China lawyersOne of the most interesting things about representing foreign companies that do business in or with China is how Chinese companies all seem to operate from the same playbook. Our China lawyers can go years without a Chinese company doing XY and Z and then all of a sudden, we will have five deals in a row where the Chinese company does XY and Z. Right now we are seeing a slew of Chinese companies seeking to become distributers of American products via Joint Ventures. Though this post focuses on this one sort of transaction, it has lessons about China company negotiating tactics that have universal value.

We represent many foreign companies that have their product made in China under a contract manufacturing arrangement. At the start, the foreign company targets its product sales in the North American and European markets. But as China’s consumers grow wealthier and more sophisticated, it often happens that the foreign company is approached about selling its products  in China to Chinese customers.

When the foreign company investigates the situation, it turns out that such sales are more complex than they seem. Since the foreign company does not own the product until after the product is shipped outside China, sales within China involve a complex process of exporting out of China and then selling back into China. This results in the potential for VAT to be paid twice: once on the export and again on the import. As a result, the U.S. buyer of the contract manufactured product will often be approached by Chinese companies with elaborate schemes designed to avoid such taxation. Such schemes should virtually always be avoided.

Often the Chinese side will try to convince the foreign company to enter into a complex “partnership” or joint venture arrangement, so that the foreign entity participates in the conduct of the distribution business in China. Entering into such a partnership is almost always a mistake. Operating a distribution and sales business in China is complex and it rarely makes sense for a sensible Western company to get involved in this kind of business in China, particularly when tax avoidance and “incentives” for making sales is the major objective.

Instead the foreign product buyer should insist on operating via the standard distribution model used throughout the world. The foreign company should purchase its product from its Mainland China manufacturer, receive that product outside of China (in an export processing zone or when shipped) and then sell that product to a qualified PRC distributor. The distributor can be located in China, or in a PRC export processing zone or in Hong Kong. The foreign company buyer should earn its profit from that initial sale, freeing it from concerns with the financial side of the Chinese operation. On the other hand, the foreign company buyer should strictly monitor the operations of the Chinese distributor through a standard distribution agreement.

If the foreign company buyer wants to support its PRC distributor, it is free to offer incentives, such as the following:

  • Not charging the distributor for product that will be used as samples.
  • Reducing prices for a certain number of products
  • Providing cash incentives for advertising or seminars and/or to partially/completely cover the cost of registrations.

However, such incentives should be offered to a distributor that operates under a standard distribution agreement that allows the foreign company buyer to terminate the agreement if the distributor does not perform (which is common) and gives the foreign company buyer the absolute right to audit the performance of the distributor on an arms length basis and to terminate if the China distributor engages in irregular conduct such as bribery or kick backs (which are common). One major defect in any kind of partnership/joint venture approach is that it is difficult to hold the Chinese side to a tight performance standard when there is a business ownership relationship. It is like a marriage: easy to get into, but hard to get out of.

Due to the need export from China and then ship back into China, it often happens that the distributor will establish an entity in Hong Kong to handle the operations. If the foreign buyer wants to take an ownership interest in the Hong Kong distributor, it can do that, but the basic rules remain the same: The Hong Kong distributor should be treated as an arms length third party, operating under a standard distribution agreement with the foreign company buyer earning its profits from sales to the distributor (profits now), rather than from the very uncertain and tax disadvantaged distribution of profits from the distributor at some unknown inherently uncertain later date. The foreign company buyer should also understand that it is a myth that they will be able to exercise more control in a joint venture setting. The truth is exactly the opposite: joint ventures are nearly impossible to control by a foreign entity located thousands of miles away with no right to make a quick and decisive contract termination decision.

It is rare for Western companies to want to get involved in the business of distribution in a vast and complex market like the PRC. This is why so many major multi-nationals hire Chinese distributors to do the work. It is even rarer for Western SMEs that understand the issues to take on this difficult burden. However, it is inexperienced SMEs and start-up companies that get approached with these ill-conceived concepts, for obvious reasons. You should asses any such proposal by applying the three basic rules set forth below, which rules apply to just about any project concerning China:

  1. If the proposal is complex, don’t do it. You should be able to understand the proposal in a first reading.
  1. If the proposal involves an equity joint venture business, be very wary. Avoid China business relationships that you cannot terminate by a simple contract termination notice.
  1. If the proposal is not supported by a legitimate financial projections, don’t do it. A “business plan” full of fluff and fancy jargon that no one really understands does not count. What counts is a set of standard financial projections (hard numbers, not jargon) with each assumption clearly spelled out and supported with facts.

If you follow these rules you will save yourself time and money in doing business in China.

China trademarks and design patentsIn part 1 of this two-part series, I stressed the need for just about any company doing business in China or with China to register their brand name(s) and logo(s) as a trademark in China. We have considered registering your trademark in China as a no-brainer since we started this blog and the need to do that has only increased as trademark enforcement in China consistently strengthens. And, yes, this applies even if you are just outsourcing to China and exporting all that you are having made.

I ended part 1 by noting how about a year ago, our China lawyers became convinced that if you are outsourcing your product production to China or selling your product in China, in almost all instances you really do need to register a design patent on your product. Because if you don’t, someone else will and then you will find yourself either having to challenge that patent (which is relatively expensive and time-consuming) or just walk away from China.

A design patent in China is generally analogous to a design patent in the U.S. or a Community design in the EU and it covers novel product designs that (1) incorporate shapes, patterns, and/or colors, (2) are rich in aesthetic appeal, and (3) are fit for industrial application. China registers design patents without conducting a substantive examination of the design patent application and so it truly does not take much at all to secure one. Substantive examinations only occur if a third party challenges a patent’s validity after registration. A design patent applicant need only submit an application to SIPO that satisfies the procedural requirements, particularly with respect to proper formatting of documents and drawings.

Even though many of the design patents in China are nothing more than slight modifications of existing product designs they still can have substantial value because its owner can sue for design infringement and register the patent with Chinese Customs and have counterfeit or copycat products seized at the border. Even if you do not think your design is novel enough to be patented, there is a first mover advantage to your filing for the design patent simply because your design patent will be valid until successfully challenged by a third party. A Chinese design patent grants its holder exclusive use of the aesthetic features of a product, not its functioning portion. In other words, the patent is on how the product looks; its external appearance.

What thought does it really mean to have a China design patent? The typical design patent cases our China attorneys have recently handled are a good way to answer this question.

The case typically starts with a phone call from a Western company telling us that some company (usually a company it already knows and usually either its manufacturer or a competitor) just contacted the Western company (or the Chinese company that makes the Western company’s product) and said that the Western company’s product is violating the Chinese company’s China design patent. The Chinese company then threatens to sue the Western company for patent infringement damages and to block any of the Western company’s “infringing” product from leaving China. Needless to say, the companies that call us on these matters are more than a little bit concerned.

 

Nobody has yet actually had customs block their product from leaving China. The reason is because China customs generally requires a party seeking such a block to post a substantial bond. That substantial bond then becomes available to the party whose product has been blocked by customs. Again though, you want to avoid these cases if at all possible because even if you end up prevailing, you will need to incur considerable time, trouble and money to get there.

The Chinese companies threaten to get an order blocking our client from having its product made in China, but they never do. They never do because they know the cost of doing so is high and the likelihood of their getting such an order and having that order stick is low. I read somewhere once that something like 70 to 90 percent of all Chinese design patents get invalidated when challenged. These Chinese companies know that if we were to challenge their design patents we would prevail, so why spend big money only to lose in the end? The Chinese company’s power comes from the design patent threat, not from its reality.

 

What’s the best way to nip design patent hijacking? Register your design patent first, before anyone else can do so. And that is why we are adding design patents to our list of the one thing (well, maybe two) you must do if doing business in or with China if your business involves a physical product.

China trademarks and design patentsOkay, so that’s two, but you get the point.

Way back in 2011, I wrote a blog post entitled, China: Do Just One Thing. Trademarks. As you can guess from the title, the point of that post was to emphasize that no matter what else a foreign company does when doing business in or with China, it must, must, must file to secure China trademarks for its trade names and logos, because if it does not, someone else will and then the foreign company will not be able to use its trade names or logos in China, even if all it is doing is having its products made in China for export.

In talking with foreign companies looking to do business in or with China, I talk about how NNN Agreements can help prevent their China counter-party from competing with them, contacting their clients/customers, and duplicating their products. And if they are going to be manufacturing in China, I tell them about the importance of Product Development Agreements for protecting their intellectual property before their product is fully developed, and Manufacturing Agreements for protecting their intellectual property after their product is developed and for ensuring quality and timely deliveries.

These agreements are all very important and in some cases, not having one can be fatal to a company. But with the exception of an NNN Agreement, they are relatively expensive and in some cases — rightly or wrongly (almost always wrongly), we get foreign companies who believe that their Chinese counter-party can be fully trusted and such agreements are just not worth it to them. I have better things to do than to argue with such an analysis and so I don’t.

But when it comes to the need to have a trademark, I always fight back because I and the other China lawyers at my firm have seen far too many companies go under after having lost their trademark to China and having their goods seized at China customs for violating someone else’s trademark and then not being able to switch their manufacturing to some country other than China. When it comes to the need to secure the appropriate trademarks in China, I am blunt: anyone who doesn’t do it is making a big mistake:

I tell them how if they do nothing else, they should immediately register their trademarks in China. This one usually surprises them and they often think I have misunderstood what they are planning for China. They at first do not understand why I am emphasizing the need for their filing a trademark in China when they have no plans to sell their product in China. I then explain how China is a first to file country, which means that, with very few exceptions, whoever files for a particular trademark in a particular category gets it. So if the name of your company is XYZ and you make shoes and you have been manufacturing your shoes in China for the last three years and someone registers the “XYZ” trademark for shoes, that company gets the trademark. And then, armed with the XYZ  trademark, that company has every right to stop your XYZ shoes from leaving China because they violate that other company’s trademark.

And this happens constantly.

About a year ago, we started seeing the same thing with design patents and in tomorrow’s post I will explain how that works and what you need to do to prevent it.

 

Choosing your China company nameThough I generally recommend foreign companies filing for trademarks in China avoid the Madrid system and file a national application – that is, an application directly submitted to the Chinese Trademark Office (CTMO) – the Madrid system does provide one minor advantage. National applications must include the applicant’s Chinese name, whereas Madrid applications have no such requirement. Companies often spend considerable time and money in determining their Chinese branding strategy, and rightfully so. The annals of advertising are filled with tales of inopportune translations when companies go abroad. Indeed, we work with marketing companies whose sole raison d’être is to help foreign companies with branding in China.

That being said, it’s no big deal if you haven’t come up with a Chinese name for your company but still want to file a trademark application in China. First, it’s important to distinguish between the Chinese name for your company and the Chinese name for your product. For some companies, the company name is the brand; for other companies, the company name is of little import. Second, and most importantly, an applicant’s Chinese name on a trademark application is solely used for internal purposes at the CTMO. It has no meaning, relevance, or effect in the outside world.

If you have already determined the Chinese name for your company, then by all means use it in the trademark application. But if you don’t have a Chinese name and you don’t have the time, money, or interest to create one, it doesn’t matter what name you choose. You will want to continue using that name for any further trademark applications (to maintain internal consistency). But in all other respects, it will be as if your company does not have a Chinese name, so when it comes time to select a Chinese name for use in commerce, you won’t be limited by your choice on the CTMO application.

China LawyersBecause of this blog, our China lawyers get a fairly steady stream of China law questions from readers, mostly via emails but occasionally via blog comments as well. If we were to conduct research on all the questions we get asked and then comprehensively answer them, we would become overwhelmed. So what we usually do is provide a super fast general answer and, when it is easy to do so, a link or two to a blog post that may provide some additional guidance. We figure we might as well post some of these on here as well. On Fridays, like today.

I got an email the other day from a reader who linked over to a Vox article, entitled, Bill Clinton and Loretta Lynch’s meeting scandal is every Clinton scandal in miniature, along with the following text:

How can you always say China is the most corrupt country in the world when your own country is equally as bad? It is not fair that you always focus on China and ignore your own country. You should cover the Clinton scandals and how influence has been for sale in the United States with lobbying for the last century. Why do you never compare levels of violence between the United Stats and China either?

We actually get such emails and comments all the time (usually with a lot more vitriol), both here and even more often on our Facebook page, where there was one person who would leave a similar comment just about every time we posted anything remotely negative about China. Here though, once and for all, is the answer to the above email and to the many that we receive:

  1. What are you even talking about? We have never called China the most corrupt country in the world, nor do we consider it as such.
  2. We fully recognize that the United States is far from perfect.
  3. Read the title of this blog. It starts with “China” for a reason.

Any more questions?

Importer of Record
Don’t get crushed when you import

The US Importer of Record is liable for antidumping and countervailing duties tied to the product being imported. The Importer of Record is the company listed in Block 26 of the U.S. Customs 7501 form. When I told a US Senator this, he responded by saying he “thought the Chinese company was liable for the duties, not the US company.”

Under US Antidumping, Countervailing Duty and Customs laws, the Importer of Record must exercise reasonable care in importing products and in filling out Customs forms. The Importer of Record must correctly state a product’s country of origin and also whether Antidumping and Countervailing duties apply to the imported product. A knowingly false statement on a Customs form constitutes criminal fraud.

If AD or CVD rates go up in a subsequent review investigation, the Importer of Record is retroactively liable for the difference, plus interest. Retroactive liability for AD and CVD cases is a particular problem involving goods imported from China, because the U.S. Commerce Department treats China as a non-market economy country. Dumping is generally defined as selling products in the United States below their normal value, which generally means selling a product in the United States below its price in the home market or below its fully allocated cost of production.

Since China is a non-market economy country, Commerce refuses to use actual China prices and costs to determine whether a Chinese company is dumping. It instead uses complicated consumption factors for raw materials and other inputs and surrogate values from five to ten constantly changing countries to calculate the Chinese company’s production costs. All this makes it impossible for the Chinese manufacturer/exporter to know whether it is dumping, never mind the US importer.

In the Mushrooms from China antidumping case, from the time the antidumping order issued in 1999 through numerous subsequent yearly review investigations, many antidumping rates were in the single digits because Commerce used India as the surrogate country. But when Commerce switched from India to Columbia as the surrogate country in 2012, the Antidumping rates went from less than 10% to more than 200%. The Importers of Record were then liable for the difference in the duty rates, plus interest.

How can you as an importer of products from China (or from anywhere else) avoid getting hit with a massive antidumping or countervailing duty fee? Do not become the Importer of Record. The dollars saved by this can be staggering.

In the Wooden Bedroom Furniture from China initial investigation, for example, I represented a U.S. company importing furniture purchased from a Chinese furniture manufacturing company.  At my recommendation, the U.S. importer pushed the Chinese furniture producer to become the importer of record for its own sales to the company.

In the initial investigation, the Chinese furniture company initially received a 16% antidumping rate which for various reasons, eventually hit 216%. My client estimated that the Chinese manufacturer exported $100 million, which created $200 million in retroactive liability for its U.S. importers. The Chinese company then decided not do a second review investigation, creating an additional $200 million in retroactive liability (for a total of $400 million) in retroactive liability for the U.S. importers.

However because my client it was not an importer of record on the sales from the Chinese furniture manufacturer, it never had to pay a penny. This was not true of most of the other U.S. import companies and a number of those went bankrupt.

What if your company is the Importer of Record and your antidumping or countervailing rates go up? U.S. antidumping and countervailing duty laws are remedial, not penal. This means requesting review investigations at the Commerce Department, appealing adverse rulings to the Courts and working with Customs often can substantially reduce or even eliminate any penalties. Chinese exporters also can (and often do) use the Commerce review process to reduce their antidumping and countervailing duty rates so they can export to the US again.

China NNN Agreement
         Was it a subcontractor?

One of the primary ways foreign companies lose their IP to China is via infringement by manufacturing or service subcontractors. Our China lawyers constantly see/hear of foreign companies that enter into “iron-clad” contracts with a primary Chinese company, only to lose their IP to a subcontractor for whose behavior the primary Chinese company has no responsibility. Often, the subcontractor is in some way related to the primary Chinese company and the infringement is intentional. In other cases, the subcontractor has no direct relationship with the primary Chinese company and is simply trying to create a new business for itself. Either way, subcontractors are a big threat to your intellectual property and they must be treated as such.

There are essentially the following three options for dealing with subcontractors in your China contract:

1. Prohibit subcontracting. This is our preferred option but it is often not practical. You should, however, always consider how it seldom it makes sense for your primary Chinese company to need to contact subcontractors at the NNN stage, rather than later at the product development or manufacturing stage. A China manufacturer (or service provider) that is claiming it must deal with its subcontractors at the NNN stage is oftentimes a Chinese manufacturer planning to steal your intellectual property. Some of the larger electronics and Internet of Things (IoT) hardware manufacturers are notorious for this.

2: Permit subcontractors, but make your primary Chinese contractor liable for the subcontractors’ conduct. This is the standard option to which most Chinese manufacturers and other Chinese companies will agree, simply because it is the easiest system to manage. In the last ten years, virtually no legitimate Chinese manufacturer or other Chinese company has objected to this option in the NNN stage for the reason discussed above: no subcontractors are usually involved at the NNN stage.

Option 3: Limit the use of subcontractors. We often draft contracts that limit the Chinese company to using subcontractors only when the following conditions are met: a) the primary Chinese company gives written notice of each subcontractor, b) our foreign client formally approves the subcontractor and c) the subcontractor enters into a separate NNN contract with our client. This is actually a very good system, since it gives you a direct contractual relationship with the subcontractors who have all signed binding contracts that explicitly protect your IP. Note though that this almost never comes up at the NNN stage, only after. This requires you draft and get signed formal agreements with each subcontractor and you may have to deal with your Chinese manufacturer (or lead service provider) that is worried about you cutting them out by going direct to their subcontractors.

Even though subcontracting should not be relevant at the NNN stage, we often put a subcontracting provision in our NNN Agreements because it can force the primary Chinese company to reveal that it is not really going to be doing the manufacturing or the work, but instead will be using a subcontractor to do everything.

China LawyersBack when I used to watch a lot of horror movies (a long long time ago), When a Stranger Calls was one of my favorites. Spoiler Alert: It was about a babysitter who was experiencing weird things and constantly getting calls from someone who kept asking “have you checked the children.” To make a long story short, the creep was in the house.

I mention that movie today because our China lawyers have been getting a spate of calls lately to assist from American and European companies who have just learned that the creep is in their house.

Let me explain by way of some examples:

1. U.S. company terminates its head of China operations and then a couple of its China employees reveal that the U.S. company’s leading supplier is owned by the former head of China operations who — almost needless to say — has been charging about 40% over market.

2. Spanish company terminates its head of China operations only to learn that it actually does not have any China operations. The WFOE this person claimed to have formed and which the home office for the last three years believed was there actually wasn’t. The head of China operations had pocketed all of the money for the WFOE and all of the money marked for China income taxes as well. Fortunately, it turned out it never made sense for this company to have a China WFOE in the first place and so it exited China and now contracts with a Chinese company to accomplish what its fake WFOE had previously done. I say fortunately because if it had to have remained in China, it would have been at risk for not having paid its China taxes. For more on this fake WFOE phenomenon check out So You Think You Have A China WFOE Or Joint Venture Or Trademark. What Makes You So Sure?

3. American company flies to China to meet with its nine employees, only to learn from one employee that it has only five employees and that the head of its China operations has been pocketing the extra funds that allegedly went to pay the salaries of the four phantom employees. For the past three years!

Why are we getting so many of these calls now? All of them can to at least some extent be traced to the downturn in China’s economy. Many foreign companies are checking on their Chinese operations more closely than previously simply because they are concerned because they are less profitable. To quote Warren Buffett: “Only when the tide goes out do you discover who’s been swimming naked.”

Do you really know who’s in your house? Have you checked your children?

China employment contract

China permits only the following three categories of “dispatched” employees to be hired by a labor dispatch agency:

  1. Temporary employees with a term of no longer than 6 months.
  2. Auxiliary employees who provide supporting services that are not central to the employer’s core business.
  3. Substitute employees who perform tasks in replacement of permanent employees during a period when permanent employees are unable to work due to off-the-job training, vacation, maternity leave, etc.

Both the PRC Labor Contract Law and the PRC Interim Provisions on Labor Dispatch require that a dispatch agency and a dispatched employee enter into a labor contract for a fixed term of no shorter than two years. It should be noted that the labor dispatch agency is for legal purposes treated as the employer in this relationship.

As covered in some of my previous posts, China’s labor law mandates that an employee is entitled to an open-term contract after having executed two consecutive fixed-term labor contracts (unless grounds for termination exists). So a question arises: if a labor dispatch agency has consecutively executed two fixed-term labor contracts with an employee, will the employee be entitled to an open-term contract? In other words, will a dispatched employee be treated the same as a regular employee under this circumstance? Note that China’s labor law clearly states that at the time of renewal or execution of the labor contract, unless the employee requests a fixed-term labor contract, an open-term labor contract must be concluded.

Consider two recent cases in Beijing (I have simplified both a bit for purposes of this post). In the first case, after having executed two consecutive fixed-term contracts, the employee requested an open-term labor contract, however, the labor dispatch agency ultimately refused and served the employee with a termination notice. The labor dispatch agency argued that the law on open-term labor contracts does not equally apply to dispatched employees. The employee sued and the Second Intermediate People’s Court of Beijing ruled against the labor dispatch agency and instead held that China’s law regarding open-term labor contracts does apply to dispatched employees. And then, just as would have been the case had the employee worked for any other company in China, the Court required the dispatch agency pay the employee double the employee’s monthly wage and forced it to enter into an open-term contract with that employee and pay that employee damages for wrongful termination. And here’s the kicker: the company that retained the labor dispatch agency and used the employee was deemed jointly liable for both of those amounts (the wages and the damages), meaning it too was on the hook for payment.

In another case involving a dispatched employee, the Xicheng District People’s Court also concluded that China’s labor law applies with equal force to labor dispatch agencies. This court reasoned that even though the PRC Labor Contract Law states that a labor dispatch agency and a dispatched employee must enter into a labor contract for a fixed term of no less than two years, this provision does not preclude such a labor contract from being a regular labor contract. The court also discussed how since the law treats a labor dispatch agency as an employer for legal purposes, this means the labor dispatch agency is subject to the same responsibilities as an ordinary China employer, including the obligation to execute an open-term contract when conditions for being required to do so have been met. The Court went on to make clear that the general intent of China’s Labor Contract Law is to protect employees, and allowing a labor dispatch agency to be exempt from this requirement on open-term contracts would be contrary to that intent.

Though it is true that Beijing tends to be a pro-employee municipality and the above cases are not necessarily conclusive regarding how similar cases would turn out in other municipalities, this does reinforce the Chinese government’s generally negative view of labor dispatch situations. For how China’s on the ground labor law can vary from city to city, check out China Employment Law: Local and Not So Simple

The bottom line here is the same as the bottom line when doing just about anything regarding China employment law:

  1. Assume the Chinese courts will favor the employee.
  2. Figure out all of the laws and rules, and especially the local rules and cases, before proceeding.
  3. Know that China does not generally like the hiring of workers via third party hiring agencies. It never has and its distaste for such arrangements just keeps growing.
  4. You as the company that retains the third party hiring agency and uses the workers provided by the third party hiring agency can be held liable and hit with damages for the misfeasance of your third party hiring agency. I am tempted to repeat this (but I won’t) simply because there is a widespread belief that using a hiring agency eliminates any legal responsibility for the workers employed. This is just flat out wrong.
  5. If you are going to use workers from a third party hiring agency, you should make sure that you have a good contract with that third party hiring agency and that the third party hiring agency you use has a good contract with those who will be working for you.

 

China Lawyers

Because of this blog, our China lawyers get a fairly steady stream of China law questions from readers, mostly via emails but occasionally via blog comments as well. If we were to conduct research on all the questions we get asked and then comprehensively answer them, we would become overwhelmed. So what we usually do is provide a super fast general answer and, when it is easy to do so, a link or two to a blog post that may provide some additional guidance. We figure we might as well post some of these on here as well. On Fridays, like today.

I had no idea what question to use for today but the following email (modified slightly to delete anything that might enable tracking) from this morning solved that problem for me:

I am _________ from _______, consulting company located in Spain. First of all, thank you for the informative blog posts. They have been very helpful.

My client company is a high-tech manufacturer (digital __________) and tries to expand the market to China.

Is it possible for you to recommend me some China distributors who supply to Department Stores and Home Convenient Stores?

Best Regards.

My response to these emails is usually somewhat along the following lines:

I’m sorry but because we represent a number of similar companies who have paid us tens of thousands of dollars over the years I just can’t. I do not think it would be fair for me to take what we have learned from getting paid to represent these companies and then turn around and give that information for free to one of their competitors. I hope and trust you will understand.

There you have it. Your thoughts?