China CopyrightWhen I was growing up, I watched a lot of television. A LOT. I was a latchkey kid and every day after school my brother and I would come home and turn on KTVU and watch TV Powww! and Captain Cosmic shows like Ultraman. Ultraman, if you don’t know (Philistine!), was a Japanese science-fiction show that ran from 1966-67 but, much like Star Trek, circulated widely in reruns and had an outsize influence on subsequent science fiction pop culture.

So when I read last week’s China Film Insider story about an allegedly unauthorized Ultraman film being produced in China, it felt like a personal insult. A Chinese fan-created Ultraman movie a la Axanar would be amazing, but the producer of this film, Chinese film company Blue Arc Animation, is just making a blatant ripoff.

Or are they?

Japanese company Tsuburaya Productions Co. Ltd., the creator of Ultraman, alleges that Blue Arc Animation has no right to make an Ultraman film in China. But Blue Arc contends that they got the rights from UM Corporation, another Japanese company. And UM Corporation contends that they own all foreign rights based on an alleged 1976 agreement in which Tsuburaya’s president Noboru Tsuburaya granted to Thai filmmaker Sompote Saengduenchai the exclusive, perpetual foreign rights to Ultraman. Sompote’s rights were then assigned to his son Perasit Saengduenchai, who in turn transferred them to UM Corporation, who in turn has licensed the rights to a number of companies all over the world.

Tsuburuya has consistently held that the 1976 agreement is a forgery, not least because Sompote didn’t even mention the existence of such an agreement until 1995, after Noboru Tsuburaya had passed away. The dispute has led to a number of lawsuits between Tsuburuya on the one hand, and Sompote and his successors in interest on the other. Back in the mid 2000s, Tsuburuya won several victories in Thai and Japanese courts, which seemed to bring things to a close, but not so much. The victories were only partial victories, and the key piece of evidence in Sompote’s favor is that the 1976 agreement, despite having a number of inaccuracies and other indicia of inauthenticity, was nonetheless chopped with Tsuburuya’s company seal. And so the litigation has continued. Most recently, UM Corporation sued Tsuburuya in a Los Angeles federal court on May 19, 2015, alleging copyright infringement, breach of contract, and intentional interference with contractual relations. I just checked the docket and the case, staffed by a number of big-firm LA litigators, is still going strong.

What does all this have to do with China? First of all, this should be a wakeup call for anyone with a Chinese entity who thinks they don’t need to know where their company seal is at all times.

Second, it’s an example of how NOT to license copyrighted content in China. What sort of due diligence did Blue Arc Animation conduct regarding the rights they were allegedly getting from UM Corporation? We have conducted due diligence on numerous film projects in China and our efforts have saved more than one high-profile project from guaranteed litigation over the source material.

Chinese courts are getting better and better about enforcing copyrights. The dispute between Tsuburuya and Blue Arc Animation hasn’t resulted in a lawsuit in China – yet – but Blue Arc Animation has to be wondering what, exactly they have gotten themselves into. Are the Ultraman copyrights registered in China under either their name or the name of UM Corporation? Do they have a licensing agreement with UM Corporation written in Chinese and enforceable under Chinese law? Is the licensing agreement registered with the Copyright Protection Centre of China? Unless the answer to all of these questions is “yes,” Blue Arc Animation will be hard pressed to prove that they have any rights at all. (And meanwhile, if Tsuburuya hasn’t already registered all relevant copyrights for Ultraman in China, shame on them.)

If you’re going to spend millions of dollars on a film project (or even just tens of thousands, as may be the case here), don’t buy a pig in a poke.

notarization, appostille, consularizePretty much every week, our China lawyers get emails or phone calls from someone (probably half the time a fellow lawyer) seeking assistance with making a document legal for some sort of use somewhere in the world. Maybe 40 percent of the time, the request relates to a need to authenticate an official Chinese document or government record so it can be used in a United States court or government filing or U.S. transaction. Maybe another 40 percent of the time, it’s essentially the opposite: the person needs a U.S. document authenticated so it will work for a Chinese court or a Chinese government filing or China transaction.

Much of the time, the party reaching out to us expects a quick answer that will allow them to do what they need to do, at little to no cost or for us to do it for a couple hundred dollars. Pretty much without exception though, we have to burst that bubble by explaining how these things can be quite complicated and time consuming and, hence, expensive. The reason being that what is actually required varies in pretty much every instance, depending on the exact reason the authentication is needed and if they wish us to provide them with legal counsel we will need to do the following:

  1. Research exactly what will be required. This typically involves our reviewing the law and talking with the appropriate government official (especially if it is China).
  2. Oftentimes, we must arrange with a notary in a specific city to notarize a document and many times we also must deal with the appropriate Secretary of State (or comparable) for an appostille or comparable and with the appropriate consulate or embassy or court for the consularization or legalization. Accomplishing these things can be incredibly time consuming as they often involve multiple letters and phone calls, and even occasionally flights when things get delayed.
  3. Translations are also often required.

Just saying….

 

China employment lawyers
China employment law: it’s a maze out there.

It is usually very difficult to back out of or even change a China employment contract once a China employment contract has been signed, it is particularly difficult for the employer to unilaterally change any of its terms, especially the important terms such as the employee’s wages and position. China employers that try to change employment contracts often find themselves in arbitration or in court, paying legal fees and fighting against damages and oftentimes bad publicity as well.

A case in Zhejiang province illustrates the difficulties employers can face when they try to change an employee contract. In this case, the employer and an employee entered into a fixed-term employment contract that was to run from April 2012 until April 2015. The contract stated the employee’s position as assistant to the general manager, with pre-tax monthly wages set at 11,000 RMB. The contract also provided that if the employee met certain evaluation criteria at the end of the calendar year, he would get an additional 30% in monthly wages, which would make his annual wage 190,000 RMB. In July 2013, the employer unilaterally demoted the employee to HR administrative staff and reduced his monthly wage to about 3800 RMB. The employee handed over his unfinished tasks to his colleague immediately after he learned of this decision and filed for labor arbitration the very next day. The following month, the employer issued a written decision terminating this employee’s contract on the basis that he had failed to show up at work for six consecutive days.

The employer’s policy stated that employees would receive periodic evaluations (with A being the highest score, and E the lowest) and if an employee received 2 Ds or 3 Cs or 1 E during a 6-month period, the employer would consider the employee incompetent at his/her current position, and would then have the right to demote or adjust the employee’s position and reduce or adjust the employee’s pay.

The employer argued that the demotion of this employee was because of poor evaluation results: the employee had received three Ds three months in a row, from April 2013 to June 2013. However, the court said that because the evaluations conducted concerned the employee’s fundamental rights, including labor remuneration and work position, the employer must come forward with definitive and strong evidence to justify the demotion and salary reduction. The court ruled that it was inappropriate for the employer to make such significant changes based solely on three poor evaluation sheets and the evidence supporting the employer’s unilateral decision was not sufficient.

The employer also argued that even though it unilaterally amended the employment contract, it did not give the employee the right to unilaterally terminate the contract without prior notice and if the employee had wanted to terminate the contract, he should have given 30 days’ written notice, his failure to provide such notice constituted absenteeism justifying his terminating for failing to show up at work for several consecutive days. The court did not side with the employer on these arguments either, finding that because the employer had received notice of the employee’s labor arbitration claim it had no basis for issuing a termination notice based on the employee’s not showing up at work.

The court held that an employer may in some circumstances amend an employment contract, but amendment of significant issues such as an employee’s salary or work position should be done through mutual consultation. The court also stated that under ordinary circumstances an employee must give 30 days’ written notice for unilateral termination, that was not the case here since the employer unilaterally amended essential employment terms without first consulting with the employee, where the employer had failed to provide the labor conditions or protections required by Article 38 of the PRC Labor Contract Law. According to the court, the employee had every right to unilaterally terminate his employment contract without notice. As expected, the court also held that the employer’s inappropriate conduct was the basis for the employee’s departure and the employer must pay severance to the employee.

The employee also brought a claim for 30% of his wages from January through July; which according to his contract, he would be entitled to receive only if he passed the year-end evaluation. The court ruled that because the employee had to leave his employment because of employer abuse, he could not receive his year-end evaluation and for that reason, the employer must pay the full amount of the employee’s wages, including the 30% bonus. Long story short, the employer lost big time.

Even though unilateral salary reduction is possible in China, there are many hoops to jump through to accomplish this and the evidentiary burden for an employer to succeed with this is quite high. This case is yet another instance showing how Chinese courts are very protective of employees’ basic rights.

Bottom line: You as employer need to think long and hard before you take any unilateral action involving your employees in China. Unilateral amendment of an employment contract is just as difficult and risky as unilateral termination of an employee and it rarely is the most effective solution to employee problems. As Confucius said, more haste, less speed (欲速则不达). Or as our China employment lawyers are always telling our clients, please, please, please come to us before you make your employment decisions, not after!

 

China copyright lawyer
China copyrights for internet content

One of our China copyright lawyers recently sent the below email (slightly modified) to one of our clients, and since it nicely lays out the basics on what is required to secure Chinese copyrights on internet content, I am running the key portion from it below:

1. To secure copyright protection for the original elements of a website, you need to file a copyright application for a particular category of creative work: a compilation. Each webpage would be a separate item in the compilation.

2. The application must include a hard-copy printout (typically, a screenshot) of each webpage. Although it seems illogical, China will not accept webpages in digital format.

3. Note that a website is protectable via copyright in China regardless of where the website is hosted. However, China will not grant copyright protection to content it deems to be against socialist morality, the Chinese government, or the Chinese Communist Party.

4. Once a copyright application has been submitted, it usually takes about three months to receive a copyright registration certificate.

5. To have enforceable protection for your copyrights in China, you must first register those copyrights in China. You also must register any relevant license agreements to receive payments from China. Though China is a signatory to the Berne Convention and is obligated to recognize copyrights created in any other signatory country, proving the existence of a foreign copyright (and its contents) is often difficult and sometimes impossible in China, whether before a Chinese court, a Chinese agency, a Chinese e-commerce site or otherwise. From a practical standpoint, it’s always better to have a Chinese copyright registration.

Let me know if you need further clarification.

Your thoughts?

 

China joint venture lawyer
Negotiating the Chinese joint venture maze

We have recently been getting an onslaught of foreign companies (mostly North American and European) looking to do joint ventures in China. China joint ventures tend to be cyclical, rising when the business climate in China is for any reason difficult, and falling when it gets easier. It would seem we are in yet another Chinese joint venture up cycle.

One of the first things we always seek to do when contacted by a company seeking legal assistance on their China joint venture deal is to try to figure out what they want our role as lawyers to be, so we can provide them a good fee estimate. there are three basic things lawyers typically do when providing representation on a China joint venture deal: 1) provide counsel regarding the joint venture agreement; 2) provide counsel regarding the joint venture entity formation; and 3) do the actual work involved in forming the joint venture entity itself.
In our initial communications with potential and actual joint venture clients, we seek to discern what our role will be on all three of these things, especially the third one: how much involvement our firm’s lawyers will have in forming the China joint venture. If the Chinese side (or its lawyers) are experienced with how to form a joint venture, it usually behooves our client to let the China side handle that aspect of the transaction, with our role being to simply oversee that process to make sure it goes smoothly. The below email is from one of our lawyers to a new client that just retained us to provide it legal counsel regarding its China joint venture deal. I am running that email today because it provides a good overview on some of the common issues that arise in China joint venture transactions, while also nicely setting out the different roles your China attorney might play in such a deal.
It appears you want me to review documents, with the actual work forming the entity and setting up the factory to be done by your JV partner.
I briefly reviewed briefly the JV contract. The document is written in a common law style, but it is clear and complete. Are you certain you want to operate in China in JV structure? Are you certain the proposed amount of capital will be sufficient to set up and begin operations for a manufacturing venture? Are you certain you are willing to contribute ownership of your intellectual property to the JV company? Are you certain you would prefer to transfer ownership of your IP to the JV company, rather than just license your IP to that entity? Are you certain you are willing to earn income from this project solely from distribution of profits from the JV company? Are you certain you are willing to give full control over this project to the Chinese side? Your JV contract assumes you can exercise some form of control through the board of directors, but this is an illusion.
If your answer to all of the above is yes, then my review of the documents would be extremely limited. If your answer to any of the above is no or that in light of my questions you are not clear on how you wish to proceed or simply that you need more information, then I would provide for a normal review, outlining the issues. However, if you already understand and are ready to move forward on the basis of this contract, there is no need for this step.
Finally, note that forming a foreign invested enterprise in Shenzhen is a difficult process. Though your partner will be dealing with the Chinese side, much of the process and much of the delay involves obtaining information and authenticated documents from your company and very few Chinese companies (or even Chinese lawyers) have experience in that process. You should discuss with your partner how you will handle that side of the formation process. Note also that setting up a factory in Shenzhen involves all sorts of required documentation and is a complicated and time consuming procedure. However, if your Chinese JV partner has all of the above under control, none of this should raise any issues. You should, however, ascertain whether they understand the JV formation process. In our experience, most Chinese “partners” do not understand this process, which can cause confusion and delay and added expense down the road.
As always, if you have any questions, please do not hesitate.
For more on China joint ventures, check out the following:

 

Employee probationChina employee probation is one of the most often misunderstood China employment law issues. Many employers understand employee termination in China is difficult because China is not an employment-at-will country. But far too many wrongly believe things are otherwise for employees still on probation. Needless to say, this mistaken belief often leads to big problems.

Consider this scenario: an employer hires an employee on January 1st and sets a 2-month probation period, well within the legal maximum probation period. The employer conducts employee evaluations and carefully preserves evidence demonstrating the employee’s failure to meet the conditions of employment clearly specified in the employment contract. The employment contract was in Chinese and was properly executed by both parties. In other words, everything has been done right. But then the employer sends the employee his termination notice on March 1, one day after the employee’s probation period ended.

Should this employee pursue a claim against its former employee, what will happen will depend on the locale, but many courts in China will rule that the employer’s late termination notice means it cannot use “failure to meet the conditions of employment during the probation period” as a basis for unilateral termination without severance pay. This scenario is based on real cases and shows both how technical China’s courts can be when it comes to employee protections and how one day does make a difference!

Clever employers will argue that even though it notified the employee of its termination decision after the probation period had ended, its reasons for such termination occurred DURING the probation period, so it should not lose on a technicality. But this “technicality” matters for purposes of China employment law. Over two decades ago, after receiving a request from a provincial labor department seeking guidance on how to determine an employer’s right to terminate an employee for failing to meet the conditions of employment during the probation period, China’s Office of the Ministry of Labor issued a formal reply stating that after the probation period has passed, an employer cannot use probationary rules as grounds for terminating a labor contract. Many China courts still either explicitly or implicitly abide by this guidance statement.

Probation issues tend to be rife at foreign companies in China and our employer audits invariably reveal such problems. The issue goes beyond making sure you terminate an employee before the probation period ends. It is important you also check your overall HR practices regarding  probation periods across your organization. Are you using probation correctly? Are you setting your probation periods so short as to make employee terminations practically impossible? Are you preserving the evidence necessary to support a termination? If you don’t fully understand how employee probation actually works in China, you may end up worse off making your termination based on that as opposed to just waiting.

China patents and China copyrights
  Who owns your China IP? Get it in writing.

Conceptually, the basis of the “work made for hire” (often shortened to “work for hire”) doctrine is clear: employers should own (some) rights to work created by their employees, whether such work is protectable by copyright, patent, or some other IP right.

But legally, it’s as clear as mud. The “work for hire” doctrine actually only applies to copyrights. Patents are covered by the “hired to invent” and “shop rights” doctrines in the US, and by the “invention for hire” doctrine in China. And though the patent doctrines have some similarity with the respective copyright doctrines, they are not the same. Not even close.

Legal scholars have explored in some detail why copyrights and patents for employee-created work are treated differently in the U.S. (see here and here), and make the credible argument that a uniform doctrine should apply to both forms of IP. I am unaware of similar scholarship explaining why copyrights and patents are treated differently in China, but note that modern Chinese IP law is based on Western models, and was largely adopted as part of China’s (relatively) recent accession to the WTO. Suffice it to say, the default rules regarding copyrights and patents for employee-created work are different under both Chinese and U.S. law, and employers need to understand those differences or be caught unawares when it comes time to enforce their IP rights.

As I explained a couple months ago in this space, Chinese copyright law is quite employee-friendly.

Per Article 16 of the Copyright Law and Article 13 of the Regulations for the Protection of Computer Software, the default rule in China is that an employee will own the copyright to anything they create during the course of employment, except for (1) “drawings of engineering designs and product designs, maps, computer software and other works which are created in the course of employment mainly with the material and technical resources” of the employer and (2) computer software developed at the employer’s direction or as an inevitable consequence of the employee’s job description. For all other works, the employee will own the copyright; the employer has a two-year exclusive license to use the copyrighted material, and thereafter a non-exclusive license.

If an employer (say, a WFOE) wants a different rule to apply to its employees’ creations, it needs specific language in a signed contract with the employee that assigns all rights in any “work for hire” to the employer. Such contract should be in Chinese and governed by Chinese law, and signed at the beginning of employment.

Chinese patent law, by contrast, is rather employer-friendly.

Per Article 6 of the Patent Law and Rule 12 of the Implementing Rules of the Patent Law, the default rule in China is that an employer will own the patent rights to any invention for hire, which includes any invention created: (1) within the scope of employment, (2) outside the scope of employment but nonetheless assigned by the employer as a task, (3) within one year after the end of employment and satisfying either of the two previous conditions, or (4) mainly by using the employer’s resources. In other words, pretty much everything.

Employers do not need to sign a specific agreement with employees to own the patent rights to such inventions; nonetheless, it is always a good idea to do so, to avoid any confusion. If you’re an employer, the last thing you want is an argument with your employees about whether their creation is an invention protected by patent (and therefore your property) or a creative work protected by copyright (and therefore their property).

The bottom line is that all employers in China involved in creative work should enter into a comprehensive IP ownership agreement with each employee at the beginning of employment. The agreement should be in Chinese and governed by Chinese law, and should unequivocally establish the employer’s ownership of any works created by the employee, whether governed by copyright, patent, or otherwise. Putting all this in writing will protect the employer’s rights, and just as importantly, it will make those rights clear to both sides. A well-drafted agreement can stop a dispute before it even arises.

China lawyersIn my first post on payments from China, I discussed the risk that payments from China will not be made due to failure to obtain approval from the transmitting bank or from the Chinese government. In this and my next post, I will discuss the general ways to mitigate those risks. In this post I will discuss the basic principles. In my follow up post, I will give specific examples keyed to the four basic types of transactions I outlined in the first post.

The basic rules for dealing with payments from Chinese entities are as follows:

Rule Number One: Always put the the burden of dealing with Chinese banks and government authorities on the Chinese side. And always put the burden of a successful resolution on the Chinese side. China is the rare country where its resident businesses will try to shift the burdens of its own governmental actions onto a foreign party. This is not acceptable. A country resident must be liable for the actions of its own government, since the country resident is the only party to the transaction with any real chance to influence the actions of its local government and banking institutions. Think about this for a minute: are you or your Chinese counter-party more likely to be able to persuade a Chinese bank and/or Chinese government official to get money out of China? If your Chinese counter-party is trying to put this burden on you, this is a red flag and a good indicator it knows it likely will never get the money out.

In the area of payments, this means two things:

First, the Chinese side must take on the burden of paying China taxes and fees. That is, all payments to you on the foreign side must be net payments, free of the imposition of taxes and fees on the Chinese side. If a tax is or fee is imposed by the Chinese bank or local tax authority, the Chinese side must pay this tax/fee, with the payment to the foreign side being unaffected. If the payment to the foreign side is $5 million, the foreign side must be paid $5 million. It makes no difference to the foreign side whether the tax/fee imposed in China is zero, 10% or 100%; the foreign side still receives its $5 million payment.

The reason for this is obvious. First, the Chinese side must be motivated to have the tax or fee reduced. If the tax or fee is simply passed on to the foreign entity, no such incentive exists. Second, there is little consistency in the taxes and fees imposed by Chinese foreign exchange banks. The same transaction my be treated differently from region to region and from bank to bank. Even within the same region and the same bank, treatment may change from transfer to transfer. This means it is difficult to predict the amount of any tax or fee that may be imposed. The Chinese side must take the risk of this uncertainty; it is unreasonable to impose the risk on the foreign party.

Second, the Chinese side must take on the risk that payment will be approved within strict timelines. These timelines should be tight. The Chinese side should not be given 30 days to pay. Ten days should be the maximum and five days is better. The reason for imposing a tight deadline for payment is that it is critical you determine as early as possible whether the Chinese side will be able to make payment. Due to the capricious nature of Chinese banks and taxing authorities (especially in the last year or so with China’s increasingly tight capital controls), approval has to be determined for every payment. You should do no work nor take on any risk until after receipt of the applicable payment from China is confirmed, and I mean really confirmed.

Your contract should provide that if payment from your Chinese counter-party is delayed for any reason — including for lack of approval by the Chinese bank or government authorities — you have the right to terminate the underlying transaction. Chinese parties will often argue that failure to pay due to bank or government lack of approval should be treated as a force majeure event that excuses the Chinese side from enforcement. That is, the Chinese side will argue that the foreign party is not permitted to terminate and even call for a force majeure provision in the contract making this explicit.

This provision might then mean you are required to perform under the contract even though no payment is made by the Chinese side. This is not, of course, what the standard doctrine of force majeure provides. However, the Chinese side will often seek to insert this absurd provision. As clever negotiators, they will insert this in an otherwise standard force majeure clause. Since this type of clause is treated as “boilerplate,” the language is often not read carefully, leading to very unpleasant results for the foreign party. For this reason, I routinely refuse to allow any form of force majeure clause to be included in any contract I draft for China. We also have more than once been contacted by foreigners whose contract says one thing for force majeure in China and something very different in English, but the Chinese controls. Do not let these sort of things happen to you!

Rule Number Two: Force early payment. It is important to test as early as possible whether the Chinese side actually has the ability to make a payment. The test is made by providing for an early payment from the Chinese side in an amount large enough to force the Chinese side to go through the full approval procedure with the Chinese bank and with government authorities. A small, token payment is not sufficient.

One purpose of the initial payment is to ensure your written documentation related to the transaction is acceptable to the foreign exchange bank. For example, for any payment that can be classified as a royalty, a number of issues can arise concerning the documents, including the following:

  • The bank may require the underlying agreement be registered with the applicable government regulatory body. This is common for technology transfer and licensing agreements.
  • The bank may require the transaction itself be approved by Chinese government authorities. This is standard for outbound investments. Approval is also normally required for licensing in the publishing and audio-visual fields.
  • The bank may impose various requirements on the written contracts. Typically the bank will require the main agreement be written in Chinese. Many banks also will require an written, signed invoice for each separate installment payment.
  • The bank may work with the local tax office to impose various taxes and charges on the payments. Both the amount of tax and the processing of tax payment can be confusing and can cause delay.

By requiring an initial payment from the Chinese side, the parties can isolate the problems and correct them before the foreign side begins work or takes risks by relying on the ability of the Chinese side to actually make payment. Our China lawyers are constantly getting called by American and European companies that have not received payment under their contracts with a Chinese entity and in many of those instances it is because their contract has not been drafted in a way that will permit payments to leave China.

Your receiving the first payment is NOT sufficient to pass the test. You as the recipient must also check that payment for the following three things:

— First, was the payment actually made by the Chinese side from China (not Hong Kong), or was it made by another entity, perhaps located outside of China?

— Second, was the payment made through a standard Chinese foreign exchange bank, or was it made through some irregular payment mechanism such as a credit card or through a U.S. financial institution or by bitcoin?

— Third, was the payment made in a single lump sum, or is the payment an aggregate of a number of separate transfers?

All of the above are common and these sorts of irregularities show the Chinese side did not obtain China-side approval for payment. This means the Chinese side failed the test. You now know you are facing significant risk for the later, more substantial payments, unless, of course, the Chinese side for whatever reason will be able to sustain its irregular payment methods beyond its first payment, which is rarely the case.

Rule Number Three: Never get behind on getting your payments. Always get paid first. Get paid before you manufacture and ship your product. Get paid before you start the service work. Get your royalty payment at the beginning of the year, not the end. For the sale of your business (or shares in your business) and the sale of real estate, use a tight closing date with a substantial pre-closing escrow deposit.

In some cases, it is not possible to get all payments in advance. In such cases, you should limit your risk should to loss of profit and avoid getting hit with the loss of your out of pocket costs. For example, in the sale of expensive and highly customized equipment, your should set your risk of non-payment by ensuring the initial installment from China will cover all of your manufacturing cost. The risk for the final payment is then limited to your potential profits, and not to your out of pocket costs in material and labor.

A similar approach should be taken in other fields. For example, license payments may be split into a beginning of year fixed payment, with a variable payment based on sales or earnings paid at the end of the year. This approach ensures you will receive at least some payment that can cover your costs and give you a basic level of profit. It is never advisable to depend substantially on a final payment from a Chinese company; it is almost always better to agree to a smaller, secure fee than to seek a higher fee that shifts the payment risk away from the Chinese side.

The critical point is to recognize there is always payment risk when dealing with payments from Chinese companies. To succeed in selling to Chinese entities, you must recognize the risks and mitigate against those risks as I describe above. In my next post, I will describe some of the strategies our Chinese lawyers recommend for specific types of transactions where payments will be received from a Chinese entity.

UPDATE: And do not for a second believe that even China’s biggest and best-known companies are immune from payment problems. Today’s papers are proof this is not so. See today’s big China story: China cracks down on Dalian Wanda’s overseas deals.

China due diligence lawyers
Good advice when doing business in or with China

In part 1 of this series, I talked about how fraud tends to increase when the economy is good, but revealed when the economy is bad. Or as Warren Buffet once, said, “Only when the tide goes out do you discover who’s been swimming naked.” I also mentioned how in the last few months our China lawyers have been called in to help on more suspected fraud cases than maybe any time in our law firm’s history and of how our goal with this series is to help arm you with information that will enable you to discern China-related frauds (really frauds anywhere) on your own, or at least get you to the point where you realize you need to do something to act on your suspicions.

I am convinced that nine out of ten times when bad things happen to good people who do business in or with China it is the “good person’s” fault. The victim’s failure to discern what was happening to it usually stemmed from one of three things:

  • They failed to account for how China is different from their home country.
  • They too much wanted to believe that their “good relationship would somehow insulate them from problems.
  • They saw issues that ordinarily would cause one to suspect problems, but they either explained each of these issues away on their own or they simply accepted the explanations of their Chinese counterpart, without conducting any investigation into their veracity.

Or as a China consultant friend of mine always likes to say, they “checked their brains at the airport gate.”

Like all attorneys who work with China, I have a ready set of horror stories, which I rotate depending on the occasion, but usually include one or more of the following (modified slightly to protect the guilty):

1. The guy who “invested” an “initial” $500,000 into a China business because the owner of the Chinese business was allegedly the son of a five star general. Co-blogger Steve Dickinson was so troubled by the wild and unsubstantiated claims this Chinese company was making that he suggested to this investor that instead of putting this $500,000 into the Chinese company, he instead use the money to fly him and Steve to Las Vegas and put the money on red, because, as Steve put it, the chances of his not losing his money were much greater this way and it would be a lot more enjoyable. This guy went ahead and invested the $500,000 and lost every bit of it. He then wanted us to sue the “son of the general” on a contingency fee basis, but we would not have taken on that case for a 150% contingency. When your Chinese counterpart focuses more on its connections than on the inherent strength of its proposed deal, you should be doubly wary.

2. The guy who bought a million dollar condo in Shanghai in the name of his girlfriend because she had convinced him that foreigners were not allowed to own real property in China. His girlfriend then left him and claimed he had given her the condo as a gift. The guy wanted our law firm to  bring on local litigation counsel to sue the girlfriend, but we demurred because we did not think he should throw more good money after bad by pursuing a case where he would need to stand before of a Chinese judge and explain the deal by starting out saying he had put the condo in his girlfriend’s name so as to avoid Chinese law. And here’s the kicker: when he bought this condo for his girlfriend, he could have purchased it in his name, no problem! His girlfriend had lied to him about Chinese real property ownership laws and he had spent a million dollars without doing anything to confirm. They say love is blind, but we see this sort of thing all the time on the business front as well.

3. The countless people who call my firm after having sent hundreds of thousands of dollars (sometimes millions of dollars) to someone in China for a product that never arrives. Eventually the person and “company” to whom they sent the money disappears. Anatomy Of A China Scam. Part I. Just The Facts.

4. The US company that used the local Chinese lawyer of its joint venture partner (what was this company thinking?) who drafted up agreements that involved the American company giving its critical technology to the joint venture permanently without getting any real influence or control in it (this is an amalgamation of probably half a dozen poorly formed joint ventures in which we have been called in). For more on this type of joint venture deal, check out, When in China Trust Everyone.

I could go on and on. Easily.

So what can you as a foreigner do? A lot.

The following rules to employ when analyzing a Chinese company with which you are doing business, taking the first six from an article by Muddy Waters entitled, “The Six Rules of China Due Diligence“:

Approach the company as a potential customer does. Dishonest companies have far less confidence that they can fool a Chinese company and far less ability to do so. They also will tend to be less willing to take risks with local companies than with foreign companies. Look at whether the Chinese company does business with other Chinese companies with whom you are interested is treated by other Chinese companies.

Take all company-provided introductions with a grain of salt. It’s not hard for an unscrupulous company to buy someone’s loyalty for the duration of a meeting or phone call. You should rely on your own networks to help you understand the company and industry. If you don’t have those networks, you should not be doing business with China yourself.

Try to construct your own fraud scenario. Ask yourself how everything you have seen could have been staged. This kind of thinking reveals how surprisingly simple measures (like switching factory signs before you arrive, painting old machinery) can be so effective in fooling the credulous foreigner. Our firm’s China business specialists love regaling us lawyers with how different a facility is when they check it out for the first time at the company’s invitation as compared to what it looks like when they pop in unannounced one or two weeks later.

Forget about the paper. Focus on your China counter-party’s operations. “In today’s world where you can buy a competent color printer for less than $200, it’s hard to understand why investors place so much faith in bank statements, invoices, and contracts. China’s deal making world abounds with stories of forged bank statements and other documents leading to disastrous deals. Unfortunately, most auditors apply the US audit playbook in China – reviewing and taking documents at face value….Instead, you have to look at the operation itself. How much does the output seem to be, how much material is moving into and out of the factory, does the office seem to be a hive of activity, how many employees can you count, what is the square footage of the facilities? These are all basic questions one should concern themselves with during site visits. And it pays to visit two to three (or more) times – a good fraudster can put on a show, but they’re unlikely to be able to do it the same way each time. Watch for the subtle differences. Ultimately if you cannot find a good way to measure the company’s sales or productivity (as in the case of a service company), you should think carefully about proceeding with the investment.”

Scrutinize the paper. Yes, you should be wary of every piece of paper provided to you by your Chinese counterpart, but you still should scrutinize it and hunt down and review even more. We love scrutinizing the paper (especially early on in a deal) provided to us by the Chinese company because so often their methods to obfuscate are so crude and obvious. And when we find that the Chinese side tried to trick our client, we suggest our client walk away from the deal. The seventh rule (my added rule) is to put the documents you receive under a microscope because the fraudulent company will nearly always make some mistake in its documents. In my career, I have caught the following, all of which threw up massive red flags:

Company claimed to have a multi-million dollar account at a non-existent bank;

Company documents showed a subsidiary in the Marshall Islands, yet always spelled the country as Marshal Island. It had no such subsidiary;

Company claimed to have a branch office in a particular city, yet its documents on that branch office (including supposed government documents) put that city in the wrong province;

Company claimed to be bringing in twice as much product as physically possible on a particular ship;

Company claimed to have been shipping out product on a particular ship that did not exist during the first few years when the product was allegedly being shipped;

Company claimed to have won an IP lawsuit in a country’s Supreme Court (they produced the Supreme Court’s decision and everything), but there had never been such a case.

And these days, the Chinese government has a lot of “good paper” on its companies. That Chinese company with which you are looking to partner on an aerospace joint venture? Did you know that they are licensed only to bake cookies and cakes and they have been in business for all of 10 months? We frequently search Chinese corporate records for our clients and though it is not inexpensive or easy, it can be incredibly enlightening and it goes far beyond the information provided by the basic company search firms.

The China company search firms typically provide only a fairly basic list of information, such as the names, and addresses of those involved with the company and its registered capital. in addition to not being terribly complete, the information from these search firms is of dubious provenance. How did they get the information? Can you be sure they looked at the entire file? We know the files are only supposed to be open to lawyers. How did they obtain access? When did they review review the documents? Last year’s documents may be of no help at all. Will they know how to interpret the information? Just as one example where knowledge on how to interpret is critical. Suppose a parent company does an IPO in Hong Kong or the U.S. and then claims the IPO proceeds were injected into the WFOE in China. Was the money injected into the WFOE or not. And if so, when? And if not, what is the most recent record on the registered capital status of the WFOE. For a WFOE that receives an injection of capital from an IPO, there is typically at least six months of advance work in increasing the registered capital amount. All of this is public and can normally be found in the company’s official corporate file. In addition, the annual audit will show an injection of capital. But the audit is of the previous year. So for recent injections of capital, we have to rely on the approval for the increase in the registered capital.

Speak with competitors and speak with employees and speak with people in the neighborhood. We love sending one of our China business specialists out to speak with these sorts of people because it is amazing what you can learn.

Do not delegate. Be attuned to the dichotomy between the amount at stake with your investment/deal and the income/wealth of the people on whom you rely for judgment. In other words, you need to be able to trust the people on whom you are relying and if you cannot, you need new people. About half the time when my law firm has been brought into a fraud situation, we have to ask ourselves whether the “trusted subordinate” was incredibly stupid or in on the fraud.

Delegate. There are certain things that only you as a company should be doing and there are other things in which you absolutely positively must bring in the experts. There are no hard and fast rules on when and what is required because it varies with the company and the nature of the deal, but I can tell you that on the legal front there have been hundreds of times where our China lawyers have been brought in too late to help and there has pretty much never been a time where we were brought on too early.

 

And it is not just deals in China that require care and feeding. Deals with Chinese companies in your home country often do as well. Way back in September, 2011, I wrote about a China deal that appeared to have badly soured. The post was entitled, China FDI, Whatever Happened To Show Me? and it was on a China deal that went bad for the small Missouri town of Moberly. The point of my article was to emphasize the importance of conducting due diligence before entering a China (or any) deal:

So why am I writing about this and how is this relevant to you?

I am writing about it because it appears (having only “seen” this from afar I do not know) that the government fell into three classic traps. First, it appears that various governments got overly excited about the possibility of getting Chinese money. It appears it fell prey to the classic “China is rich. We want money. Therefore this is a good deal” syndrome. Second, it appears nobody conducted adequate due diligence. Were the very valid suspicions of my e-mailer ever checked out? I doubt it. I have no idea if my e-mailer ever raised her/his suspicions with City Hall, but having dealt with governments, I can only imagine how they were treated. Can you say groupthink? Third, the deal was rushed. The Columbia paper noted how it all went through in “73 days, far less than the six months or more usually needed to conclude such a deal.” Rushing a deal does not mean it will fail, but it certainly increases the chances.

I had no idea our post would thrust me into a political firestorm half a country away.

Almost immediately after our post ran, I started getting phone calls and emails from the Missouri press and from individuals in that state, wanting to talk to me about Moberly’s deal and wanting to talk to me about a potential China Eastern Air Cargo terminal in St. Louis. It seems that those who opposed the St. Louis terminal were using my Moberly post as new ammunition for why that unrelated deal should be terminated (loose pun intended).

I ended up giving an interview on St. Louis radio and to a few Missouri journalists and got quoted a few times (here and here) regarding the Moberly deal. I also ended up talking with a someone down there (whose name I cannot recall), who talked of flying me to St. Louis (which never happened) to explain how just because one Missouri town had been ripped off by mercurial “Chinese Investors,” that alone has absolutely no meaning when analyzing a completely separate deal involving a legitimate and well funded Chinese company like China Eastern.

I thought again of Moberly this week after reading an absolutely fascinating Business Week article by Susan Berfield recounting what happened there. The article is entitled,  “A Missouri Town’s Sweet Dreams Turn Sour” and appropriately subtitled, “Bruce Cole persuaded Moberly, Mo., to help him build a Sucralose plant. The town’s sweet dreams of jobs and opportunity soon became a nightmare.” To sum up a long and detailed and thorough and fascinating (yes, I know I already used that word) article, it seems Moberly heard the words “Chinese Investors” and lost their heads after that. It appears Moberly got duped out of millions of dollars it did not have and now the town is going to be considerably poorer because of it. And all because of their lack of due diligence.

These days, the Chinese companies that are coming to America (and to Europe) have gotten considerably more sophisticated and we wrote about their newest foreign direct investment (FDI) tacts in The China Fake Investment Scam: Does that Chinese Company Want to Invest in Your Company or Steal Your Technology? and in The China Stock Option Scam.

I love writing about China scams because they make great cautionary tales for our readers. Just about whenever we write such a post, we get a comment and/or email or two from someone who finds it hard to believe anyone could have been so “easily” duped. And/or they just want to let us know that whomever it was who was duped was “incredibly stupid.”  I disagree. I do not see these things as hinging so much on one’s intelligence but on their inexperience with international business and especially with China. These are the people who “check their brains at the gate” when doing business with China.

I conclude this already overly long post with an admonition from a good friend of mine (and a true expert on doing business with China), Ben Shobert, effectively emphasizing the need for, and the benefits of, conducting due diligence:

It is such a simple insight, but one that bears repeating:  you will never, ever regret spending money up-front vetting a potential partner or running a deeper due-diligence process on a particular fatal flaw in your international strategy.  In the case of this sort of vetting procedure in China, or other emerging economies for that matter, the process you need to go through isn’t as clear-cut as we experience in the developed West.  In emerging economies, you are looking for reputational, not just financial, information.  You might be able to get a D&B or S&P report on the company in question, but in an emerging economy, it probably doesn’t reflect the set of books that you care most about.

Be careful out there.

For more on avoiding China problems, check out the following:

China fraud lawyersFraud tends to increase when the economy is good, but revealed when the economy is bad. Or as Warren Buffet once, said, “Only when the tide goes out do you discover who’s been swimming naked.”

I mention all this because in the last few months our China lawyers have been called in to help on more suspected fraud cases than maybe any time in our law firm’s history. I wish I could discuss those cases, even elliptically, but I cannot, for fear of tipping off those who are suspected. So I will instead re-hash old blog posts on this issue with — when necessary updated information. The point of today’s posts and those that follow is to help arm you with information so you can better discern China-related frauds (really frauds anywhere) on your own, or at least get you to the point where you realize you need to do something to act on your suspicions.

But I would first like like to discuss a company called Sino-Forest and start out doing so with a giant WE TOLD YOU SO, obliquely on here but not so obliquely to our clients. There, now that that’s out of the way, let me tell you about Sino-Forest. Sino-Forest was at one time a high-flying Chinese company that traded publicly in the United States. We first hinted at our suspicions of Sino-Forest back in 2011 in a post entitled, How To Really Really Investigate A Chinese Company. Another reason for my writing this post today is because the Ontario Securities Commission hearing panel just “found that Sino-Forest Corp. and four individuals, among them former CEO Allen Chan, engaged in ‘deceitful or dishonest conduct’ that constituted fraud, according to a decision released Friday.” One of the ways we as China attorneys spot China company frauds is when a company claims to own something or be engaging in some sort of business that cannot legally be true in China. This leads us to conclude the company is either lying or operating illegally, neither of which makes for a good investment or business partner.

I feel compelled to warn you that this is going to be a fairly long and fairly technical post and more posts on China fraud will follow. But if you even have an inkling that you are in any way dealing with a fraud, I will tell you — with all the humility I can conjure — that this post and those that follow it (starting tomorrow) are must reads.

I will start out by talking about some of the main issues to consider when looking at Chinese companies that trade publicly overseas, by quoting liberally from Thinking Clearly About Chinese Companies Listed On US Stock Exchanges. Or, If A Tree Falls In A Sino-Forest…., a post my fellow blogger Steve Dickinson wrote way back in 2011. I note that what reeks of fraud in publicly traded companies generally holds true for private companies as well. Steve’s post provides good background on risk assessment:

I have been doing a lot of consulting lately for investment professionals concerned about the issues recently raised by Muddy Waters LLC about Sino-Forest and other Chinese companies listed on North American stock exchanges through reverse mergers. I have found that most of these investment professionals are confused about what is going on with Chinese companies listed on foreign stock exchanges and their confusion is causing them to improperly evaluate the true risks of investing in Chinese companies.

The fact is that there are risks concerning every Chinese company that lists outside of China. China is a developing country based on socialist market principles that are unclear even to the Chinese. It is a certainty that even the best managed and most profitable Chinese company will not be managed and operated in a manner that would be typical of a well-managed U.S., Canadian or Western European company. This is going to be true of pretty much any company from the developing world. However, it is also important to account for major distinctions concerning Chinese companies that have listed outside China.

There are basically three kinds of companies that list their shares outside China:

The first group is made up of well established Chinese companies that form the heart of the Chinese industrial and service economy. These companies are typically state owned enterprises already listed within China on the Shanghai and Shenzhen stock exchanges. Examples of such companies that have listed on the New York Stock Exchange are:

  • Aluminum Corporation of China Ltd
  • China Eastern Airlines Corporation Limited
  • China Life Insurance Company Limited
  • China Mobile (Hong Kong) Limited
  • China Netcom Group Corporation (Hong Kong) Limited
  • China Petroleum and Chemical Corporation
  • China Southern Airlines Company Limited
  • China Telecom Corporation Limited
  • China Unicom
  • Guangshen Railway Company Limited
  • Huaneng Power International Incorporated
  • Jilin Chemical Industrial Company Limited
  • Petro China Company Limited
  • Semiconductor Manufacturing International Corporation
  • Sinopec Shanghai Petrochemical Company Limited
  • Suntech Power Holdings Company Limited
  • Yanzhou Coal Mining Company Limited (ACH)

It makes sense to ask whether or not these companies are actually profitable. It may also make sense to ask whether these companies are working on behalf of their investors, both Chinese and foreign. However, it is absurd to even consider whether these are “real” companies, with real assets, real operations and real cash flow.

The same is true of many other lesser known privately held Chinese companies that have listed in the United States. Whatever an investor may think about how they run their business, there is no question that they are in business and are working actively to make money for someone.

The next group are typified by companies that operate in China under unique structures such as the VIE (variable interest entity) structure that is common in the Internet sector. Many people are surprised to learn that Alibaba, Baidu, Sina, Tudou and other foreign listed Internet companies do not actually have any direct Internet operations in China. This is because, as foreign companies, they are not permitted to operate directly in China’s Internet sector. They therefore operate through Chinese companies that they create and then “control” through elaborate contractual arrangements. Though one can certainly raise many questions about the security of these contractual relationships in terms of calculating the real worth of these companies, there is no question about whether or not these are “real” companies. Alibaba and Baidu and their related companies dominate the Internet sector in China and operate vast numbers of businesses. Since they operate on the Internet, these businesses are relatively easy to monitor to determine whether or not they really exist. In addition, in their public filings in the U.S. and Hong Kong, these companies clearly describe every detail about the structure of their business and clearly state the possible risks arising from their unusual business structures. This means that while the VIE approach to doing business in China raises unusual risks, it would be difficult to claim that their structures are not well described and that their risks have not been exposed. More importantly, one cannot say that their business structures are designed to conceal a business that does not really exist or that operates on a scale far small than reported.

Muddy Waters and its followers are not claiming that their target companies fall into either of the above two categories. Muddy Waters states quite clearly that it believes that Sino-Forest and others are absolute frauds. The claim is that these companies have used complex structures and claims about the unique nature of doing business in China to hide the fact that they are complete frauds. The claim is that they are not doing any real business in China at all. The claim is that they have no income, no employees, no factories, no nothing. They are empty shells, created to take money from naive foreign investors.

I do not know whether these claims are true and I am not personally aware of any proof that any of the Chinese companies listed in the U.S. and Canada are complete frauds. I have found, however, that many investment professionals are confused about the accusations against Sino-Forest and others. In an attempt to make a case that they have not been completely duped by the fraudsters, the investment community seems to want to argue that Sino-Forest and others should be treated as though they were members of the two groups of companies I describe above. In this way, they can excuse their analysis by claiming that the company practices of Sino-Forest and its ilk can be “excused” by the unique characteristics of the Chinese business environment and regulatory system.

This position is a mistake. The claim against Sino-Forest is not that it has a complex business structure required for doing business in the Chinese market in wood products. The claim is that Sino-Forest has used this argument as a smoke screen for creating a company that is a complete fraud. The claim is that Sino-Forest owns little or nothing in China. The claim is that Sino-Forest has earned little or nothing in China and has no prospects for any real earnings in the future. This has nothing to do with the nature of the Chinese system. The claim is a simple assertion that Sino-Forest is a hollow shell and a fraud.

I do not know whether this claim against Sino-Forest and other Chinese companies that have listed as reverse mergers is true or false. However, this claim is quite different from the concerns that can be raised against Chinese companies that come within the two categories I enumerate above and two mistakes arise from this confusion.

First, legitimate companies under the first two categories are unfairly questioned and their stock is unfairly attacked. I am not contending that their stock is properly valued. However, the accusations against Sino- Forest and others should have no bearing on evaluating the business of these companies.

Second, Sino-Forest and others are given too much credit because investors assume they must be using legitimate business practices that are employed by the legitimate companies that fall into the first two categories.  Many people who have discussed the Sino Forest matter with me assert that Sino-Forest must be using a VIE structure. They argue that since Alibaba and others use a VIE structure, the Sino-Forest system must be acceptable. Though I do not understand Sino-Forest’s so-called “authorized intermediary” structure, I can say for sure that it is not a VIE structure. Therefore, Sino-Forest should not be assumed to be engaging in an unusual and risk but otherwise well known business practice. This is just an example of wishful thinking common in the investment community.

In tomorrow’s post, I will discuss some due diligence you can and must do to avoid becoming a victim.