China employment lawyer

China employment law is technical and getting technicaler (yes, I made up that last word but you know what I mean). See China Employment Law: Local and Not So Simple. It is one of the most consistent problem areas for foreign companies doing business in China and it has become a massive growth area for our law firm. As we are always writing, China wants harmony and China is a communist country. Combine those two and you have a country that wants to keep its workers happy, especially as compared to your run of the mill foreign company that operates in China and competes with Chinese businesses.

All of this combines to mean that if you have employees in China or you are thinking of having employees in China it is of paramount importance you have at least some understanding of what is required of you as an employer in China. This book, for the low low price of less than $20 in paper form, gives that to you. It is also sold as a Kindle version for $9.99, but you really should spend the extra $10 to be able to have it in physical form in your office for you and anyone else to be able to consult easily whenever necessary. I am writing about this book again today because we just learned that it is now available at Barnes & Noble as well as at Amazon.

Disclaimer: This book is written by our lead China employment lawyer, Grace Yang and we get a cut of every sale.

Our typical attorney-client interaction on China employment laws usually goes something like this:

  1. Foreign employer company contacts one of the China lawyers at my firm because it terminated an employee and that employee has either sued or threatened to sue, oftentimes over a technical violation by the foreign employer.
  2. One of our China employment lawyers looks at the case and determines the foreign company employer violated Chinese law in the termination and the employee would almost certainly prevail in his or her claim. See China Employee Terminations: Don’t Get Lazy.
  3. We explain the above to the foreign company employer and we learn the company is violating China’s employment laws with all of its employees.
  4. The foreign company employer wants its violations excised.
  5. We then conduct an employer audit to determine what other employment problems need fixing. See China Employment Compliance and Audits: THE New Big Thing.
  6. The employer audit invariably generates a laundry list of problems that require fixing.
  7. We fix the employment law problems, one by one.

Foreign company employers have so many employment problems in China not just because China has started getting so tough with such problems and not just because there is probably but one employee in all of China who does not understand the leverage they hold over foreign employers –and that one employee probably will immediately find a lawyer who will tell them of their employee rights? The small to mid-sized foreign company typically goes into China with maybe one or two foreign employees and one or two Chinese employees, none of whom know anything about Chinese employment laws (on the local, regional or national level) and all of whom are — naturally — focused more on getting the business off the ground than on complying with the letter of the multiple sets of China employment laws. And anyway, at this point they are usually a tight-knit group of founding employees who view themselves as much as founders as they do employees and who all get along with each other and view their futures with the company as bright. As the company grows, little to nothing changes on the China employment compliance front, mostly because nobody realizes how important it is to make the changes and because even if they did, there is nobody in-house who knows how to do it. Plus, why spend money on complying with obscure employment laws when there has never been a problem necessitating that? So employment law compliance gets kicked down the road.

But then a problem arises and a China attorney at my firm gets called — usually by someone high up in the U.S. or the Europe or the Australia office as opposed to someone on the ground in China. The person who calls us is often the head of HR, the CFO or the CEO who is trying to find out what is going on with HR in China and is receiving only vague or nonsensical responses and is starting to worry.

All of the above is my long-winded way of saying foreign companies with employees in China need to get on top of their China employment situations and stay there. Employer audits are the way to go in most situations, but in the meantime and as a supplement, it is critical someone at your company understand China employment law basics. Someone at your company needs to know enough to be able to spot your company’s China employment law issues before they blow sky-high.

The China Employment Law Guide is the book for that and you really really really should buy it and put it on your shelf. And when I say put it on your shelf, I mean you should buy the softcover version (not the Kindle version) so you can literally put it on your shelf. Heck, get more than one copy and give it to everyone in your company who manages your employees or plays any role in their hiring or their firing. This book is meant to be used for background and for reference and as a decision-making guide.

Just a little bit about Grace Yang, its author. Grace grew up in Beijing and excelled at and graduated from China’s best law school there — Beijing University. She then came to the United States to attend the University of Washington law school where she again excelled and graduated. Grace is my firm’s lead China employment and labor lawyer and she is the lawyer at our firm to whom everyone else goes for China employment and labor law questions. Grace is a licensed U.S. lawyer (she is licensed in both Washington and New York) and she splits her time between Seattle and Beijing.

Anyway, did I tell you that you should buy the book? Of course I did and you should. And while on the subject of shameless plugs (hey, come on, how many of those have you seen in our more than a decade writing this blog?), I would be remiss if I did not also mention that Grace will be putting on a webinar on October 26 on Chinese Employment Law Landscape: Key Issues and Staying Compliant in the Local Market. This webinar is described as follows:

China’s employment laws are complicated and highly local. Foreign companies doing business in China face complex China labor and employment issues and questions every day – often without even realizing it. What works in the United States has very little in common with what works in China. Employment compliance has become one of the most important issues foreign companies face in China and it is the rare foreign company that gets it right. Employee disputes are becoming considerably more common and government enforcement is getting significantly more stringent. It virtually always costs less for your company to deal proactively with China employment law issues than to wait to address them only after they have come via a dispute. As such, it is imperative that you understand the framework of Chinese employment law and steps you can take to mitigate risk.

Please join Grace Yang as she helps you better understand the Chinese employment law landscape. She will focus on helping you recognize key China employment issues and give you guidance on how to solve real-life China employment law issues and problems.

WHAT YOU’LL LEARN

This webinar will cover the following:

  • The basics of China’s employment law rules
  • How to draft an employment agreement that works for your China locale
  • How to draft China employer rules and regulations (aka employee handbooks)
  • The other agreements you should consider for your China employees
  • Frequently contested issues, such as overtime, vacation days, commission payments, and leaves of absence
  • Employee terminations
  • HR audits
  • AND MUCH MORE!

YOUR CONFERENCE LEADER

Your conference leader for “Chinese Employment Law Landscape: Key Issues and Staying Compliant in the Local Market” is Grace Yang. Grace heads Harris Bricken’s China employment law practice and contributes a weekly column about China employment law issues for the multi-award winning China Law Blog. Grace received her B.A. degree in law from Peking University and her J.D. degree from the University of Washington School of Law. She represents both China employers and employees in their China employment law matters. Grace recently published a book entitled The China Employment Law Guide.

How can you miss it?

China IP lawyers

I am not a big fan of filing Madrid Protocol applications for China. In certain situations, they can work well, but when they don’t work (which is fairly often, especially when applications are filed without forethought) the trademark registration process takes longer and costs more than just filing a national application. See China Trademarks. Register Them In China Not Madrid.

Filing a priority application in China is another matter. As part of the IP modernization begun under Deng Xiaoping’s leadership, China acceded to the Paris Convention in 1984. Under the Convention, if you file a trademark application in one Paris Convention country, and then file an application on a priority basis in another Paris Convention country within 6 months of the date of the original application, you can claim the first filing date as the date for your subsequent applications as well. For example, if you filed a trademark application in the United States on May 1, 2017, you would have until November 1, 2017 to file a trademark application for the same goods/services in China and still be able to claim the May 1, 2017 filing date for your China trademark application.

The vast majority of countries in the world are signatories to the Paris Convention, so the convention has wide-ranging effect. Priority filing is particularly important in first-to-file countries – most notably China – where there often truly is a race to the trademark office between legitimate IP owners and unsavory trademark squatters. See Register Your China Trademark or Go Home.

Priority filing can be an extremely useful tool for China trademark protection, but there are a couple common misconceptions about it. First, priority filing will not improve your odds of registration. The only thing priority filing does in China is establish an earlier filing date. An application filed on a priority basis is considered a national application, and once it is submitted it goes through the same examination process as any other national application. In other words, if you have priority filing for a brand name or a logo that has already been registered as a trademark in China, you will not succeed in getting your brand name or your logo registered in China.

Second, priority filing is not the only option for filing in China. Sometimes clients will contact our China IP lawyers in a frantic rush because they have received notice that they have only a few days before the priority filing window closes on their trademark, and they believe that once that window closes they will not be able to file a trademark application in China at all. Not so! The only effect of the priority window closing is that you cannot claim an earlier filing date. Going back to the earlier example, if you filed a trademark application in the United States on May 1, 2017, and then filed an application in China for the same goods/services after November 1, 2017, the deemed filing date in China would be the actual filing date for China. Priority filing changes the deemed filing date, nothing else.

Another important point regarding priority filing is that priority filings are limited to the same goods/services as in the original application. In this way, priority filing is similar to Madrid Protocol filing, and often not well suited to filing in China. But if the application only covers a narrow range of clearly stated goods/services, and those are the only goods/services that you care about protecting in China, it will work just fine. Priority filing cannot be used for the “Starbucks strategy” of covering all goods/services. But if you use it to establish a beachhead and cover the most important goods/services, it will usually dissuade the first wave of squatters.

Because the description of goods and services for trademarks in the United States (and for many other countries as well) is often quite different than the description of goods and services for China trademarks, for clients interested in filing in both countries I generally recommend filing concurrent applications without regard to priority. But for clients who first file in the United States (or some other Western country) and then realize belatedly that they ought to protect their IP in China as well, a priority filing can be ideal. More than once, a priority application has meant the difference between securing a China trademark registration and having to deal with a trademark squatter with superior rights.

How to Terminate a China Employee
How to terminate a China employee: make it mutual if you can

Terminating China-based employees is difficult. Article 40(2) of China’s Labor Contract Law permits an employer to unilaterally terminate an employee, with severance, if the employee is incompetent and remains incompetent after training or assignment to a different position. In practice though, Chinese courts tend to be very strict in applying this law and employers that fail to have “checked all the boxes” before the termination almost always face adverse consequences.

Consider hypothetical 1: The employer and the employee enter into a written employment contract in year 1. The employer also provides its employee with a written statement explaining its expectations and performance requirements for the employee’s position. The employee signs on that statement but the employee’s performance perpetually fails to meet the employer’s expectations. The employer unilaterally terminates the employee for “poor performance” and pays the employee statutory severance: three months salary, plus one additional month’s salary in lieu of advance notice. The employee sues on the basis of unlawful termination.

How will a Chinese court likely rule: This termination will almost every time be deemed unlawful because the employer failed to generate good contemporaneous evidence of its employee’s failure to meet the job requirements.

Now, let’s consider hypothetical 2. Same facts as above, except that the employer did yearly performance reviews and documented the results. These performance reviews indicated the employee was not cutting it and they were acknowledged and signed by the employee. Then during the next 6-month period, the employee did nothing to improve her job performance and it became clear the employee was not going to get better at her job. The termination notice in year three was the same: unilateral termination of the employee with the same amount of severance for “poor performance..”

In this scenario, the employer did a better job documenting the employee’s incompetence but it will still almost certainly lose. The employer will lose because it did not follow the law in making the termination decision as it did not provide the employee with any training so she might improve at her job nor did it ever assign her to a different position. For these reasons, the employer will lose for failing to meet its burden of proof regarding the need to provide a failing employee with training or a different position.

Hypothetical 3. Same facts as above, except: during the 6-month period before termination, the employer worked with the employee diligently to come up with a corrective plan for improvement. The employer worked with the failing employee on correcting her work errors, on monitoring her work progress and on providing her with ample training, all of which the employer documented clearly in writing.

Will this employer prevail in a legal proceeding initiated by the employee? Probably yes. I say “probably,” for two reasons. First, generally speaking, if there is a workers union, the union needs to be consulted before a unilateral termination decision can be made final. Failing to go through this step may subject to the employer to liabilities for unlawful termination. Second, even assuming there is no workers union, there may still be additional requirements imposed by the local authorities and those will need to be followed as well.

Your outcome from your termination decisions will, of course, depend on the facts, including where your company and your terminated employee are based. Note though that even in the last hypothetical the multiple hoops with which employers must jump through to satisfy their burden of proof oftentimes makes sense even for employers that have followed all termination steps to come to a mutual termination agreement with their terminated employee to avoid the legal battles altogether. The more you do right, the less you will usually need to pay.

 

 

China WFOE ownership lawyer
Who should own your China WFOE?

Late last year, China revamped its WFOE formation rules and — as much as anything, these new rules have complicated ownership structures. The below is an email from one of our China corporate lawyers to a client

 

As we discussed today, the first task in forming a WFOE in China is to determine what entity will be the shareholder of the WFOE. The basic analysis for this is as follows:

1) You will be creating an entity that will perform services for a fee for its shareholder parent. For this type of WFOE, the normal procedure in China is for the shareholder to be the specific entity for which the WFOE will perform services. In this case, this entity would be ABC US. The Chinese WFOE would then be another of your company’s several direct subsidiaries. Direct ownership of the WFOE by the operating company parent is most common in single owner WFOEs, such as that planned for ABC US here.

2. The alternative you are considering is whether or not the shareholder should be a separate holding company not directly linked to ABC US. This is what is referred to in China as a Special Purpose Vehicle (SPV). It would be unusual but permissible to make use of an SPV in your situation. The analysis here is as follows:

a. Over the past decade, the Chinese government has become quite suspicious of SPVs. At one point, the government even moved to prohibit SPVs for WFOE formations. However, after recently adopting the new WFOE formation rules, the Chinese government now permits the use of SPVs. So the current Chinese government rules are neutral on the issue.

b. In the past, one reason investors used an SPV was to hide the true identity of the owners of the WFOE. Under the new rules, the investor must provide a complete organizational chart detailing ownership of the shareholder and identifying the actual controlling person. It is therefore impossible to conceal ownership. Accordingly, an SPV can no longer be used to conceal actual ownership from the Chinese government.

c. SPVs continue to be used in situations where there are several investors in the WFOE. Often these investors are resident in different jurisdictions. In that case, it is common to take all these investors into a single SPV. The SPV is then the single shareholder of the WFOE. Issues such as management, distribution of profits and purchase and sale of ownership interests are handled at the SPV level. In many cases, the SPV is formed in a tax haven such as Hong Kong to allow distribution of profits free of tax. These considerations do not apply in a single shareholder setting.

d. In terms of limiting upstream liability to the shareholder, there is no benefit in making use of an SPV. The WFOE will be a limited liability legal person. The limitation of liability rules apply in China in the same way as in the United States in that the financial liability of the WFOE is limited to the amount of investment. Liability beyond the investment amount occurs only in the case of illegal acts. In general this liability would be as follows:

i. The shareholder will be held liable if the shareholder does not contribute capital and the failure to contribute capital results in non-payment of taxes, non-payment of employee salaries or fraud against creditors.

ii. Directors will be held liable for instructing the WFOE to commit an illegal act. Examples of illegal acts are tax fraud or commission of a significant safety violation.

iii. Directors and the shareholder will be held liable if the WFOE terminates business and does not liquidate in accordance with the provisions of Chinese company law. The penalty here is that both the investor and the directors are placed on a blacklist and prohibited from doing other investments in China. In addition, individual directors will not be able to travel to China since they may be detained.

All of the above liability is very real. However, creating an SPV does nothing to reduce this liability. First, most of the liability falls on the individual directors, not on the shareholder. Second, the Chinese government will use the org chart/actual controlling person information to “pierce the corporate veil” to assign liability to what the Chinese government determines in its own discretion is the actual party/parties in interest.

Note that other reasons for liability arising from WFOE operations are so rare that they can usually be discounted. On the other hand, i, ii and iii above are common and care must be taken not to incur these forms of liability.

3. There may be tax or other operational or accounting reasons to create an SPV for China. In that case, as noted above, the Chinese government is neutral about the use of such SPVs. In considering whether to make use of an SPV, you should do a cost-benefit analysis. Most of our firms’ clients have found the SPV approach to be more trouble than it is worth in the single shareholder setting. However, your situation may be different and we should explore the tax ramifications before you make this decision.

 

China box office numbersAs reported by numerous media outlets, the MPAA-requested audit of the Chinese box office numbers is complete and the numbers ain’t pretty. Chinese theaters underreported 2016 box office results by 9%, which given the 25% revenue share for quota movies, means that US studios have been underpaid by about $40 million.

I don’t know anyone who follows the Chinese movie business who was surprised by these results. No, I take that back. Many people (myself included) were surprised the number wasn’t considerably higher. One possible explanation is that PricewaterhouseCoopers conducted the audit, and after the Oscars debacle they were probably triple-checking their results and eliminating anything they couldn’t justify six ways from Sunday. And even with that, they still found a 9% discrepancy.

The full audit results haven’t been publicly released; all we know is that the auditors looked at data for 29 films in a handful of theaters and then extrapolated the results across China’s more than 40,000 screens. Such extrapolation, based on statistical sampling, is commonplace and perfectly normal, but I have to wonder what a full audit would have found. Without putting too fine a point on it, a lot of strange things happen in China’s third and fourth-tier cities. Even as it is, the audit found a whole host of irregularities, including unreported screenings, unreported ticket sales, and counting box office revenue as concession sales. No word on whether the audit turned up more instances of ascribing ticket sales from US films to Chinese films – which is what happened in 2015 when an alleged $11 million in ticket sales for Terminator: Genisys were instead attributed to the Chinese propaganda film The Hundred Regiments Offensive.

So what now? One argument is that the audit helps the United States in its ongoing negotiation to increase the quota and the revenue share, but it’s also likely that it hurts. China already knew it had massive problems with movie accounting and had taken steps earlier this year with a very public punishment of 326 cinemas for box office fraud. Being called out in the press like this by foreigners is a tremendous loss of face. Then again, $40 million is a lot to leave on the table.

It’s easy to understand the studios’ frustration that led to the audit. Box-office fraud in China has been rampant for years, and even the box-office revenue that is reported takes eons to get paid. And as China’s box office continues to grow, the revenue share becomes an increasingly important part of studios’ bottom line. Long gone are the days when revenue from China is just a nice bonus for US studios; indeed without China, some movies wouldn’t be made at all.

I’m reminded of the opening lines of Annie Hall: “There’s an old joke. Two women are at a Catskill mountain resort, and one of ’em says, ‘Boy, the food at this place is really terrible.’ The other one says, ‘Yeah, I know; and such small portions.’” That’s essentially how the studios feel about their relationship with Chinese movie theaters – full of underreported revenue and unhappiness, and they hope it never ends.

Of course, if the studios actually see the $40 million in additional revenue, the audit will be worth it. Either way, we can expect to see more of them.

And it’s not like the US studios are the only ones who should be conducting audits. We work with accounting firms that audit Chinese film and television productions on behalf of Western investors, and the extent (and creativity) of the financial shenanigans is astounding. For most of these audits, there’s no political or reputational element; it’s just common sense.

If you’re dependent on your Chinese partner to account for and remit revenues (be it in the movie industry or otherwise), an audit should be part of your repertoire too.

Beware the fake China attorney
Beware the fake China lawyer

American Lawyer Magazine recently did an article, That Law Firm’s Website Might Not Be for a Real Law Firm on “a new white paper [that] examines a growing trend of fraudsters posing as attorneys or legal consultants online to exploit those seeking legal services.”  To which I can only say, well yeah.

To which I can only say, well yeah.

We actually first wrote about the fake lawyer phenomenon way back in 2006, in China: Where Even The “Law Firms” Are Fake (2006). In that post I talked about fake Chinese lawyers taking money from American companies for trademark registrations:

There are those who take money to file trademarks in China and then simply run away. A new client told me he had sent about $750 to what he thought was a legitimate China law firm to have his company’s brand name registered. As soon as the first $750 hit Shanghai, he was asked to send an additional $600 to “cover the filing fees,” which he did.

A week later the website was down and the Shanghai “firm” was gone.

It turns out this scam is actually pretty common and it also turns out that in every case of which I am aware the scammers were neither licensed Chinese lawyers nor licensed Chinese trademark agents. In other words, they are just people who run China trademark registration scams.

Since 2006 I have heard multiple accounts of foreign companies that paid for trademarks or employment contracts or manufacturing contracts  or company registrations or various other things China lawyers typically do for their clients, only to receive nothing in return and only to learn that the “Chinese law firm” or the “Chinese lawyer” they paid for their legal work never even existed. How many foreign companies believe their trademarks are registered in China when in fact they never were? How many think they have registered companies in China when they don’t? I don’t know the numbers, but I do know that the number of these fake law firms is on the rise, fueled in large part by foreign companies seeking to reduce their costs wherever they can.

In addition to fake law firms that simply steal your money, there are also a whole host of companies with no lawyers who advertise their China legal services on the internet. These companies (at least as far as I know) do not flat out steal your money but what they do can in some cases be almost as harmful. These companies lead their clients to believe they are communicating with lawyers when in fact they are not. This means that there is no attorney-client privilege and that the odds of whoever does your legal work knowing your situation and your goals and having the capability to draft a cross-border document that will work for you are about 1,000 to 1. Be careful of these companies as well.

So how can you avoid these things happening to you? Do some due diligence before you pay/hire a China lawyer, especially if you will be paying upfront for something like a China trademark or a China company registration where it may take you years to realize that you have been had. There are, for instance, some fast and easy steps you can take to confirm that your lawyers actually have a law license. I believe every U.S. state lists its licensed practitioners online and avvo.com also lists all or nearly all licensed lawyers. Here is my proof on Avvo that I am a real lawyer, licensed in Alaska, Illinois, and Washington. Most countries have something similar. Check to see how long they claim to have been in business as compared to how long they have had their website. One fake China attorney claimed to have more than 20 years experience but his website appears to have been online for a total of only 5 months.

Anyway, just be careful out there.

 

We are always emphasizing on here how you need a China-centric contract when doing business in China or, in most cases, even with China. See China Contracts: Make Them Enforceable Or Don’t Bother. This holds doubly true for employment contracts with China employees because everything about such agreements is highly local. If you are having someone in China other than a company performing services for you, you need both your own entity in China (See Doing Business in China with Deportation or Worse Hanging Over Your Head) and a China specific written employment contract with each of those individuals.

China employment law
Don’t let your China employment agreement get lost in translation

And though I should not have to say this, translating your existing employment agreements into Chinese is not going to cut it — not even close. Yet just about every month some foreign company (almost invariably an American or Australian company for some reason) or an executive with such a company (again, almost invariably American or Australian) will come to one of our China employment lawyers with a problem involving a foreign country employment agreement that was translated into Chinese.

The below are some of the common examples we see where a foreign contract/foreign mindset does not jibe with the China employment law reality.

  1. The employment agreement makes clear the employee is being hired on an at-will basis, which means he or she may be fired for “good reason, bad reason, or no reason at all.” This generally works in the United States and in a few other countries around the world, but it absolutely positively does not work in China and putting such a provision in your employment contracts can and often is used as evidence to support a wrongful termination claim, so please just skip it. Terminating a China-based employee nearly always requires good cause and far too often companies that put these at-will provisions in their China employment contracts actually believe what they say and end up in big trouble for wrongful firings.
  2. The employee is expected to work whenever needed to get the job done. This can sometimes work for certain China employees provided various specific conditions have been clearly met, but putting this sort of provision in a contract is not a way to meet those conditions — it is yet another red flag for China judges when you get sued by one of your employees. For you to be able to use your China employees after hours without having to deal with overtime provisions, that employee must (1) have been cleared by the appropriate labor bureau authorities as eligible to work under an alternative working hours system, (2) have specifically agreed in his or her employment contract to work under such an arrangement. Note also that clearance for one of your employees being able to work under an alternative working hours system typically lasts for only a year, depending on the locality. Note also that the alternative working hours system cannot be used with most employees and that means they must work under the standard working hours system which requires overtime for anything beyond 8 hours a day and 40 hours a week. Getting an employee to consent to this without government approval does not work.
  3. The employee agrees to adjudicate all employment-related disputes through arbitration. This does not work if you try even to limit your employees to only labor arbitration and it certainly does not work if you try to require your employees to arbitrate disputes against you in your home country or really anywhere outside the jurisdiction where they are employed. I surprisingly often have to tell American companies that putting a provision in a contract with a China employee that United States law will apply and all disputes must be resolved in some U.S. city has the same likelihood of success in China as would a provision requiring an Omaha employee be bound by Chinese law and Chinese jurisdiction, which is exactly zero. Think about it. Is any American jurisdiction going to let you hire someone and pay them pursuant to China’s minimum wage requirements? Of course not, and the reverse is equally true.
  4. The employee agrees to a non-compete that comes into force after termination of employment and the consideration for this non-compete is the promise of employment. This generally works in the United States (though not in California), but in China, if you want one of your employees to be bound by a non-compete provision, you must pay them consideration for their not competing during the entire term of the post-termination non-compete period. For example, a sign-on bonus may not be consideration for a China non-compete; the (former) employee must receive compensation via bank transfer on a monthly basis after termination for your non-compete to hold.

Provisions like the above send strong signals to your employees, to China labor bureau authorities and to China’s courts that you do not understand how China’s employment laws and you are not willing to make the effort to comply with them. This increases both the odds of your having China employment law problems and the odds of your employees suing you when such problems arise. And as mentioned above, having these unenforceable and illegal provisions in your China employment contracts also tends to prejudice judges against you when you are actually sued.

Bottom Line. Use a China-centric employment agreement with all of your China employees.

China Manufacturing Contracts
China Manufacturing Conmtracts: Like a Maze

Our China lawyers have in the last six or so months been getting more than the usual number of manufacturing contracts that involve U.S. based sourcing companies, oftentimes one in a close (ownership connected?) relationship with the China factory(ies) at which the product or products are going to be made. Figuring out the appropriate party(ies) with whom to contract can be quite complicated in these situations, as can the drafting of the contract(s) as well.

The below is an amalgamation of some recent emails we have sent to clients that are working through an American sourcing company with close ties to the China factory. I am running this because it should prove helpful to other companies in similar situations.

Please advise on the below for your relationship with US Sourcing Company A. Keep in mind that US Sourcing Company A is a U.S. company that will be working with Chinese subcontractors. So you must permit a first layer of subcontracting to factories in China. We can call that first layer the Primary China Contractor.

You should require US Sourcing Company A to provide you with the following:

1. The identity of each Primary China Contractor.

2. You will have essentially the following two choices regarding the appointment of the Primary China Contractor:

a. You will have the right (but not the obligation) to inspect the factory of the Primary China Contractor factory and to approve the Primary China Contractor business and its factory chosen by US Sourcing Company A. US Sourcing Company A must also first provide you with notice of any change in Primary China Contractor and this same procedure will apply to that change as well.

b. No Primary China Contractor can be used until you first approve it in writing. If the Primary China Contractor will change its factory location(s), American Sourcing Company A must give you prior notice of this and you must approve this in writing as well.

3. You will have access to the factory(s) of the Primary China Contractor at all times.

4. US Sourcing Company A must provide the NNN Agreement we drafted for you and your company’s Code of Conduct to the Chinese Primary Contractor. No work will begin until after the Primary China Contractor has returned to you a) an executed version of the NNN and b) a written and signed acknowledgement it has received and will comply with your company’s Code of Conduct. We will revise your NNN to apply in this situation and we will also draft a short acknowledgement for the Code of Conduct.

After deciding on the basic policy towards the Primary China Contractor, we must together consider the issue of how to deal with subcontracting done by the Primary China Contractor.

It is common for the Primary China Contractor to further subcontract out part or even all of the manufacturing process. Will you allow such sub-contracting or not? This is a complex issue:

Though this kind of subcontracting is common (and especially so in your industry) this process greatly increases your intellectual property risks. If the subcontracting process gets too extreme, no one really knows who is doing what. I have worked in situations where there were five layers: U.S. sourcing company and Primary China Contractor with three layers of subcontractors under the Primary China Contractor. It was a mess when things went wrong with quality and with control of IP because everyone pointed to everyone else as the source of the problem. On the other hand, without the extensive subcontracting, no product at all would have been produced for this client.

In theory, we will want the subcontractors to abide by your NNN Agreement and your company’s Code of Conduct. You may inspect the Primary China Contractor factory and find all is in compliance. But, if you allow for subcontracting below the Primary China Contractor, the Primary China Contractor may then subcontract work to a different factory(s) that is not compliant in any way. But, if you require the NNN and Code of Conduct from EACH subcontractor below the China Primary Contractor, you could end up with 30 or more executed agreements and the costs to go with that.

You need to decide how to deal with the issue of subcontracting by the primary Chinese contractor. Your options are as follows:

1. The Primary China Contractor is not permitted to subcontract. At all.

2. The Primary China Contractor is permitted to subcontract. The subcontractors are not required to execute the NNN Agreement or your Code of Conduct. The Primary China Contractor and the US Sourcing Company A are liable for violations by the subcontractors.

3. The Primary China Contractor may subcontract, but only on the same terms under which US Sourcing Company A is permitted to subcontract.

In theory, Option 3 provides you with the most protection. However, as discussed above, the logistics of Option 3 can be very difficult. In addition, many Chinese subcontractors will refuse to execute an NNN Agreement (or any other agreement) with a U.S. company with which it has no direct purchase/sale relationship. For this reason, most U.S. companies (especially those without a massive amount of purchasing leverage) usually settle on either Option 1 or Option 2.

Please consider the above and provide me with your initial choices on how to proceed or let’s talk some more about your various choices. You may wish to discuss the above issues with US Sourcing Company A as well. If US Sourcing Company A will not allow its Primary China Contractor to subcontract, the China subcontracting issue disappears for this particular contract.  However, this issue likely will come up in the future, so we should consider your basic company policy on the issue.

China Factory ClosuresChina factory closures are a hot topic. In the last few months, our China lawyers have received multiple emails from companies that were having their products made in Chinese factories that have been shut down due to environmental concerns.

And needless to say, we are not the only ones dealing with this issue. See More Thoughts on China Factory Closures and What if your supplier has to close due to China’s Ministry of Environmental Protection (MEP) cracking down on polluters?

To us though, the big issue isn’t so much what do you do if your factory in China closes, as those situations usually are governed by the actual facts on the ground. No, for us the more interesting question is what can and should you be doing now to avoid a situation where your China factory closes.

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

I run a _________ company in __________ and I have come upon my own situation in which I would like to ask for a legal opinion. We were having our [widgets] made by a factory in Guangzhou that is part of a large Chinese company with more than a dozen factories throughout China. Unfortunately, this one factory that was making our [widgets] is the only factory this company has that makes [widgets].

To make a long story short the company is saying that the Chinese government has shut down its [widget] factory for “environmental reasons” and they will not be supplying us with our [widgets]. This is very bad for us because we now have a long line of very unhappy retail customers and many of them have told us they are done with us (even for our other products) because of our failure to deliver them the widgets we promised.

Can we sue this company in China?

Our typical response is usually something like the following:

Certainly you can sue but can you win? Without reviewing your contract with this company, I have no way to know what you can and should do. If you have a good contract (preferably in Chinese and chopped by the Chinese company) that makes clear that the company must provide you with products and that does not have a force majeure provision broad enough to include this factory being closed by the Chinese government for environmental reasons (even if the fault of the Chinese company) then we should consider pursuing litigation.

But what can you do to avoid a similar situation for your company? The following can help.

  • First off recognize that the Chinese government is more concerned with social harmony than with economic numbers and that is why it continues to shut down highly-polluting factories.
  • Many 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. Some of these companies are claiming to have been shut down by the Chinese government when in reality they shut down on their own because they were losing money. Foreign companies that do business with Chinese companies in these industries must keep up their guard.
  • The key to weathering China’s onslaught of factory shutdowns will be for foreign companies to focus on due diligence at a company-to-company level.

Even though China’s low-end companies are suffering both from environmental shutdowns and rising costs, its 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 but these sort of companies 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.

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. If your Chinese factory is going to shut down after you have paid for your products and your Chinese factory has made them, you want to be able to walk away with them (2) do your utmost to determine the financial wherewithal of your Chinese counter-parties before you pay anything. These two steps aren’t foolproof, but if you do both you’re a lot less likely to get burned, shutdown or not.

None of these things are foolproof or even close, but if you do all of these things you are a lot less likely to get burned, slowdown or shutdown or not.

Check your China employment contracts
Check your China employment contracts

Do you check your employment contracts? A company in Shenzhen wasn’t careful in checking theirs and it had to pay an employee nearly 150,000 RMB as contract damages for unpaid wages and an additional nearly 3,000 RMB for overtime compensation. In the end, this company had to pay this one employee nearly 50 times more than what was actually owed. Before I discuss this case and what you should do to prevent the same thing from happening to you, let’s quickly review relevant China employment laws.

An employee can demand its employer pay contract damages pursuant to the parties’ employment agreement. The law only imposes restrictions on employers imposing contract damages (similar to and called liquidated damages in some countries) on their employees, but an employee can collect contract damages from an employer under certain circumstances. At the time of termination, unless there is a law to the contrary, the employee can demand contract damages in addition to the applicable statutory severance. But again, be careful, this is just the general law in Guangdong tvince and there may be exceptions and, as is pretty much always true when dealing with China employment laws, there are local variances.

Now back to the case I mentioned above. In that case, the Shenzhen employer and the employee entered into an employment contract under which the employer agreed to pay its employee 50 times any missed/miscalculated base salary and overtime pay. In other words, for every Yuan the employer is short in wage payments, the employee must be paid 50 RMB as a penalty. When the employment relationship went awry, the employee sued and sought nearly 150,000 RMB in contract damages for having been shorted a bit under 3,000 RMB owed to him. The trial court — The People’s Court in Baoan District — sided with the employer on this claim, concluding that this damages provision did not comply with the employment law and the amount far exceeded the actual amount owed to the employee. It then applied a “fair” standard for damages and ordered the employer to pay the owed wages plus an additional 25% of those wages as damages.

The employee appealed, arguing that the Baoan court had no legal basis for its ruling. The employee argued that the employer intentionally included this damages clause in the employment contract to make the job look more enticing and it would not be fair to allow the employer to be released from a contractual obligation it had created. The employee also argued that China’s freedom of contract laws called for enforcing the contract.

The Shenzhen Intermediate People’s Court determined the damages clause did not violate any mandatory laws or social interests and it reflected the parties’ true intent. The employer was the more powerful party and the employee an ordinary worker with only minimal bargaining power. The contract damages provision was therefore enforceable against the employer and the employee was entitled to the full amount of contract damages.

If the Shenzhen employer had been careful about what it allowed into this employment contract it could have avoided this penalty altogether. Our China employment lawyers regularly audit the employment records of foreign employers in China and this means we frequently see employment contract provisions that heavily favor the employee. One of the most common things we see is for the English to say one thing (that’s good for the employer) and the Chinese to say another (that’s good for the employee). This is a problem because the Chinese language controls.

Do your employment contracts contain a “surprise” clause that would potentially expose you to unwanted liabilities? Now is the time to check to make sure.