

5. Good twitter accounts related to China.

6. Good Facebook pages related to China.

7. Good books related to China.

8. Good Linkedin Groups related to China.

This is going to be a massive and long-term undertaking and it is going need your help. And so towards that end I ask that you send your suggestions and your lists to us at “firm at harrismoure dot com” and that you put “China List” in your email’s subject. We will over the next few months be reviewing what you send us and doing our own research and then eventually be coming out with a bunch of blog posts with the results.

So speak now (actually within the next few months) or forever hold your peace.

A Guide To Doing Business In China

Posted in China Business, Recommended Reading
Doing Business in China? Our Linkedin China Law Blog Group is as sweet as these chocolates.

Doing Business in China? Our Linkedin China Law Blog Group is as sweet as these chocolates.

Gordon Orr, Chairman of McKinsey Asia, has put up on Linkedin a very helpful “Pocket Guide to Doing Business in China.” There is not much if anything new or earth shattering in this guide, but it is an excellent (and blissfully brief) compilation of information helpful to anyone doing business in China or doing business with China, or even contemplating the same. I highly recommend that you read it.

My favorite part of the guide was the section entitled, “Industries with potential for faster growth in the next decade.” I liked that part because I both because I know that a company like McKinsey knows whereof it speaks on something like this (to the extent anyone can know) and because I found myself agreeing with the industries listed. In fact, with but one exception (clean energy), if I had to list out the fastest growing industries within my own law firm, I probably would have listed out the very same. Orr listed out the following, and provided clear and cogent explanations for each:

  1. Etailing
  2. Logistics
  3. Education
  4. Healthcare
  5. Tourism
  6. Wealth management
  7. Entertainment
  8. IT Services
  9. Clean energy
  10. Agriculture

While on the subject of Linkedin, I cannot resist suggesting that those interested in China law or business check out and consider joining our China Law Blog Group on Linkedin. We have more than 10,000 members and yet we keep it 100% spam-free and 100% China-relevant. Most importantly, it is a great forum for China discussions.