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Terminating China Employees: The Basics

Posted in Basics of China Business Law, Legal News

Under China’s labor laws, terminating a China employee who has completed his or her probation period is virtually never easy. Termination usually requires good cause and a severance payment. Most importantly a China employer must be able to show that any unilateral termination was based on statutory grounds. In this post, I lay out some basic rules on terminating the labor contract with your China employees. Note that “China employees” essentially means any employee who works for your China-based company, whether that employee is actually a Chinese citizen or not.  China Employment Law

The PRC Labor Contract Law permits employers to unilaterally terminate labor contracts without having to provide notice or economic compensation under one of the following circumstances:

  • The employee does not satisfy the conditions for employment during the probation period.
  • The employee materially breaches the employer’s rules and regulations.
  • The employee commits a serious dereliction of duty or practices graft, causing substantial damage to the employer.
  • The employee has established an employment relationship with another employer that materially impact the completion of his or her tasks with his or her existing employer, or he or she refuses to terminate such employment relationship with the other employer, after required to do so by the existing employer.
  • The employee uses deception or coercion, or takes advantage of the employer’s difficulties, to cause the employer to conclude the labor contract, or to make an amendment thereto, that is contrary to the employer’s true intent
  • The employee has criminal liability imposed against him or her.

Under one of the following circumstances, the employer may terminate the employee, but it must either give thirty days written notice or pay additional economic compensation equal to one month of the employee’s salary:

  • The employee falls ill or is injured for a non-work-related reason, and is unable to handle his or her original position upon expiration of the medical treatment period as prescribed, nor can he or she assume any other position as arranged by the employer.
  • The employee is incapable of doing his or her job and would remain so even with training or with adjustments to his or her position.
  • A major change in the objective circumstances relied upon at the time of the signing of the labor contract hinders continued fulfillment of the original contract and, after consultations, the employer and employee are unable to reach agreement on amending the labor contract.

In addition, under the Labor Contract Law, an employer may terminate employees by initiating mass layoffs, provided conditions are met under the relevant laws and regulations.

If a China employee is wrongfully terminated (i.e., the employee is not terminated according to one of the statutory grounds), the employee may demand reinstatement of his or her position and the employer is required by law to give the employee his or her old job back. If the employee does not wish to continue working for the employer or if performance under the labor contract is not possible, then the employer must pay damages equal to double the economic compensation in the case of lawful termination. Note this is all very different from the U.S. employment law system.

Bottom line: Though your China employees can terminate the labor contract relatively easily (by providing thirty days written notice or three days notice during the probation period), you as the employer generally cannot terminate an employee without cause and a severance payment.

Foreign SaaS in China: Get off of my cloud

Posted in Basics of China Business Law, China Business, Legal News
China Cloud Computing Laws

China Cloud Computing Laws

Internet software business is rapidly moving to the cloud. So far, however, the Chinese government seems to be taking the lead from the Rolling Stones: the message is “Hey! You! Get off of my cloud.” The PRC wants to run its own private cloud, and no foreigners need apply.

The primary issue for Internet business in China is that all commercial Internet businesses require the website owner acquire a commercial ICP (Internet Content Provider) license. This means that in addition to traditional e-commerce websites, cloud computing, software as a service (SaaS) and software as a platform (SaaP) sites all require a commercial ICP license.

This ICP licensing requirement makes it very difficult for foreign software developers to get into the PRC cloud computing market. Foreign entities fully controlled by Chinese individuals have found a way around this restriction by using VIE structures. But for foreign controlled software developers, the door has been and remains closed.

One solution to this barrier is too license the software to a Chinese company formed specifically to obtain the ICP license required to host the cloud based software. What we have found, however, is that it is very difficult for small to medium software developers to find an entity in China willing to act as such a host. The primary reason is that obtaining an ICP license is costly and time consuming. Often, we find that Chinese companies will casually agree to act as a host. However, when they learn what is actually involved, these entities often back out of the deal.

If you are a such a SME software developer, it is therefore important to be sure that your potential licensee for China fully understands what it is agreeing to do before you waste time on negotiations that will go nowhere. In this post I will explain the basic issues. If you have these issues firmly in mind as you work on developing your China program, you will save much wasted time. Given that time is critical in this business, this is a critical issue.

I. Legal background.

Every entity in China that operates a commercial website within China is required to obtain a commercial ICP license 互联网信息服务增值电信业务许可证. The rules for obtaining a China ICP license are based on two regulations: 1) Information Technology Regulations电信条例 (Technology Regulations) 2) Method for Management of Internet Network Information Services 互联网信息服务管理办法 (Internet Regulations).

A commercial website is a website that charges Chinese citizens for access to the site or for information obtained from the site. Internet Regulations, Article 3. Failure to obtain the required ICP license is a violation of law. The penalty for operating a commercial site without a license is 1) cancellation of the entity’s business license, 2) confiscation of illegal income, 3) a fine of three to five times the amount of illegal income earned from the site, 4) termination of website access, and 5) criminal penalties for responsible individuals. Internet Regulations, Article 7; Technology Regulations, Articles 70, 71.

Until recently, many Internet regulators in China assumed that the only form of commercial website was the standard e-commerce site for sale of product. They tended to ignore e-commerce sites for sale of services and they simply had never heard of SaaS or SaaP type websites. To encourage businesses to locate in their district, some of the local regulators suggested that these types of sites were not subject to the commercial ICP license requirement. This is no longer true. The word has come down from Beijing and now every regulator is quite clear on the rule. If a site earns money on the web, an ICP license is required. There are no exceptions.

II. ICP license rules.

The rules for obtaining a commercial ICP license are set out in the Technology Regulations and the Internet Regulations. These rules are quite general. For this reason, each regulatory district in China is required to determine the specific requirements. As is common in China, each regulatory district has a different interpretation of the requirements and the required documentation for application. This post is based on the rules as interpreted by the Beijing Communications Administration (“BCA”). The BCA is the agency that issues all ICP licenses for businesses operating in the city of Beijing.

Pursuant to the BCA rules, the requirements for obtaining an ICP license are as follows:

1. The applicant must be a 100% Chinese owned and managed PRC entity. No foreign capital is permitted. No foreign officers or directors are permitted. This is more strict than the Technology and Internet regulations which in principle allow for sino-foreign joint ventures.

2. The applicant entity must have a minimum registered capital of RMB 1,000,000. Registered capital must be fully funded at the time of application. Funding must be proved by a standard confirmation of capital contribution issued by a PRC certified public accountant. This registered capital requirement is enough to eliminate casual players from the application pool.

3. The applicant must submit a copy of its lease. The lease must be for office space suitable for the type of business and for the number of employees and equipment. A “virtual office” is not permitted.

4. The applicant must employ at least eight full time employees. Proof of employment in the form of proof of payment of at least one month of employee taxes and social benefits must be submitted with the application. Unlike many other jurisdictions, Beijing does not require proof of any special technical expertise on the part of the employees.

5. Only one license is permitted for a specific Internet business. That is, it is not permitted for an ICP license holder to act as the licensee/host for more than one foreign Internet business. This means that the license holding entity must be dedicated to a single foreign software provider. This restriction makes it difficult for SME software developers to find a suitable PRC host. If the potential income is not substantial, it simply is not worth it for the Chinese entity to go the expense and effort required to obtain an ICP license.

The regulations provide that a decision on the license application shall be made within 60 days. BCA staff cautioned us that they are overwhelmed with work and that the process has lately taken from 60 to 80 working days.

Note that the application requirements must be met at the time you submit your application. That is, the applicant company must be formed, the lease must be signed and registered, capital must be deposited and the employees be hired and paid before submitting the application. This involves a certain amount of risk: the company is formed and the basic expenses are incurred before issuance of the ICP license.

Note that there are other licensing issues that may apply for any cloud computing project. Article 5 of the Internet Regulations provides that where the web content involves news, publishing, education, medicine or medical devices, separate licensing from the applicable regulator is also required. Proof of such licensing must be provided in the application for the ICP license. Most of the projects that I see fall into one of these categories.

The general practice in China is that the foreign company will find “China internet consultants” and local Chinese companies who claim that none of the above applies. And when we tell our clients that what these people are proposing cannot work, these people will insist that we do not “understand China” and that there are numerous ways to evade the rules. In my experience, this is never true. Searching for a way around the rules just results in wasted time and money and exposes the foreign party to excessive risk. When the door is shut, sometimes there is just no way to pry it open. That is what you discover when you actually “understand China”.

China Joint Ventures: How To Give Away Your IP In China, Part 2

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

 

China Joint Ventures

How to protect your IP when doing a China joint venture

Last month I wrote a post entitled, How To Give Away Your IP In China, explaining how foreign companies so often “gift” their intellectual property to their Chinese manufacturers by not initially making clear in a Chinese language contract who will own the intellectual property that will be developed jointly by the Chinese manufacturer and the Western company.

Since foreign companies seem so eager foreign to give away their intellectual property to their Chinese competitors, I thought I would continue my series on this topic by describing my personal favorite method for making such a gift. This technique makes use of the classic sino-foreign joint venture company. I call it the joint venture scam. This technique started in China way back in the early 80s and after over thirty years of hard work, Chinese state owned companies have now mastered the technique.

I can illustrate the early form of this system by describing a project on which I worked back in the late 80s. A U.S. company developed an advanced and expensive aquaculture technique that turned out to be ideally suited for species and conditions along China’s coast. The original plan was to sell six of these systems to a state owned fish grower in Shandong province.

The Chinese company agreed to purchase the systems at a bargain price. After all the terms were agreed upon, I drafted the contracts and joined the U.S. company in Shandong to finalize and execute the contract. The day before the signing ceremony, the local government officials in charge of the project called us all in and stated that the price for the six as yet untested systems was just too high. They then explained how they had instructed the Chinese company not to execute the contracts.

The local government officials then proposed the following as an alternative:

  • The U.S. side would contribute one aquaculture system as its capital contribution. The Chinese side would contribute the space for the system in the local bay, together with all other infrastructure required for six systems.
  • The JV entity would commit to purchase five additional systems after the first system was up and running.

I told my client this was a bad deal and did everything I could to try to convince it to stick with the straight sale deal. Against my strong advice to the contrary, the client chose to move forward with the JV, on their own and without my help.

The U.S. company later told me how the deal went down. The U.S. company delivered and installed the first system. The Chinese side claimed that the system was no good. The JV then refused to purchase the five additional systems. The JV then went bankrupt and disappeared. Undaunted, the U.S. company then explored selling its aquaculture systems to an unrelated Chinese company in southern Zhejiang. However, when the U.S. company went on its first visit to the Zhejiang company, it found ten copies of its original system up and running. The only thing the Zhejiang company wanted from the U.S. company was consulting advice on how to fine tune its ten systems. The U.S. company was permanently closed out of the China market and had to feel the sting of seeing clones of its systems being used up and down the China coast.

This is the classic technique for using a Chinese joint venture to “assimilate” foreign intellectual property. The technique though has been refined somewhat since the 80s. The current standard technique works as follows:

  • Foreign company offers to sell complex and expensive technology on a standard technology licensing basis.
  • After much discussion, the Chinese side indicates that the price is too high for untested technology. The Chinese side then offers to establish a joint venture company where the foreign side will own some percentage of the to be formed China Joint Venture.
  • The foreign side contributes one unit of its technical system in exchange for its ownership interest. The Chinese side contributes the rest. The contribution means that the JV now owns the technology for China. The JV agrees to the purchase a number of units at full price after the first unit is up and running properly.
  • The foreign company then delivers and fully trains the Chinese side in how to operate the foreign company’s technology.
  • The JV never purchases any additional units, claiming that the foreign company’s technology does not work properly. The foreign company eventually discovers that its technology has been cloned and is being actively utilized by an unrelated (usually state owned) company in China. Since the JV owns the technology, this unauthorized use is an infringement of the JV’s intellectual property. The JV must therefor sue to defend its rights. But, the JV is controlled by the Chinese side and the JV management refuses to take any legal action.
  • The JV then disappears. Normally, the Chinese side simply buys out the foreign side at a substantial discount.

This system in various forms is still being actively used in China. A variant of this system was used to extract the high speed rail technology from foreign companies and to extract jet fighter technology from the Russians. Since foreign companies continue to participate in these ventures, and since the intention of the Chinese side is so transparent, I am forced to conclude either that the foreign companies fully intend to offer their IP to the Chinese side as a gift: a gift  Chinese companies are happy to accept.

The DOJ In China: Second-Guessing Corporate Cooperation*

Posted in Legal News

For years, China has featured prominently in the US Department of Justice’s investigations under the Foreign Corrupt Practices Act, or FCPA. That’s not news to the readers of this blog, who can refresh their memories here, here and definitely here. But as a colleague recently reminded me, there is a big difference between settling an FCPA case, and actually having to investigate it—especially in China. This is a distinction that too few lawyers appreciate, but they should.

Sometimes it makes sense not to cooperate with a DOJ FCPA investigation involving China

Should you cooperate with a DOJ FCPA investigation involving your China operations?

To make sense of this distinction, one has to understand a little bit about how the DOJ typically approaches FCPA investigations. After receiving a tip or other indication of wrongdoing, DOJ lawyers will typically ask a company to investigate itself and turn over the evidence. If there is enough evidence of guilt, the DOJ will initiate settlement discussions, which can result in eight-figure penalties or more.

The DOJ can be a tough negotiator. To encourage settlement, they hold out the possibility—usually implicitly—that they may bring formal charges against a company that refuses to “cooperate.” Meanwhile, the DOJ shrouds its own investigative efforts in secrecy, leaving the company to wonder whether personal emails have been searched or if the FBI has an informant on the inside. In short, the DOJ negotiates by emphasizing downside risk, while maximizing the ambiguity around that risk. It’s a smart strategy and, judging by its increasingly large FCPA settlements, an effective one, too.

But how strong is this negotiating position, really? If a company does not volunteer overseas evidence to the DOJ, then what can the DOJ actually do? The DOJ claims they can do quite a lot. Deputy Assistant Attorney General Mashall Miller says the DOJ benefits from “deepening relationships with foreign governments.” And, “when corporations engaged in wrongdoing choose not to cooperate — which, of course, they have every right to do — the criminal division will make the cases on our own.”

When I was a federal prosecutor, I spent a lot of time worrying about what evidence I could, and could not, pull out of China. As I am sure Miller would acknowledge, the DOJ is actually quite limited in obtaining evidence from within countries that are not traditionally geopolitical allies, like China. So, for example, though the US has bilateral treaties governing evidence-sharing with many European and Central and South American countries, it has no such treaties with China. The DOJ can and does (and when I was a prosecutor, I did) make requests to China for information, but such inquiries are dealt with on a notoriously slow track, subject to China’s diplomatic judgment.

The US maintains an informal treaty-like process with Hong Kong, but Beijing supervises Hong Kong’s response and is known to intercede at the faintest whiff of national interest. Meanwhile, the very techniques that have made the DOJ’s recent crackdown on white-collar crime so successful—wiretaps, body wires, physical surveillance—are unavailable to US enforcement authorities on China’s soil.

Last Fall, Miller cited the conviction of a French citizen who was recorded on a body wire directing a would-be conspirator, who in fact was a cooperating witness, to “destroy everything, everything, everything.” That’s good evidence, if you can get it. And in China, you probably cannot. China generally does not allow the FBI to interview witnesses or search Chinese servers, offices and homes — let alone induce cooperating informants to wear a wire. In short, when it comes to China, the DOJ cannot do much without a company’s cooperation.

Why does this matter? Certainly, this does not mean that US companies should now rebuff the DOJ wholesale in all requests for cooperation in China. Not at all: Most companies still recognize there can be substantial benefits to cooperating with the authorities, both in the present, and in anticipation of what might be coming round the bend. Yet a clear understanding of the DOJ’s investigative limits can—and should—affect the negotiations over the nature and terms of any settlement. After all, where the DOJ’s investigative capacity is limited, should that not reduce its negotiating advantage?

In other words, when the DOJ demands an FCPA settlement, or else “the criminal division will make the cases on [its] own,” there may just be cases where it is better to call their bluff.

* This is a guest post from Tim Perry, counsel in WilmerHale’s Los Angeles office and a member of the firm’s Securities and Litigation/Controversy departments. Tim’s practice focuses on white collar matters, internal corporate investigations of all types, and the defense of government enforcement actions related to securities.

What Your Chinese Operations Needs To Know About Iran Sanctions

Posted in China Business, Legal News

Recent news about a framework agreement between Iran, the United States, China, France, Germany, Great Britain, and Russia raises important geopolitical issues – and also important business considerations. The agreement basically rests on two important representations. Iran would allow monitoring of its nuclear programs and the United States and Europe would agree to eliminate restrictive sanctions on commercial dealings with Iran. Such an agreement would dramatically change the way companies conduct business globally.  China Operations

For companies with even the slightest interest in expanding sales to Iran, even the current framework discussions and possible elimination of U.S. and E.U. sanctions is likely spurring careful analysis about how such Iranian sales would be structured. This caution is due to the restrictive nature and severe penalties of current U.S. sanctions on dealings with Iran.

For U.S. companies with Chinese operations, U.S. law generally prohibits the U.S. companies and their Chinese subsidiaries from engaging in commercial and financial transactions with Iran and its citizens. A U.S. company’s Chinese wholly foreign-owned entity (“WFOE”), and a Chinese Joint Venture subsidiary in which the U.S. company owns at least half of the controlling interests, cannot sell or export products manufactured in China to Iran. Doing so violates U.S. sanctions laws on transactions with Iran.

U.S. companies and and their Chinese subsidiaries also generally cannot sell or ship products to a distributor if they know or have reason to know the distributor will transship or sell the products to Iran. In other words, U.S. companies and their Chinese subsidiaries cannot structure “blind-eye” sales transactions to Iran through third parties and claim they were unaware of their products’ delivery destination.

The reason to know standard can be established through circumstantial evidence. For example, a Chinese subsidiary and its U.S. owner may have reason to know that a sale to a distributor is destined for Iran if the distributor’s customer base is exclusively or overwhelmingly Iranian companies. In such an example, the U.S. owner and its Chinese subsidiary would be well advised to undertake and document due diligence to confirm the ultimate destination of such sales in order to comply with U.S. sanctions on Iran.

Current negotiations on the framework agreement do not preclude U.S. enforcement of its Iranian sanctions. In fact, the contrary may be true as the United States most likely wants to demonstrate not only its resolve to effecting change through sanctions if an agreement is not concluded, but also how Iran can benefit if such sanctions are eliminated.

Last October, while the negotiations were underway, the U.S. Office of Foreign Assets Control (“OFAC”) entered into a settlement agreement with Indam International, Inc. located in Houston, Texas. Indam paid about $45,000 to settle potential civil liability stemming from alleged violations of U.S. Iranian sanctions based on shipments to the United Arab Emirates that Indam had “reason to know” were intended for transshipment to Iran. OFAC stated that the $45,000 settlement amount was based on the following aggravating factors:

  • Indam’s failure to conduct due diligence of its products’ end users.
  • Indam’s understanding that exports for use by Iran violated U.S. sanctions based on a previous incident.
  • Awareness by Indam’s management that the shipments were ultimately destined for Iran.
  • The benefit Indam’s shipment would have conferred on Iran’s petroleum industry, which would have harmed U.S. sanctions’ objectives.
  • Indam’s failure to implement appropriate corporate policies and procedures to avoid transactions that violate U.S. sanctions.

The Iran framework agreement is currently just that – a framework. It faces intense scrutiny in the signatories’ home countries and further detailed negotiations between the parties before it can be finalized. Consequently, companies contemplating possible commercial engagement with Iran must carefully understand their current obligations and risks under Iranian sanctions implemented by the U.S., E.U., and other countries. As the U.S. OFAC’s settlement agreement with Indam suggests, U.S. companies and their Chinese subsidiaries have a reason to know about trade sanctions and a reason to ensure compliance with such sanctions.

Doing Business In China: Lessons From The Music Industry

Posted in Basics of China Business Law

Loyal China Law Blog reader Declan Nolan, of Shanghai SIP Engineering Consulting, sent me a really excellent Smart Shanghai article the other day on Archie Hamilton. Hamilton is the Managing Director of Splitworks, a China-based concert promotion agency, and the interviewee in the article. Hamilton has been in the China music business for ten years and in his interview he shares countless pearls of wisdom applicable for anyone doing business in China or planning to do so.

How do I know the article is excellent and Hamilton’s words constitute pearls of wisdom? Because our China lawyers have either seen or dealt with pretty much everything he describes, and in most instances, many many times.  China's Music Industry

Hamilton starts the interview talking about the cancellation of Lenny Kravitz’s show:

It just bugs the shit out of me, because all these agents and managers, they’re always like, “Fuck we just got burned again!” and “It’s a shit market…” And you’re like, “You know there are good promoters in China, because you’ve worked with all of them, so why don’t you give the fucking shows to the good promoters?” And they’re like “ahhhh yeah but the money was so good…” And generally when something sounds too good to be true, it is.

Exactly. I cannot tell you how many times we have seen a company choose someone in China because “the money was so good” but in doing so set themselves up for problem after problem. We see it with the partners these companies choose and the unnecessary risks they take. Even closer to home, we see it with the law firms they choose, and all to save (or make) just a little bit more. An example from this week is telling. An American company contacted my firm about a year ago for help with what I knew would be a complicated and risky China joint venture. This company ended up choosing not to hire us because we were “considerably more” than the -no-name Chinese law firm that had been referred to him by his China handler. Now he was e-mailing because the government had turned down the Joint Venture for the exact reason I had told him it could not work. He was frustrated because he had wasted massive time (and even money) and was seeking our assistance on what to do. Amazingly enough, when I quoted him the initial retainer we would require to get started, he balked because a Chinese law firm that someone he knew had referred him to would be “considerably cheaper.” I did not even bother to tell him what his always seeking to save had already cost him, I merely told him that we would not be budging on our retainer amount or our fees and also stated that I did not see our two firms as a “good fit.” It would be un-lawyerly of me to use the same sort of language as Hamilton, but seriously?

Hamilton then notes how he is seeing fewer expats coming to China, which absolutely jibes with what our China-based lawyers are seeing. Hamilton also sees the second tier cities becoming “even more interesting” than Shanghai and Beijing, and due to rising costs, we are seeing the same thing for our clients.

Hamilton’s views on China’s anti-corruption crackdown jibes with ours as well in that he sees it as real and as having an impact. He also very rightly notes that “the rules are laid out very clearly, if you take the time to listen.” Here’s how he sees it:

Yeah there’s a big crackdown on red envelopes, but there’s also a lot more competition. A lot of people are going, “Well if I write about cool stuff, then people will read it, and we’ll get more ad revenue.” So we’re finding a lot more than the Chinese media we talk to are a bit more open to talking about stuff without being paid for it, and that’s a huge change.

For me, there’s always been a way to do it. All our shit’s above board. The rules are laid out very clearly, if you take the time to listen.

Reminds me of what I said in a 2011 post, China Law: Don’t Blame It On The Gray

For years I have been fighting against those who claim Chinese laws are gray. China’s business laws are generally as well written or as clear as any other country’s. My contention has always been that those who claim China’s laws are grey are usually just saying that to excuse their own failure to abide by them.

Hamilton does a great job explaining how and why China is increasingly enforcing its laws:

It demonstrates to me that there is a level of pragmatism within the authority, like “We understand this has to happen. We understand this is an important part of development. We’ve let it happen up to now in the grey, but actually it’s too big and it’s too out of control from a safety/crowd-control perspective, and we need to start regulating this stuff, because every other country in the world does.” It’s gonna force change, and make things a little bit more expensive, but regulation always does…

What are your thoughts?

 

China Closes 66 Golf Courses And Why That Really Matters

Posted in China Business, Legal News

Since becoming China’s President about two years ago, Xi Jinping has consistently stressed rule by law. Even if you do not know exactly what that means (and I am not sure that anyone does), it is damn clear that he means it. And when I say that he means it, I mean that he not only means it but he really believes it is of critical importance for China.

We can talk about why he believes this. Is it to maintain order? Is it out of fairness? Is it for philosophical or moral reasons? Is he just using it to crush his enemy? But that does not really matter. What matters, and I will say it again because this is important, is that he really means it.China Law Enforcement

I could write page after page giving you countless examples of why I know this to be true, and still not go beyond the last six months or so. But I won’t. I will instead provide four specific and telling examples from just the past month and start with one very general one.

The general one is that despite China’s slowing economy, the China lawyers at my firm have never been busier than in the last year and I mean by a wide margin. And I am convinced that much of that business stems from the realization by foreign companies doing business in China that they need to figure out which of China’s laws apply to them and follow them. It is that simple. And that is what many of them are telling us. One client just the other day told me that he has been in China for 20 years and he “has never seen anything like this,” referring to the scrutiny his business is getting from Chinese regulators and to what he knows to be happening to his domestic and foreign competitors in the same industry.

Now for the five specific examples, all of which happened in the last week:

1. News reports suggesting that Foxconn is having trouble securing investment benefits promised by the Zhengzhou government. The rumor is that Foxconn was lured to Zhengzhou with promises of over 5 billion RMB in tax benefits and related incentives. These incentives were granted in direct opposition to central government policy. Beijing found out and laid down the law and now the Zhengzhou government is backing down. In other words, Beijing is enforcing a long-standing but often violated law, and doing so against one of the two or three largest foreign investors. For more on this, check out Foreign Investment in China: Beware of Local Governments Bearing Gifts.

2. China this past week shut down 66 illegal golf courses. Everyone (even me, who proudly terminated his budding — okay so that’s a lie — golf career in a pique of frustration at least a decade ago) knew that China had tons of illegal golf courses and that nothing was being done about that. The “nothing being done” part is no longer true. Reuters described these closures “the first real sign of enforcement of a 2004 ban.”

3. Two reports from friends/consultants in China with whom our China lawyers have done substantial work. I am combining these two reports into one, both because they are so similar and so as to disguise any identities. These consultants reached out to my firm on behalf of two of their clients who were just shut down this week in big cities for half of their “employees” being off the grid. Both of these companies had less than 10 off-the-grid workers and here’s the kicker — one of these companies is a Chinese domestic company. In both instances, the consultant had no idea why the closings were happening now. Have you heard of similar?

4. Foreign company doing business in a small Chinese city as a WFOE is told by city officials that it needs to form a new WFOE because the scope of its existing one does not cover its operations. The funny thing is that this WFOE had been formed only a few years earlier with the help and at the direction of this same city. When asked what had changed, the city said that “Beijing is looking at this sort of thing.” We have been warning of this for years but this is the first time I have heard of a city issuing this sort of order so much out of the blue. Are you aware of this happening elsewhere in China? For more on the importance of “scope,” check out How To Form a China WFOE. Scope Really Really Matters, Part II.

5. Just this week, I personally have received three phone calls from American companies wanting our help in figuring out how to get their Chinese investors’ money out of China. One was a real estate development company in the Midwest that has been expecting $2 million dollars each from two different Chinese investors and that money has not been cleared by China. The other two were from residential realtors in the Northwest who are working with China-based buyers whose funds have been blocked from leaving China. In both of these instances, the realtors told me that they have heard that China allows its citizens to transfer only $50,000 a year outside the country, but in the past Chinese home buyers have circumvented that rule by paying ten or twenty or thirty or more of their relatives and friends to each transfer $50,000 to the same bank account in the United States. Seems that all of a sudden China is stopping that and these people are not able to buy their U.S. houses and these realtors are not able to make the sale and get their commision. I forgot about these three calls (until I got two just today) simply because my response is just to tell them that our China lawyers are not the right lawyers to assist both because it is their Chinese clients who need the lawyer and there is no reason for a Chinese citizen to hire a U.S. law firm for what is for the most part a China (not transnational or international) issue.

The common theme here is that if you are a foreign company doing business in China, you need to get legal. And fast. China as Wild West — at least for foreign companies —  is no more.

What are you seeing out there?

Beijing Wins World’s Most Livable City Honor: Fong’s Pizza Proves The Point

Posted in China Business, China Travel, Good People, Recommended Reading
Fong’s Cat. Des Moines, Iowa. Photo is from Fong’s Website at www.fongspizza.com

Fong’s Cat. Des Moines, Iowa. Photo is from Fong’s Website at www.fongspizza.com

According to yet another highly scientific and thoroughly researched study, Beijing was just named as the world’s most livable city. No big surprise there, what with its recently cleaned air, its friendly cab drivers, and its overall friendly and polite vibe. The fact that it has such pure drinking water and low rents no doubt aided in this choice. Paris came in second, which makes complete sense, particularly if you are Jewish and have no problem living in a city where large swaths are no-go zones. It also may be the only city in the world with cab drivers as pleasant as in Beijing, and its citizens match Beijing’s really one for one in both friendliness and politeness.

And rounding out the top three — again no surprise here — is Des Moines, Iowa. If you doubt this choice, I have two words for you Fong’s Pizza.

How do you rank the world’s cities on livability?

China vs. Vietnam For Product Sourcing

Posted in China Business, Recommended Reading

As my law firm’s Vietnam practice continues to grow, I have become fascinated with how company’s make the decision on where to outsource their product manufacturing as between China and Vietnam, both for new products and for products currently being made in China. One of the reasons I am so fascinated by this is because so many factors must go into the decision and unless IP is paramount for the company, the legal issues are not usually central.

So I was delighted to read the post, 3 Key Factors for Sourcing in Vietnam, particularly since it is written by InTouch Manufacturing Services, a company I know to have substantial China sourcing experience.

That post starts out talking about how the media has been writing often of late about manufacturing shifting from China to Vietnam. It then notes that Nike now gets 42 percent of its product from Vietnam, as compared to 30 percent from China, widening the gap even since 2010. The post then presents the following wage chart from the Japan External Trade Organization showing that China factory workers make, on average, three times as much as factory workers in Vietnam.

Factory Wages in China and Vietnam

The post calls this wage disparity “significant for any labor-intensive product like footwear, garments, and electronics.” It is, but as I am always saying, if wages were the only factor, every company would be looking to start sourcing in Afghanistan, South Sudan or Yemen, and of course they are not.

Most importantly though, this post analyzes from a sourcing perspective the following three key issues involved in choosing between China and Vietnam.

1. Product Type. The post notes that “Vietnam has proven to be quite capable of producing labor-intensive products like footwear and is now starting to win over major technology companies for significant investments in more technical manufacturing.” However, though “capabilities and confidence in Vietnamese manufacturing are growing … China still maintains a significant competitive advantage.”

The post rightly warns those looking to shift production from China to Vietnam to consider “the risks posed by a [Vietnamese] workforce that is relatively new and inexperienced” and suggests asking “what might you be taking for granted in China now that you may find yourself struggling to manage or live without in Vietnam?”

2. Your Existing Supply Chain. The post rightly points out that Vietnam’s infrastructure is not as good as China’s and this could be particularly problematic for smaller companies that cannot essentially fund their own infrastructure:

Vietnam’s fragmented manufacturing industry makes it harder to identify suitable suppliers, especially for those new to Vietnam. Lack of basic infrastructure is a main cause of this fragmentation. Contrast that with China where you can find just about anything you want – and usually more than a handful of viable options that aren’t too far away from where you need them. With well-paved roads, 7 of the world’s 10 busiest shipping ports, and a massive network of high-speed and commercial rail lines, infrastructure in China is extremely well established.

*     *     *     *

Both countries pose their own unique challenges to foreigners looking to establish operations there, but the path is clearer in China. Tons of businesses have already set up shop and blazed the trail for mega corporations and small-time entrepreneurs alike. Potential foreign buyers and business owners of all sizes will have a relatively easier time finding guidance about China than for Vietnam.

This is very true and one of the things we are finding we are having to do for our clients looking to go into Vietnam is to connect them with appropriate people in Vietnam, far more often than we do for our clients looking to go into China.

3: Foreign-owned Manufacturers. The post discusses how so many of the “manufacturers in Vietnam established for export are actually foreign owned,” with a large portion of those owned or operated by Chinese or Taiwanese. Very true, and for more on that, check out this post, What’s Your Vietnam Strategy? on my time in Vietnam during last year’s anti-Chinese riots.

Interestingly, the post notes how this foreign ownership means that the time and energy you have spent “learning the nuances of Chinese culture and manufacturing will not have gone to waste. This makes it easy to transfer existing QC checklists, specification sheets, or other documentation that might have been written in English and Chinese. You’ll generally find that these factories also employ Vietnamese staff proficient in both English and Chinese.”

The post also wisely notes that with so many Chinese manufacturers themselves having set up in Vietnam, you should discuss with them how you “may be able to work with your Chinese supplier to keep some of the production processes in China, while outsourcing others.”

It makes for a really good read and I recommend that you read it.

Foreign Investment in China: Beware of Local Governments Bearing Gifts

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

Recent news reports suggest that Foxconn is having trouble securing investment benefits promised them by the Zhengzhou government. The rumor is that Foxconn was lured to Zhengzhou with promises of over 5 billion RMB in tax benefits and related incentives. These incentives were granted in direct opposition to central government policy. Beijing found out and laid down the law and now the Zhengzhou government is backing down. Construction of a major factory is being delayed as the issues are being sorted out. Of course, Terry Gou, Chairman of Foxconn claims that this report is untrue, confirming that nothing is what it seems in China.

Beware of local government gifts

Beware of local government gifts

Whether true or not, the basic story is a standard in China, describing a practice that has been going on since the beginning of China’s opening up to foreign businesses in 1979. From the very start of opening up, the regions and the center have struggled over the issue of investment incentives. Local governments have always offered incentives to encourage foreign investment and jobs in their own backyard. The primary incentives typically consist of tax breaks and a reduction in land prices. The central government has consistently opposed these incentives. The center is the “owner” of both the taxes and the land. In Beijing’s view, local governments have no right to give away what rightly belongs to the center.

For this reason, the center has always issued clear rules, stating how much by way of tax reductions and land pricing incentives is permitted to be provided by local governments to encourage investments. The rules provide for a level playing field: no local government can legally offer any more than any other local government. Under this system, there is general encouragement to invest in China, but the decision on where within China to invest is based on the overall investment environment of a local region, rather than on the benefits provided. This also allows the center to on its own favor particular regions that it deems need extra help in securing foreign investment.

But what do local governments do when they are located in a region that is simply not terribly attractive to foreign investment? The standard response is to make yourself more attractive by improving local infrastructure, education levels and institutions. This sounds good, but it takes time and for many local governments this approach is simply impossible. For example, Zhengzhou is located in central China, with all the weaknesses that this location implies.

So what we have seen since the 1980s is that disadvantaged regions often seek to compete for foreign investment by offering incentives substantially in excess of that permitted by the central government. To be blunt, they have offered illegal incentives. Where this works, these illegal incentives can make a bad investment at least more attractive. However, the risk is considerable, as the report on Foxconn in Zhengzhou makes clear.

In my own experiences in China, I have seen the following investment incentive disasters:

— One client went to rural Sichuan in the 80s and worked for almost three years on a complex joint venture aimed at the trucking industry. When it finally came time for this client to sign the final investment documents, they were not met by the local party secretary who had been the leader in the project. Instead, they were greeted by a new party secretary and when our client asked about the set of documents they were there to sign the new party secretary told them that there were no documents. “The former secretary has been removed in disgrace. I have been assigned to replace him. His crime was to offer illegal incentives to foreign investors. I am here to clean up. Your project is one of the projects I am targeting. We are pleased to do the investment, but only on the basis of what is permitted by the central government. If that will not work for you, you will have to just go home.”The U.S. company went home, with three years wasted.

— In a different project in Sichuan at about the same time, a U.S. company made the investment. Under the central government rules, the project did not “pencil.” However, with the generous incentives offered by the local government, there was some chance of success. In year two of the investment, when it was too late to back out, a new party secretary arrived. The new secretary revoked the tax incentives and dictated that the joint venture would now be required to pay for the land and buildings at their current market value, not at the reduced price (essentially free) previously negotiated with his predecessor. These changes crushed the venture financially and it fairly soon had to shut down.

— On an aquaculture project in Shandong, the local government offered the standard illegal incentive of low to no taxes and free land and buildings. I advised this company not to go forward with the project since these incentives were clearly illegal. The client said: Steve, you just don’t understand China. In China, the law is not relevant. All that matters is who you know. We have the support of the local party secretary, Mr. X, and he has approved all of these benefits. There is no problem.” The company then headed off to a small coastal town in Shandong for the signing ceremony. On the day before the ceremony, representatives from our client company were eating breakfast in the party-owned and operated hotel, watching the national news playing on the TV. They looked up and saw Mr. X being led from his office in the custody of two policemen. He was arrested and imprisoned for corruption. That doomed the project.

— On a manufacturing investment project near Shanghai, I again advised the client not to go forward because the incentives offered were clearly illegal. The client fired me as his lawyer, giving me pretty much the same “You do not understand China” speech. The former client made the investment at significant cost. As the project proceeded, the company made a small profit, entirely due to the benefits provided by the incentives. However, after the Hu Jintao government took control of the center, the entire upper layer of officials in this region were replaced for having engaged in — your guessed it — corruption. All the special benefits were quickly revoked and this company rapidly spiraled down into bankruptcy.

What should a potential investor take from all this? The alleged situation faced by Foxconn in Zhengzhou is not an exception. This sort of thing is standard practice in China. But that does not make it legal or safe or wise. You are getting incentives, you should should evaluate your China investment in accordance with the central government’s investment rules. These rules (at least in Chinese) are easy to find and are quite clear. If your project makes financial sense under these rules, move forward. If the project does not make financial sense under these rules, you probably should stop.

The key rule is that you should never make your China investment decisions solely based on local investment incentives that violate central government rules. These incentives can be evaluated and accepted as a sweetener, making an already profitable project even more attractive. However, if your project hinges on such incentives, your risk will almost always be too high.

Beware of local governments bearing gifts. Look what happened to the Trojans. It could happen to you.