Header graphic for print

China Law Blog

China Law for Business

How To Sell Your Food And Beverages Into China The Easy Way

Posted in Uncategorized

A friend of mine with one of China’s leading online retailers just sent me an article listing out food and beverage companies that are using JD.com to market and sell their product in China. For more on JD.com, check out this week’s New York Times story on it. The article my friend sent me is entitled, China: JD.com expands imported food program.

Our China lawyers have long advocated a “distributorship-type” model as a lower cost and oftentimes better alternative for foreign companies looking to sell their products into China The following posts (going all the way back in 2010) detail why a distributor/reseller model can be a better way to “get into” China than via a WFOE or a Joint Venture and explain the ins and outs of such a model in China:

It makes particular sense for food companies to sell their food and beverage products into China through distributors and resellers. China’s food safety regulations, import laws and food and beverage distribution systems can be immensely complex, and someone like JD.com is likely going to be better able to navigate these things in China than you are.

But it takes more than just saying “yes” to a company like JD.com to succeed with selling your food or beverage products into China. Even if you end up using an established China food or beverage distributor for your products, you should, at minimum, do the following:

  1. Make sure that your agreement with your distributor/reseller protects your reputation in China and elsewhere.
  2. Make sure that your agreement does not lock you in with your distributor or reseller if sales are poor.
  3. Make sure to protect your intellectual property (particularly your trademarks) from both your distributor/reseller and from China and elsewhere.

For many American food and beverage companies, relationships with companies like JD.com make perfect sense, so long as they are done right.

China’s Film Industry Getting More Industrial

Posted in China Film Industry

China Economic Review editor Hudson Lockett interviewed our Beijing-based entertainment lawyer, Mathew Alderson, for his story, 2014: The year China’s film industry got more industrial. Mr. Lockett was interested in some of the issues Mathew covered in his recent series on digital ancillaries in China’s film industry.

The below are some of the questions and answers from Mr. Lockett’s interview with Mathew:  

 

CER:                      To what extent does focus on box office take for domestic films obscure the greater earnings potential of the industry?

Alderson:            To a substantial extent. But let’s not forget that ancillaries still account for a tiny proportion of the market so it’s natural to focus on box office.

 

CER:                   Broadly speaking, what role has copyright enforcement, or lack thereof, played in the stunting of digital film ancillaries in China?

Alderson:        Though the strength of copyright protection is certainly a factor it’s not the only one. Other factors include that the market is still relatively undeveloped and growing at an extraordinary rate. Over the past five years we’ve seen unprecedented growth in box office. That is attributable to something known as “physical exclusion” — it’s a relatively simply matter for copyright stakeholders to exclude moviegoers from theatres if they don’t buy tickets. This doesn’t depend on copyright. Improvements in the strength of copyright protection have only started taking shape during the time that box office has been exploding, but the means of exclusion in the non-theatrical sphere have been slower to develop because they have been more dependent on enforcement and technology. The stunting of digital ancillaries, as you put it, was originally caused, or at least abetted, by the absence of a legal or technological form of exclusion.

 

CER:                   Before going too deep into digital ancillaries, how does China’s current IP environment affect the profitability of ancillary rights for physical merchandising–particularly for animated films/franchises?

Alderson:            China is awash with counterfeit merchandise. Counterfeits are often made in the same factories as genuine merchandise. This makes them harder to detect because, in such instances, the manufacturing standards and overall quality are the same. The luxury brands don’t like to talk about this but they accept it as a cost of doing business here. There are even retail assistants in the boutiques of Beijing and Shanghai who swap genuine items for counterfeit items without the buyer, or the brand, being aware. This is less an intellectual property problem and more a problem in the enforcement of license terms. Physical merchandising, as a type of ancillary, is subject to these problems too. These problems all erode profitability.

 

CER:                   As online-mobile consumption increases, how likely is it to cannibalize box office revenue?

Alderson:            I don’t know whether it will cannibalize it. I think it’s more likely that online handheld viewing will supplement box office as digital ancillaries grow.

 

CER:                   How did the 2009 Coca-Cola/Pepsi infringement case spur growth in licensed content?

Alderson:            In that case the plaintiffs went after foreign advertisers and held them responsible for contributing to the infringements that were occurring on the platforms on which they advertised. The Chinese providers of these platforms were facing the rapid evaporation of their advertising revenue. They started to clean up their act and the result was an explosion in license fees for content that had previously been pirated.

 

CER:                   You mentioned Charles Zhang referring to an “explosion in paid content”, but how easy is it to shift from the ad-based model now en vogue to a pay-for-content strategy as the basis for ancillary revenues?

Alderson:            It has proven relatively easy when the license fees are set per program or per series. It has proven more difficult when entire catalogues or channels are licensed. Deals of the latter type involve lump sum advances and the task of calculating recoupment or allocating fees among discrete programs is difficult because the usage data are either unavailable or unreliable.

 

CER:                   How rampant is online piracy of films in China, not just via streamed video, but through torrenting and other methods? Are there reliable figures available, and if so, how are they trending of late?

Alderson:            It remains a problem but my impression is that it is not getting worse. If anything it is getting better. Don’t forget that the Chinese are now the most-IP litigious people in the world. Chinese companies are now suing each other over copyright all over the place. Gone are they days when copyright was a kind of stick wielded by Hollywood alone. There are Chinese production and distribution companies whose in-house legal departments include full-time copyright litigators. They spend good money acquiring copyrights and they will no longer sit back and let other Chinese companies free-ride on the investment. The prevention of free-riding has long been the classic economic rationale for copyright law. The landscape is now much more sophisticated than foreigners realize.

 

CER:                   You end the series on a more upbeat note suggesting creativity will outpace censorship, but if the success in clamping down on Weibo and Weixin was in part possible because of those companies’ reliance on friendly ties with the government to do business, won’t BAT-produced films run the same risk?

Alderson:            Ultimately, yes.
CER:                   How do you think cinema is likely to change in form to suit the online-mobile format in China?

Alderson:            I take the view that a preponderance of handheld viewing will naturally lend itself to shorter programs and aspect ratios different to those for feature-length motion pictures. That is not to say that the theatrical format itself is threatened. I think there will always be a place for it and the Chinese are certainly demonstrating a zeal for movie-going. It will just make more sense to format for the handheld screen, in much the same way as motion pictures are formatted for television or in-flight viewing.

 

CER:                   What unique features of the consumer landscape need to be taken into account?

Alderson:            That Chinese consumers consume goods and services online at a higher rate than Americans and they use handheld devices to do it.

China Payment Terms: Some Tricks Of The Trade

Posted in Basics of China Business Law, China Business

Whenever one of our China attorneys is retained to represent a client providing goods or services to China, we start by asking about the terms of payment. If the Chinese side is going to pay our client the full amount upfront, the contract provisions do not need to be too specific. But this almost never happens.  

A more typical scenario is one where the Chinese side agrees to pay a modest amount upfront (say 20%), another portion (say, another 20%) after a vaguely defined milestone, and the rest after the project is completed. This is far from ideal. Halfway through performance of a contract is not the time to be arguing about whether a milestone has been met. But such arguments crop up nearly every time. Even worse, this structure transfers the bulk of the risk to our client, who has to perform first and then collect. We have seen far too many situations where the Chinese side makes so many 11th-hour changes to the deliverables and the schedule that our client ends up losing money on the deal even if they do get paid. Most Chinese companies do not behave this way out of ill will, but when they hold all the financial leverage they have little motivation to adhere strictly to the contract terms.

Accordingly, we advise our clients that at a minimum, they must consider the following three things when it comes to payments:

1.  Make the terms of payment as concise and clear as possible. This is really for the benefit of both parties. It should be self-evident when a payment is due, whether it’s because the calendar shows a given date, a project phase has been completed, or a prototype has been delivered.

2.  Demand a nontrivial amount upfront, and confirm payment before they even lift a finger. It’s not just a show of good faith by the Chinese side (although that doesn’t hurt); it’s to prove that the Chinese side can in fact make a payment on the contract. The renminbi is still a nonconvertible currency, and aside from a $50,000 annual exception, any time a Chinese entity wants to send US currency to a foreign entity, it needs to get approval from the transmitting Chinese bank. This generally means that the parties have executed a contract for goods or services that are acceptable for foreign entities to provide, and that our client has submitted a formal invoice in a form acceptable to the bank – because the bank in turn usually needs to get approval from government authorities. Sometimes this approval never comes, and the Chinese counterparty is unable to make any payments at all. It’s a lot better for our client to find this out at the beginning.

3.  Add 10% to their charge and include it as a final payment due after delivery. A nontrivial number of Chinese entities insist on receiving delivery in full before making the final payment – and then never make that final payment. If our clients do get paid, it’s a bonus, albeit one they will almost certainly have earned for all of the extra work they have done. If they don’t get paid, then at least they received what they expected at the beginning.

China In Columbus, Ohio

Posted in China Business

When I spoke in Ohio last year at a China function, I met Eric McGraw of Laonei Global Trade Consulting. Eric lived in China for seven years and he is now based in Columbus, Ohio, where he and his company help American companies navigate China and Chinese companies navigate the United States. Eric and I talked about the increase in Chinese company investment in the United States and how so many Chinese companies favor less expensive and less difficult cities such as Columbus for their U.S. locations.

Our China lawyers are frequently asked by companies (and even occasionally cities) what Chinese companies are looking for when doing business in the United States and we are also often asked to write about that here on the blog. However because our law firm’s focus is so much more on helping Western companies with China — not the reverse — I sought to enlist Eric to talk about this from his more in the trenches perspective. In particular, I wanted him to talk about what he is seeing of Chinese companies coming to Columbus, Ohio. He graciously accepted and the below is the result.

 

According to various sources, there are roughly 20,000 Chinese residing in the Columbus region, up from around 16,000 four years ago. Why are they here and what do they think of Columbus? More importantly, what does Columbus need to do to become more of a destination for Chinese investment?

My company, Laonei Global, surveyed a number of Mainland Chinese in the area. Results reveal how area organizations and businesses can better promote themselves, through messaging and programs, to attract Chinese interest and investment.

How Columbus Promotes Itself to the World. The city and region created a city branding campaign, with its own website. Here are excerpts from Brand Columbus, the marketing website:

Columbus’ top-ranked location, educated workforce and vibrant cultural scene make it the perfect place to locate, whether you’re looking to grow a business, a career or a family.

Columbus is home to 15 Fortune 1000 companies and welcomes one of the highest populations of college students among more than 50 university and college campuses, ensuring we maintain youth and progressiveness. Columbus is also one of the country’s leading research and technology cities, attracting the brightest minds from around the world.

How Chinese View Columbus. We conducted our survey of local Chinese in Columbus. We collected answers from 97 respondents with varied backgrounds. A majority (57%) were university students who had lived in the area for six months to three years. Fifteen percent of the respondents were graduate students and about 30% were either working professionals or looking for work.

The overall impression the respondents conveyed about Columbus was that it is quiet and cozy. Many mentioned liking how easy it was for them to buy Chinese ingredients for home cooking. Finally, the education environments provided by Ohio State and other local universities was often mentioned as a plus. Chinese in the area call Columbus 哥村 – gē cūn, which translates as Columbus Village. On a 1-5 scale (with 5 being the most positive) 65% rated Columbus a 4 or a 5  and 30% gave it a 3. The respondents’ negative impressions related to the difficulties in getting a job in the area after graduating from local universities, the lack of reliable public transportation, and the weather.

Messaging Gaps. One of our main goals was to gain insight on how local Chinese view Columbus. The following table compares how local organizations promote Columbus with a common Chinese viewpoint on that particular issue.

 

Columbus Messaging

Chinese Views

Great access and test market      Where is Columbus?
Work talent – young and smart      Hard for Chinese to get job
Great environment for business      Not aware of business value
Market access to US population      Not quite sure where Ohio is
Array of higher education options      Ohio State University is famous
OSU Fisher College of Business      Fisher is a famous B-school
Research strength: OSU & Battelle      Know OSU but what is Battelle?
Shopping/retail      Where’s the outlet mall?
450 Intl. businesses in region      Any famous Chinese ones?
Global 500 headquarters      Abercrombie. P&G (in Cincinnati!)
Good US domestic flight service      Not cheap. Inconvenient

 

We used the wordle word cloud generator to tease out other similarities and differences between our survey results and the city’s promotional language.

Here is the wordle result for the Columbus Brand web site:

And here is the worldle result from our survey (translated into English):

Our survey and the Columbus website overlap in higher education, as many of the Chinese respondents were students. But entertainment, arts, restaurants and a few other key points promoted by local organizations did not really register with the Chinese. Our Chinese respondents never mentioned Columbus as being a smart and open city.

The Quest to be Global. Many cities states around the US like Columbus are ramping up their efforts to promote themselves for international investment by touting their communities as the new, hip, affordable place, as opposed to the developed and crowded East and West Coasts. State government and third party reports point out that increased international attention increases local sales and tax revenues, opens up more foreign direct investment opportunities and even boosts American exports to those countries from which foreign investment comes. But on the surface, how welcoming are the so-called flyover regions such as Columbus, Ohio?

Using organization web sites like www.experiencecolumbus.com, as well as local business directories from the Columbus Chamber of Commerce, we called or visited the region’s major tourist attractions, hotels, shopping malls, and local events to inquire about foreign guest services.

The results are clear and disconcerting. Columbus has virtually no multilingual or international guest services, save for a few businesses close to Ohio State, some shops like Louis Vuitton and Macey’s that cater to Chinese shoppers, and ethnic restaurants that Chinese or other ethnic groups might own or work at. Easton Town Center told us they have one customer service representative who can speak five different languages, and the Apple Store at Easton reports having one Japanese speaker. Little or no multilingual literature in any form, such as official web sites, traditional print, or phone apps, has been published in any language other than English. The Port Columbus International Airport has a small welcome booth on the baggage claim floor with a sign directing international guests to use a nearby landline phone to connect with staff that speaks their native language.

Columbus local organizations love to mention how more than 450 international companies have a presence in Greater Columbus and that 109 languages are spoken throughout the area. It is true that Columbus has become more global, with significant business investment from Japan, Germany and the UK, and even a bit from China. Columbus has also has a growing and steady influx of immigrants from Latin America, Africa and Asia. But in terms of connecting with recently arrived international and generating a positive buzz about Greater Columbus being a premiere place to live, work and play, very little has changed.

How Columbus Can Better Promote Itself to Chinese. The benefits to engaging the Chinese community in Columbus are many. Creating a more open and nurturing environment for the Chinese who reside here short-term or long-term will speak well of Columbus and encourage family and friends of local Chinese to want to experience it as well. Not only will local universities benefit from international tuition dollars, but local service industries like hotels, retail and food will reap rewards as well.

Many of the Chinese in the area are here for an American university degree. A number of these students express a desire to remain in the US after they graduate. Our survey results reveal that this young Chinese demographic already views Columbus in a positive light. Columbus needs to make efforts to make their staying here easier.  But opportunities for foreign nationals in the Columbus Region are not as easy to come by as the East Coast (New York, Washington, Boston) or the West Coast (California, Seattle, Vancouver).

Imagine you hop off a plane in a foreign country and are immediately welcomed by signs in your native language. You pick up a local map with multilingual labeling, including your own language. You are greeted at your hotel with a bilingual set of instructions, a local tourist map, and front desk staff member who speaks your language. At the top tourist destinations and restaurants around town, you have access to print or electronic versions of key information in your native language. This does not sound like Columbus – but it could.

Columbus can and should promote the following in its marketing messages to Chinese:

  • Clean air and water quality, food safety – massive problem in China
  • Affordable real estate – high value in comparison to other US markets (and Chinese)
  • Big local China community – Chinese supermarkets, authentic restaurants
  • Arts and entertainment scene in bilingual marketing forms (English/Chinese)
  • True ease of doing business – establishing a business or simply doing business
  • Easy connections to Chicago, New York, Washington, DC

Columbus is a great, open-minded city, which is the reason I founded my company here when I moved back from China in 2013. The Chinese are a small but key population for realizing both regional and city goals. We can’t be everything to everybody, but better understanding our Chinese residents and better connecting with them would benefit our area by expanding our global reach.

For a longer version of this post, please go here.

 

China Contract Damages: More Art Than Science

Posted in Basics of China Business Law, Legal News
Our China lawyers often stress to our clients the importance of a well-crafted contract damages provision that contains a “just-right” amount of damages should there be a breach. We are often asked what the just right amount should and our answer is that depends on the specific facts and to what the Chinese side will agree.  
The other day, one of our China attorneys wrote the following to a client regarding a contract damages provision in an NNN Agreement we had drafted. We had recommended one figure for the contract damages, but against our advice, our client had insisted on a much higher figure. The Chinese supplier rejected the higher figure and out of a desire to get going quickly, our client suggested that we just dispense entirely with the provision. The below email is our response to that:
With regard to our proposed language about minimum damages, I can understand why this supplier is balking at our $350,000 figure. As we discussed when drafting the initial NNN agreement, that is a relatively high amount, and considerably more than the $100,000 to $150,000 figure we recommended be used. This amount is more art than science. It is not supposed to be a penalty, but rather a realistic assessment of the damages that you would incur if the Chinese side were to breach this NNN agreement, say by selling a container full of your products directly to a third party. I would strongly advise against deleting this language entirely, though as specified contract damages are what helps to give this agreement real teeth, not least because they allow the Chinese court to impose a pre-judgment seizure of assets. That is a big advantage for you, and not one that you should give up willingly.
In a subsequent discussion among our China law group regarding this situation, one of our China attorneys wrote the following email to the rest of our group:
This shows yet again the importance of NOT making the contract damages an unreasonably high amount. It seems that whenever our clients push for a higher amount then what we are recommending, the Chinese side resists and then all sorts of problems begin. It is far better to come in with an entirely reasonable amount right off the bat. If the Chinese side resists that, we then know that our client has a problem with its Chinese counterpart. But when we come in at the start with an unreasonable amount for contract damages, the Chinese side quite correctly concludes that 1) our client has little to no experience in China and is basically an unreasonable company that will be difficult to deal with in the future. It is just a bad idea all around. And the thing is that most of the time the clients who insist on numbers much higher than we are recommending are disproportionally inexperienced and difficult to deal with.

China VIEs: A Bibliography From The Last Few Days

Posted in China Business, Legal News, Recommended Reading

The recent news about China VIEs has thrown many (most?) China lawyers into a bit of a tizzy. We all know that what is happening is complicated and important and we are all scrambling to figure it all out, knowing that whatever we conclude now will no doubt differ from what we conclude six months from now. Because this issue is so important and so complicated, I thought it appropriate to gather up the best writings on it and list them below. This is truly a situation where the more you read the more you will understand, though if you think you have it completely figured out, I think you are wrong. 

So with the goal of advancing understanding of these changes, we are going to use this post to maintain an up to date list out the sites that have engaged in a high level analysis of the situation. The below are what we have so far, and we urge you to let us know in the comments section below of any other articles or posts you think we should add to this.

Again, please let us know of any additional writings we should be adding to this.

China VIEs Are Dead. Done. Over. Stick A Fork In Them.

Posted in Basics of China Business Law, China Business, Legal News

January 19, 2015 marks the date of the death of the VIE investment structure in China. The death blow was dealt by the PRC State Council itself, the highest authority on such matters in China. Now that the issue is settled, we can all move on to figure out the effects. 

How was the VIE killed? On January 19, the State Council issued a discussion draft of legislation setting out the plan for overhauling the antiquated Chinese foreign investment legal regime. The new system is set out in the PRC Investment Law Discussion Draft (the “Draft”), a massive document in 178 Articles and 11 Chapters. The underlying philosophy of the Draft is explained in the Explanation of the PRC Investment Law (the “Explanation”).

Draft makes clear that the State Council understands how VIEs work and that their sole function is to evade the requirements of Chinese law. The Draft makes clear that such evasion is illegal and will be prohibited upon the effective date of the new investment law.

The new system will work as follows:

  1. The nationality of any business entity will be determined by the place of formation of the entity. The nationality of the shareholders, the directors or the management is not relevant. The only issue is where the company is formed. Thus, a Cayman Island corporation owned and controlled by Chinese citizens is still foreign for purposes of the law. A Chinese company formed by such foreign investors is therefore treated as a foreign owned entity.
  2. The Draft introduces the concept of “effective control”, a principle borrowed directly from the VIE structure. The Draft provides that any Chinese entity effectively controlled by a foreign owned entity will be treated as a foreign entity. This means that if foreign entity participation in a sector of the economy is prohibited, this prohibition extends to Chinese entities effectively controlled by foreign investors.
  3. It is illegal for an entity effectively controlled by a foreign owned entity to operate in sectors of the Chinese economy that are restricted or prohibited to foreign investors. In other words, the restriction or prohibition applies to effectively controlled Chinese companies in exactly the same way that it applies to a foreign owned entity of any kind. Any effectively foreign controlled Chinese entity that enters into a restricted/prohibited sector is in violation of law. The operations will be shut down and penalties will be imposed as provided by law.

As we know, the core of the VIE is structure is that a foreign owned entity (a WFOE) effectively controls a Chinese owned entity through an elaborate series of contracts. Without such effective control, the foreign owner of the VIE is not permitted to consolidate the earnings of the Chinese entity into its books. I have argued in the past that the contracts are void under Chinese law. The State Council takes a different and even more devastating approach. The State Council has said that it will accept that the contracts are legal and enforceable.

All those opinion letters you have received say that. However, since the Chinese entity is effectively controlled by a foreign investor, it is obvious that the Chinese entity is in fact a foreign controlled entity. Therefore, that foreign controlled entity is prohibited from operating in a prohibited or restricted sector.

The effect of the Draft is to kill the VIE structure as an investment vehicle in China for the future. It is important to fully understand the impact. Even if the Draft is never adopted, for the future at least, the VIE structure is dead. The VIE structure is dead because it is now clear that the State Council understands how the VIE structure works as a contractual device and it is clear that the State Council understands that the only reason VIEs exist is to evade the clear requirements of Chinese law. Most importantly, it is also clear that the State Council has firmly concluded this behavior is wrong and it will not be tolerated in the future. So it does not matter whether or not the Draft is adopted in its current form. Whatever happens, the VIE structure is dead.

Now we come to the more interesting and difficult question. A large number of very large companies operate in China’s Internet and telecom sector as VIEs. Baidu, Sina and Alibaba are only a few of the hundreds of VIEs currently operating in China. These VIEs control the China’s Internet, e-commerce and cloud computing sectors. They are the only significantly large privately owned companies in China.

Yet, the remarkable fact is that these highly capitalized, powerful companies are all operating illegally (as we have pointed out many times on this blog). However, all of this illegal activity has been conducted openly and with the tacit acquiescence of the PRC regulatory authorities. As a result, the big issue for now is what is to be done about the existing VIE entities in China that will be rendered illegal if the Draft is adopted in its current form.

The VIEs have seen this coming, and beginning in 2013 Robin Lee of Baidu led the charge in seeking to have then existing VIEs be formally declared legal under Chinese law. Mr. Lee argued that the State Council should declare VIEs legal under Chinese law so long as Chinese citizens control the management of the foreign owned entity. Mr. Lee did not propose that the limitations on foreign participation in the Internet sector be removed. His plea was simply that his particular device be declared legal. After Mr. Lee made his plea, other owners of large Internet and telecom VIEs joined in to propose various “get out of jail free” techniques to leave them in control of an otherwise closed sector.

From a legal standpoint, the proposals of Robin Lee and others put the Chinese government in a very difficult position. If the government accepts the proposals by making a blanket ruling that VIEs are legal, then open violation of Chinese law is tolerated. On the other had, to declare already existing VIEs to be illegal would involve acting against large and successful Chinese companies in critical sectors such as the Internet, e-commerce and telecommunications. However, the issue must nevertheless be confronted. Here is what we know so far on how the regulators intend to proceed:

1. Article 158 of the Draft states that the issue of what to do about existing VIEs will be resolved in accordance with the Explanation.

2. Article 3.2 provides the following “solution”:

  • A principle of “actual control” will be adopted. A Chinese entity under the actual control of foreign investors will be treated as foreign. A foreign entity under the actual control of Chinese investors will be treated as Chinese. How this analysis will be performed is not explained.
  • For existing VIEs, the government will NOT provide a blanket statement that existing VIEs are in compliance with Chinese law. In this sense, the request from Robin Lee and others has been denied.
  • The rule will be as follows. The decision on whether or not to allow effectively foreign controlled Chinese entities to continue to operate will be made on a case by case basis by the PRC government agency with control over the area of concern. The rule is:
    • If a specific permit is needed to operate in a sector, that permit must be obtained.
    • With respect to VIEs, the effectively controlled Chinese entity must go to the regulator in their field and request a special exemption on the grounds that the VIE WFOE and its parent are actually effectively controlled by Chinese investors. If they can make this showing, then they will be allowed to continue to operate.
    • Article 3.2 provides that if the regulator issues a license in this situation, the State Council will not intervene. If a license is granted by the regulator, then registration will be processed (or maintained) in accordance with the grant of such license.

This means that that the State Council has punted on the very difficult issue of what to do about existing VIE entities. We can imagine the State Council saying: You guys created the problem by turning a blind eye to this illegal activity. Now you need to figure out what to do. However, by directly citing the “effective control” standard, the State Council has provided the various regulators with an escape from their difficult situation.

The stock response to this situation is that the PRC regulators will “knuckle under” and provide the required licenses to the existing VIE operators. Virtually everyone says: There is no way that the PRC regulators will shut down Baidu, Sina, Alibaba and the other major PRC VIE entities. I believe that this assessment is correct.

There are, however, a number of problems for the regulators if they knuckle under and grant a get out of jail free pass to the existing VIE entities, including the following:

1. It is now been formally acknowledged that the VIE structure is a violation of Chinese law. If the existing VIE entities are permitted to continue to operate, then the PRC regulators will be rewarding open violators of the law. This then weakens or destroys the legitimacy of those regulators. If you do not understand the threat this poses to the PRC regime, please go back and read Max Weber on the issue.

2. Competition within China is the much more important issue. Let’s assume that Baidu and others obtain/maintain their license to operate with foreign funds in a restricted sector in absolute violation of Chinese law. Now consider the situation of other Chinese “entrepreneurs” that want to do exactly the same thing. Now that the escape hatch has been opened for the existing VIEs, a similar work around should be provided for other Chinese entrepreneurs. If this escape mechanism is not provided, then Baidu (Robin Lee) and the other existing VIES will have been granted even more benefits than they even requested.

3.  The solution being proposed is something like the following. The PRC government will use the effective control analysis. If a foreign company is effectively controlled by Chinese investors, then for PRC regulatory purposes, that company will be treated as a Chinese company. This Chinese controlled company will then be permitted by the Chinese authorities to raise funds in the overseas capital markets. Under this approach, a VIE will not be necessary, since the foreign parent will be treated as Chinese for PRC restricted/prohibited industry analysis. There will therefore be no need to rely on the complex and questionably enforceable set of contracts that are central to the VIE structure.

While solving one problem, this approach raises the following other issues:

1. Companies raising funds on foreign markets are doing so as public companies. It is the core of the public company concept that the company is operated on behalf of the shareholders and that the shareholders exercise effective control over the management of the company. Taking away shareholder control in favor of management by Chinese nationals would therefore violate basic principles of public company law and policy. This is the reason that the Hong Kong stock exchange recently refused to host the Baidu IPO. Though it may be legally possible to impose this kind of restriction on nationality of manage on a public company listed in the United States, the restrictions would need to be fully disclosed. If properly disclosed, it is not clear whether such stock offerings would be attractive to investors.

2. Following this approach puts the Chinese government in the business of assessing the affects of complex corporate control structures implemented under the laws of foreign countries. It is not clear that the PRC government has the expertise to make an appropriate analysis of complex corporate structures that would challenge the analytic skills of even the most seasoned corporate lawyers.

3. The fundamental principle behind all of this is that the Chinese want to be able to raise money in foreign markets to fund business sectors closed to participation by foreign businesses. It is not clear whether foreign governments who regulate the capital and trade markets will find this approach to be acceptable.

The situation for now is very messy. We can conclude the following for now:

1. VIEs are illegal. We disagree with those who are saying that what is proposed is a two tier, foreign/Chinese system.
2. For the future, if a foreign entity is in fact effectively controlled by Chinese investors, such entities will be treated as Chinese entities for the purpose of application of the negative list restricted/prohibited rules. How this effective control standard will be imposed is not clear. In any event, there will be no need to form a VIE. As illogical as it seems, the WFOE and its parent will be treated as Chinese controlled for PRC regulatory purposes. Thus, as noted, the VIE is well dead.
3. For existing VIEs, they will be given a chance to convert to a model where their WFOE directly holds the required license. That is:
a. The VIE will terminate.
b. The WFOE will have the opportunity to apply for the applicable license directly from the applicable regulator. If granted, that is the end of process. If not granted, then business of the VIE must terminate. Most people don’t think that will happen, but that is just a guess.
In this way, the awkward and unenforceable contractual method (VIE) of control will be eliminated. If possible legally, the WFOE will hold the license directly. This will eliminate the uncertainty over legality and the uncertainty over who owns what. This is good. However, this system then means foreign capital markets and investors will be required to accept the listing of public stock by a company that is in fact controlled not by shareholders but rather by Chinese promoters. In a way, these entities will be a type of “reverse” VIE. It may solve the problem for the Chinese side, it is not clear if it solves the problem for foreign investors in the negative list side of the Chinese market.
What do you think?

And as proof that “we told you so” on VIEs, check out the following:

How To Get A China Business Visa

Posted in China Business, Recommended Reading

Our China lawyers are often asked China visa questions and unless they are particularly complicated or legalistic, we typically refer these questions out to China visa specialists. It is always surprising to us how little good information there is out there in English on what it takes to get a China visa of any kind.

So I was quite pleased when a loyal reader referred me to this post on the Sapore di Cina blog, entitled, Business visas for China – The complete guide. This post ought to prove helpful to anyone seeking a China business visa and we recommend it to anyone seeking such a visa.

How To Draft A Contract For China

Posted in Legal News, Recommended Reading

Contract drafting guru Ken Adams interviewed our own Steve Dickinson for a post he did regarding drafting contracts for China. The interview was in the form of a Q&A and I urge you to go herefor the whole thing.

Ancient Purchase and Sale Contract

Steve made the following points, among others, during the interview:

Language of the contract. Chinese law provides that the parties are free to choose the language of their contract. If the contract is in two languages, the parties are free to choose which language will control. If the contract is in Chinese and in English and the parties do not specifically choose a governing language, a Chinese court or arbitration panel will take the Chinese version as controlling. If the contract is in English, then the court or arbitration panel will appoint a translator to do the translation. These translators are often not very good, which causes many problems in litigation/arbitration, since the case gets sidetracked in disputes about translation.

Contracts involving a foreign party in China are almost always done in a dual-language format, with English almost always the other language. For example, every contract between Russian and Chinese parties I have ever seen is dual-language, Chinese and English.

The tradition in such contracts is to provide for the English-language version to control, for the law to be that of the foreign party country, and for litigation to be in some location outside China. These provisions seldom make sense but they are common in contracts between private parties and when the Chinese party is a State Owned Enterprise not controlled from Beijing. However, Beijing controlled SOEs normally will require the reverse: The Chinese language and law controls and disputes will be resolved in China, either in the courts or through the China International Economic and Trade Arbitration Commission (CIETAC).

American and British “lawyer” Language.  Chinese lawyers and businesspeople usually reject traditional U.S. contract language outright. The Chinese use simple contract language. Often, U.S. companies insist on using U.S.-style common-law contracts. The Chinese side never reads the English; they have the document translated into Chinese and they work with the Chinese. When litigation occurs in China, the Chinese court will often say, “This contract is just a translation of a standard U.S. contract. Obviously, the Chinese side did not understand any of it. Therefore, we are going to ignore the key provisions on which you are relying and we are not going to enforce them.” Many banks and investment funds have learned this to their detriment. For example, many foreign-drafted futures contracts have been thrown out in China because the courts concluded that the Chinese party simply did not understand the contract. The result is that the Chinese companies got a free ride, which is not a trivial issue.

It is a much deeper issue than language. Chinese courts, Chinese lawyers, and Chinese business people are not going to agree to legal provisions that have no meaning under Chinese law. If you expect to litigate in China, your document must be in accord with Chinese law. If you expect to be able to enforce your contract in China, you must have a contract that is in accord with Chinese law. Much bad U.S. contract writing involves using ten words to express one concept and drafting provisions so as to address every single possible contingency. For China, only the concept is important. Another motivation for bad U.S. contract writing is to try to draft around case law or statute. China does not care about cases or U.S. statutes. Chinese courts and arbitrators do not allow drafting around the provisions of black letter Chinese law and they do not allow for results that they think are either unfair or in bad faith. Thus, the real issue is not so much bad U.S. drafting methods. The real issue is how the Chinese court views the motivation behind the contract.

I should also add that Chinese lawyers have major problems interpreting U.S. and British common law contracts. Their standard approach is to guess at the meaning and then mistranslate and then work with the mistranslation, leading to disaster on all counts.

Again, go here for the full interview. And for more on China contracts, check out the following:

China Employee Layoff Laws

Posted in Basics of China Business Law, Legal News

China’s Labor Contract Law defines what constitutes a “mass layoff” (“经济性裁员”) as one of the following:

  1. An employer reduces its workforce by twenty or more employees, or
  2. A workforce reduction that exceeds 10% of the entire workforce.

Under the Labor Contract Law, an employer may initiate mass layoffs only under one of the following four circumstances:

  1. The employer undergoes a reorganization in accordance with the PRC Enterprise Bankruptcy Law.
  2. The employer experiences significant difficulties in its business operation.
  3. The employer switches production, adjusts its business model, and after modifying its labor contracts, still needs to lay off employees,
  4. The employer has experienced other significant changes that modified the economic circumstances which formed the basis for its having signed the labor contracts, and it is unable to perform under the contracts.

For purposes of Chinese labor law, a mass layoff is treated as termination without cause. This means that the employer must comply with the applicable provisions for such a termination, including the prohibitions against terminating certain employees including those who are pregnant or nursing.

At least thirty days before initiating a mass layoff, the employer must present its layoff plan to the labor union or to all of its employees. The employer must then consider any comments it might receive and revise and improve the plan accordingly, and file a report with the relevant authorities.

During a mass layoff, the employer must consider keeping an employee who:

  1. Has a relatively long-term fixed-term labor contract;
  2. Has an open-term labor contract; or
  3. Is the only one working in the household and needs to support elderly or minor dependent(s).

If the employer wishes to bring new employees on board within six months after it has issued a mass layoff, it must notify and give preference to its former employees in hiring.

In December 2014, China’s Ministry of Human Resources and Social Security issued Draft Regulations on Corporate Mass Layoffs. Among other things, these Regulations will, if enacted, make government subsidies available to employers that take effective measures to prevent or minimize the scale of its layoffs. The goal is to help employers pay for employees’ living allowances, social insurance, new position training, skill enhancement training and other expenses. The relevant labor bureaus will provide guidance and support services to qualified employers.

These Draft Regulations are expected to help clarify matters that the current rules have left open to interpretation. If and when new rules are implemented, we will write about them.