Header graphic for print

China Law Blog

China Law for Business

Having A Hong Kong Business Does NOT Make You Legal in Mainland China

Posted in Basics of China Business Law, Legal News

As China steps up its tax and deportation crackdown on foreign companies and foreigners doing business in China without a China WFOE, our China lawyers are getting a massive (well once a week anyway) influx of emails from people looking for inexpensive solutions.

Let me explain.

China WFOE. Do it right or not at all.

China WFOE. Do it right or not at all.

If you are doing business in China without a WFOE (or a Joint Venture or a Rep Office) you are probably operating there illegally. And if you have what you think are employees or independent contractors in China and yet you do not have a business entity in China (a WFOE or a Joint Venture or a Rep Office) you are operating illegally. And what China does to those who operate illegally in China — on good days — is to have them pay all back taxes, plus interest, plus penalties, or it shuts them down and kicks them out. Simple. For more on this, check out the following:

But where there is a problem there will always be the con artists and the know-it-alls who purport to have an easy solution to it, and that is true in spades for those who seek to operate in China without a PRC business entity. And the biggest scam are those who profit from convincing people that having a Hong Kong entity is a faster and better and cheaper way to get legal in China. It isn’t.

Repeat after me:

  1. Doing business in China with a Hong Kong entity is no different from doing business in China with no entity.
  2. Doing business in China with a Hong Kong entity is no different from doing business in China via a New York business entity.
  3. Doing business in China with a Hong Kong entity is no different from doing business in China via a London business entity.
  4. Doing business in China with a Hong Kong entity is no different from doing business in China via a Sydney business entity.
  5. Doing business in China with a Hong Kong entity is no different from doing business in China via a Mexico City business entity.

Got it?

The below is a fairly typical sort of exchange we constantly have with people on this subject. If you sense our frustration, please understand how unbelievably often we get these sorts of emails and how unbelievably often those who send these to us just assume that they are on the right track and want to fight us when we say that they most emphatically are not. And remember, we respond to these emails strictly out of the goodness of our hearts.

Opening email from American individual: I read an article you wrote a couple years ago on incorporating a business in China and you mentioned at the end that you would be happy to discuss further if needed. I have an office in Portland, Oregon, where I am from, and I am currently moving to Beijing to start a _______ business.

I was informed that it is better for me to register my business in Hong Kong to work in Beijing, since the alternative would cost one million RMB to register a wholly foreign-owned enterprise [WFOE]. My question is after I get a company registered in Hong Kong, how do I get a proper visa to stay and work? I am currently own on a 10-year tourist visa, which isn’t suitable for the long run.

My first response: With all due disrespect, whoever is giving you this counsel has no clue. Having a Hong Kong company is no better for Beijing than having an Oregon company. If you do what this person is proposing you do you will be lucky if you are merely deported after your first year because if you get caught after that the punishments will only increase. Certainly you cannot get a visa under your plan and to even try would be about the worst thing you could do because that essentially just be your going to the authorities and telling them that you are not paying your China taxes and that you are there operating illegally, neither of which are things the Chinese government is very fond of these days. My advice to you would be to either do it right or leave the country. Either way, I wouldn’t wait to decide.

Next email from American individual: Thank you for letting me know, I was informed that I would be paying taxes to Hong Kong Tax Bureau. It’s obvious I have got some wrong advice which is the reason I reached out to you. My goal is to everything clean and clear as can be so I don’t have any issues with this in the future. If you were in my shoes, what would be the starting point?

My response: Do you really think that the Beijing tax police are going to care whether you may or may not have been paying taxes in Hong Kong? Can you even imagine a solely US business not paying its US taxes and then using as an excuse the fact that it paid it paid some other taxes in the Virgin Islands? I have no idea what your starting point should be because I don’t have a good sense for exactly the sort of business you want to do in China (it sounds like it is a business blocked to foreigners and so may be illegal no matter what you do) and, most importantly, I have no idea what you have done so far. About all I can say is that if it were me I’d think seriously about returning to Portland and figuring out what to do from there.

The American individual: One thing I haven’t understood is if it’s illegal to register a business in Hong Kong to do work in China, why do we have so many business use Hong Kong as a base for doing business in mainland China?

My response: Having a Hong Kong company is not a substitute for having a PRC entity. Those companies with just an HK business that are truly operating in China or doing business in China are doing so illegally. There is nothing wrong with having a Hong Kong company and a PRC company and many of our clients have a Hong Kong company that in turn owns a PRC company. And by the way, the advice you were given on what it will cost you to form a Beijing WFOE is as worthless as the rest of the advice you have been given in that the cost can be all over the map and it depends on all sorts of factors.

The American individual: But if I sign up with a company, I am concerned the business won’t be “my” business so there is some risk associated with it. What are you thoughts? Would you recommend using another company who is already established in China?

My response:  I have no idea because I do not have nearly enough facts nor am I at all clear on your goals. And let’s not forget, what you are seeking to do may be illegal for WFOEs in any event. I then apologized for my unwillingness to continue the discussion and referred him to Part 13 of a recent series we wrote on How to Form a WFOE in China and instructed him to use that one to figure out how to get to Part 1 and to read the whole series.

Your thoughts?

 

 

 

 

Quick Question Friday, China Law Answers, Part XIV

Posted in Basics of China Business Law, China Business
Can I get into China without a visa?

Can I get into China without a visa?

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

We constantly get some variant of the following “question,” always via email and almost never from existing clients. Amazingly enough, it sometimes includes a request for us to provide travel recommendations, which we do not do unless paid our regular hourly rates (that’s a lawyer joke).

Question: I’m in Thailand/Vietnam/Japan/Indonesia/India/wherever and I need to get to China fast regarding a business deal. I want to stop there next week on my way back. Is there any way I can do this without having to return to the United States/Europe/Canada/Australia/Latin America to get a China visa?

Answer: Yes, depending on your home country and exactly where you will be going in China, China now allows 72 and 144 hour transit stays without any visa at all. The rules for this are rather complicated so be careful as we have heard of people showing up in China believing that they would qualify and they didn’t!

For more information on this program, check out China 72 Hour Visa Rules and click through the links for even more current information. Our China attorneys have taken advantage of China’s transit program multiple times and never had a problem. In fact, the lines for entering China without a visa have always been considerably shorter than the lines for entering China with a visa, making getting into China without a visa faster than getting in with one!

 

Dude, Just Form a China WFOE

Posted in Basics of China Business Law, China Business, Legal News
Think of this cake as your China WFOE and be enticed.

This cake is your China WFOE. Be enticed.

Don’t fall apart on me tonight
I just don’t think that I could handle it

* * * *

I wish I’d have been a doctor
Maybe I’d have saved some life that had been lost
Maybe I’d have done some good in the world
’Stead of burning every bridge I crossed

Bob Dylan, from Don’t Fall Apart on Me Tonight

About a year and half ago, I did a blog post entitled, How To Manufacture In AND Sell In China Without A WFOE, in which I talked about how our China lawyers had drafted agreements to allow clients that manufacture in China without a China WFOE to sell their products in China via the following workarounds:

1. The foreign company and the Chinese manufacturer enter into a manufacturing agreement that protects the foreign company’s intellectual property and deals with all other related manufacturing issues.

2. The foreign company enters into a separate license agreement with the manufacturer. This agreement provides that the manufacturer will sell the product within China to entities (distributors) selected by the foreign company. The sale to the distributor is made at an agreed price that includes profit to the manufacturer and a payment to the foreign company. We have characterized the payment to the foreign entity in various ways. In some cases, we characterized it as a license royalty, in other cases we characterized it as a sales agency fee. The characterization can also influence whether the agreement must be filed with the Chinese government, and where.

My friend and China consultant extraordinaire, Michael Zakkour, immediately called me to complain about this post. Michael has been intensely involved with China business for fifteen years as a China consultant and I respect him immensely. By way of a quick aside, he is also the author of a terrific book on China, China’s Super Consumers, which if you haven’t read, you absolutely should. Anyway, Micheal did not like my post because he thought it could lead companies that needed a WFOE to justify not having a WFOE. My response to Micheal was a bit flippant and consisted of my (probably) saying something like the following:

Well Michael, I trust our readers. They are grown ups and I am sure they will get help in figuring out when it is appropriate for them to have a WFOE and when they can get along without one. My job as a blogger is to give our readers their options and if they (rightly or wrongly) think they can figure out without professional help which of the options makes the most sense for them, that’s their prerogative.

Not going to concede Michael was right but I am going to say that we have in the last few months been getting just a ton of companies coming to us with multiple wounds (any of which standing alone will likely eventually be fatal) asking our China lawyers for one or two or more “band-aids,” believing that is all they need.

The below is a composite of what our China lawyers have been getting of late:

  • Company comes to us that has been having its products made in China and then shipped back to the U.S. and then shipped back to China when sold to WFOEs in China owned by U.S. or European companies. These U.S. and European WFOEs are now telling the U.S. company they are no longer willing to buy from the U.S. company in dollars; they now will only buy from China and pay in RMB. This is happening for two reasons. One, the U.S. and European WFOEs want to pay less and they do not want to pay to have product shipped to the U.S. and back to China. And two, these U.S. and European WFOEs are having enough trouble as it is with getting money out of China (See Getting Money Out of China: What The Heck is Happening?) and they want to eliminate outgoing payments from their China WFOEs whenever possible. I tell these The best long term solution for the company is to form a WFOE in China that will allow it to take RMB in China and sell its products from China to companies in China. This is potentially fatal wound number one. The companies usually want us to fix their problem so that their planned sale FOR NEXT WEEK can go through.
  • Virtually always in addition to the above selling issue, the companies coming to us also tell us about one or more people they are using as “independent contractors” to help them in China and they want to know our “thoughts” on this. I immediately direct them to this article I wrote for Forbes, China’s Tax Authorities Want You:

Chinese law limits hiring China-based employees to only Chinese legal entities. This means that if you are an American software company, you cannot hire someone in China to do your coding or to provide your support services. This means that if you are a Canadian company selling widgets, you cannot hire someone in China to sell widgets for you.

Any person (as opposed to a registered business entity) performing employment-like services for you in China is your employee because China essentially does not recognize independent contractors — and you need to pay employer taxes and benefits on that employee. These employer taxes and benefits vary from city to city, but they usually total around 40 percent of an employee’s salary. Many foreign companies do not realize they have employees and they fail to pay required employer taxes and benefits.

I then explain how if they do not do something about this “independent contractor,” and quick, they are in real danger of    being hit with a massive China tax bill, plus interest, plus penalties, plus other even worse possible sanctions. This is potentially fatal wound number two. Once we explain the dire situation in which the company has put itself in China, they usually want us to fix this problem in a week or so as well. I usually explain various expensive and not terribly good short term remedies and then how their best long-term solution is to form a China WFOE and hire these independent contractors as employees.

  • As if the above were not enough, these companies are more and more often coming to us with some unusual and potentially potentially fatal wound number three. I do not want to go into any specifics on this one for fear of anyone seeing themselves too in this post, but what this wound usually involves is the company doing something in China that the Chinese government would likely view as constituting doing business in China, such that these companies doing these things without their having a Chinese corporate entity is in violation of Chinese law. I tell the company it is at major risk of being taxed for all of the past business it has conducted in China, plus interest, plus penalties, plus other worse sanctions, and that their only solution to stop doing these things (and hope they never get caught for what they did previously) or to form a WFOE to be able to do these things above board. This is potentially fatal wound number there and again, the company usually wants us to come up with something to staunch the bleeding while they figure out what to do and do it.

Dude, don’t wait, just get a WFOE….

China Employee Probation

Posted in Legal News
How to handle the China employee probation maze

How to handle the China employee probation maze

With China’s economy slowing, our clients with employees in China are focusing even more on hiring and firing flexibility. One of the best ways to maintaining employee flexibility (at least for at time) is to take advantage of a probation period to evaluate an employee’s performance. If the employee does not work out, you generally may terminate the employee before the probation period ends. But China’s probation laws (like pretty much all of China’s employment laws) are not without their complications and far too often foreign companies contact me after they have already botched probation for one or more of their employees.

China’s labor laws permit employers to unilaterally terminate employees that do not satisfy the conditions of employment during the probation period without having to pay severance. But to do this correctly, the employer must maintain a set of conditions of employment and provide such conditions to the employee beforehand. The employer generally must be able to prove that the employee failed to satisfy the employer’s conditions of employment. The conditions of employment should be in writing and may be set out in the relevant job ad, job description, labor contract and/or the employer’s rules and regulations, which should be provided to the employee for review and sign off before the employment relationship commences. A mere description of the relevant job requirements on the employer’s website will rarely be sufficient to prove an employee failed to meet employer expectations. Employers should keep clear records (in Chinese) of every instance where the employee fails to perform.

When an employer in China terminates an employee before his or her probation period has expired, the employer must provide an explanation for the termination. We usually advise our clients provide a written termination notice to the terminated employee, setting forth the specific grounds for termination. This is very different from how employee terminations are usually handled in the United States, where the most common advice is not to reveal to a terminated employee the reason for the termination at all.

A couple of “quick” yet important things to note about the probation period. First, the probation period is part of the employment period for purposes of China’s labor laws, so you must have a written labor contract with the employee, even though the employee is on probation. Second, the probation period is not a “free period” where you can use free labor; you must pay probationary employees wages. For more on this, go here. Third, during the probation period, employees in China are free to walk away from their employment with three days notice, without need for giving any cause. For this reason, if you are uncertain whether an employee will be a good fit for your company, it often makes sense to delay providing that employee with expensive training until he or she begins working under a standard employment term.

China Product Development, Part 2

Posted in Basics of China Business Law, Legal News
Milton Friedman. When it comes to China product development, there is no such thing as a free lunch.

Milton Friedman. When it comes to China product development, there is no such thing as a free lunch.

As I discussed in yesterday’s post (China Product Development) product development in China is a risky process. To properly address those risks, a development agreement enforceable in China is required. A development agreement is intended to cover the very important period between the NNN agreement stage when you are testing the waters and the vendor agreement stage when you have already selected the factory you will use and you have already determined exactly what you will have manufactured.

Here are the key terms generally included in a development agreement:

1. Exactly what product will be developed.

2. What the two sides (you the buyer and the Chinese manufacturer) will contribute in terms of technology. Who will provide the specifications and in what form?

3. Who will own the IP rights to the resulting product? In the last few months I have reviewed three product development projects in China (all involving the Internet of Things) where the Chinese and U.S. parties did not enter into a written development agreement. In each case, the Chinese side stated that it owned the rights to the resulting product. The Chinese factories agreed to make “their” product on behalf of the U.S. buyer, but they insisted they owned the IP to the product and they were free to manufacture the product for their own sales under their own trademark and to make the product for direct competitors of the U.S. buyer.

This position shocked all three of these U.S. companies and they were even more shocked when I told them the Chinese companies were taking a completely valid position because there was no written agreement to the contrary. For this reason, at the very least, in any situation where development by the Chinese side occurs, the parties must enter into a separate memorandum setting out the ownership rights on every product to be developed. This can be very complex when both parties are contributing technology. This type of agreement must be executed even in cases where the Chinese side is doing nothing more than tooling up in anticipation of producing a product designed by the foreign buyer.

4. Who will pay for the costs of development? Who will pay for the molds and tooling? Note that this can become a major issue if you as the foreign buyer decide to use a different factory to manufacture the product after development of the product is complete. If you seek out a new Chinese factory to manufacture your product you will likely get the following responses from the Chinese factory that did the product development work:

a. The Chinese factory refuses to release the molds, tooling, CAD drawings and related items related to your product.

b. The Chinese factory agrees to release the molds, tooling, CAD drawings and related items related to your product, but only after you pay it a substantial fee.

c. The Chinese factory will claim that the trade secrets related to the product developed belong to it and if you try to go elsewhere to have the product manufactured, it will sue you and your new Chinese factory in a Chinese court for having violated China’s trade secret laws.

You will be in a particularly bad position if your Chinese factory did the development work and has produced the molds and tooling at its own cost. If the Chinese factory did all of this at its own cost, you can be pretty certain it will request payment of a fee from you and can expect that fee to be high if you are taking the project to a competitor. However, even when you have already paid for the molds, Chinese factories will often refuse to release the molds to you without a substantial payment to cover the costs of their development work and factory set up. This will be the case unless you have a written agreement forbidding the Chinese factory from doing exactly that.

5. Setting of timelines and milestones. Chinese companies will often agree to do the development work, but will fail to do so in a timely manner. Milestones are therefore critical. However, there must be an incentive for the Chinese company to meet the milestones and a penalty if it does not. The following is a typical arrangement:

a. The Chinese company does the development at its own cost, but the U.S. company pays all hard costs for molds and similar items.

b. Milestones for development are set.

c. Clear specifications are set.

d. The parties agree on a target price and quantity.

e. IF the Chinese factory meets the milestones and specs and agrees to sell at the target price and quantity, then the U.S. side agrees to enter into an OEM agreement with the Chinese factory.

Often the Chinese side will require a minimum purchase level that will allow it to earn back its development fee. Some Chinese factories will agree to pay for the molds, but then will require a minimum purchase at a price that allows them to earn back the mold fee. There is much variation on these issues, but your objective should be the same: if you intend to hold the Chinese factory to milestones, you should set up a well-documented system of rewards and penalties by having a properly written and signed agreement.

Oftentimes, it is easiest to simply pay the Chinese side for development and set up (again, with a proper written agreement) and if the Chinese side fails to meet the milestones it will not get paid. This approach simplifies the process, but it is unusual in China. Chinese manufacturers want to do the development at their own cost, because they want to own the resulting product. The problem is that unsuspecting America and European and Australian companies far too often just let them, without realizing that by doing so they have essentially just transferred their product and its related IP to their Chinese manufacturer.

China Product Development

Posted in Basics of China Business Law, Legal News
Product Development Agreements can be key.

Product Development Agreements can be key.

Foreign companies manufacturing in China often “co-develop” products intended for sale in the West. There is a substantial range as to these co-development relationships. In some cases, the foreign side has complete product development and the only involvement from the Chinese entity is in setting up for high volume manufacture of the product. In other cases, the U.S. side has nothing more than a general product “idea” and the Chinese side is responsible for taking the scribblings off the napkin and turning it into a commercial item. In the middle, both the Chinese side and the foreign side contribute technology and know-how to the product and the final product is truly a blend of the two.

The development stage is actually the highest risk stage for foreign companies engaged in OEM manufacturing in China. This risk results from two factors. First, the lack of clarity as to which entity owns the intellectual property in the resulting product. Second, the uncertainty as to how the foreign side can ensure that the product will be developed in accordance with specifications, on time and at a price that makes the whole venture commercially viable.

Though the development phase is riskiest stage in manufacturing in China it is also the stage most often neglected by the foreign side. We find that foreign companies will use an NNN agreement in the factory search stage and they will use an OEM agreement for the production stage. But, during the all important development stage, foreign companies typically do not enter into any agreement to protect themselves.

This failure to enter into a comprehensive development agreement all too often leads to one of two disasters for the foreign company. First, is where a Chinese company does the development work for free or builds the product with its own technology as a base. In these situations, the Chinese company usually claims 100% of the IP in the product as its own once the development of it is complete. The Chinese company will say: “we own the IP in the product, but we will agree to make the product on your behalf and we will agree not to sell to others. However, you must agree to use our company as the exclusive manufacturer of the product and you must accept our price, payment, quantity, quality and delivery terms.” We see this situation all the time, especially with new companies involved in making products for the Internet of Things ecosystem. Though these foreign companies are shocked when presented with these demands from their Chinese manufacturer, there is nothing they can do because they waited until development was finished before they even considered the IP ownership issue.

Second, foreign companies seldom consider the numerous procedural issues that must be addressed to successfully develop a product. Chinese factories are not professional product developers and it is a mistake to assume that they have the skills to effectively develop any product within the tight timeframes and close tolerances required by modern business. This often leads to the following:

  • The product is never completed.
  • The product is not completed until after the market opportunity has passed.
  • The product never works properly.
  • The cost of the product as developed is far higher than was projected at the start of the project.

And again, companies involved in the Internet of Things seem particularly prone to this disaster.

Though these disasters are common when doing development with Chinese factories, foreign companies manufacturing in China seldom even consider these risks. Since they do not consider these risks, they seldom enter into a well drafted development agreement that addresses the necessary ownership and operational issues.

In my next post I will discuss how a basic development agreement for manufacturing in China can protect against these risks.

China Trademarks and The Big Game Occasionally Referred To As The Super Bowl

Posted in Basics of China Business Law

 

What's next Super Bowl toilet cleaner?

Will Super Bowl toilet cleaner be next for China?

 

It’s become somewhat of an annual tradition: in the weeks leading up to the National Football League’s championship game, the NFL’s lawyers send out a flotilla of cease and desist letters to anyone who dares to use the phrase “Super Bowl” without being an official NFL licensee, and thoughtful lawyers respond with articles explaining why the NFL is overreaching.

We have written previously about Lucasfilm’s attempts to safeguard its trademarks in China. The NFL may even be more protective when it comes to the Super Bowl. How far do you think someone would get if they tried to open up a “Super Bowl” sports bar? Don’t answer that, because in China someone just applied for that trademark and it wasn’t the NFL. Indeed, third parties have already registered “Super Bowl” as a trademark in China to cover products like water bottles, flashlights, and surgical masks. To say nothing of the various registrations for “超级碗” (the most common way to translate “Super Bowl” into Mandarin) which cover everything from instant noodles to furniture to – my personal favorite — sea cucumbers.

No doubt the NFL is disgusted with what it sees as rampant trademark dilution in China, but it does not have much recourse. The phrase “Super Bowl” may be famous in the United States, but it’s not famous in China, and that means who gets the mark is and will continue to be judged solely on the basis of who’s first to file. Or, as my six-year-old daughter would put it: you snooze, you lose. If the NFL didn’t want someone else to be able to open up “Super Bowl” sports bars, it should have filed its own trademark application in China for sports bars long ago.

So as you watch the Super Bowl from the comfort of your La-Z-Boy, just think: if you were in China, you could be watching the game in the Super Bowl Sports Bar and slurping Super Bowl ramen with diced Super Bowl sea cucumbers from a Super Bowl-branded thermos as you loll on a Super Bowl recliner.

For those of you who think your brand is so famous that you don’t have to register your trademark in China, ponder this: if Lucasfilm and the NFL can’t win that argument, what makes you think you can?

China NNN Agreements

Posted in Basics of China Business Law, China Business, Legal News
Keep your IP safe from China by using an appropriate NNN agreement

Keep your IP safe from China with an NNN agreement

The first step in doing OEM manufacturing in China is finding a good factory to make your product. To protect your product at this early stage, you must require the Chinese party to execute an appropriate agreement before you reveal any information. This agreement must comply with three basic rules: First, do not use a U.S. style NDA (non-disclosure) agreement. Second, use an NNN (non-disclosure, non-use, non-circumvention) agreement written to deal with the specifics of OEM manufacturing in China. Third, draft the NNN agreement so it is enforceable in China.

I. Do Not Use a U.S. Style NDA 

NDA agreements focus on protecting trade secrets. For a trade secret to be protectable property, the information must remain a secret. For this reason, NDA agreements are geared to preventing disclosure of a trade secret to the public. NDA agreements therefore focus narrowly on preventing secret information from being revealed to the public. Since U.S. companies generally focus on maintaining their domestic intellectual property portfolio, they have a natural tendency to believe they can rely on a single NDA agreement, written in English, subject to U.S. law, and exclusively enforceable in a U.S. city and state. But for the following two reasons, this kind of NDA is of no value in China.

First, the fundamental issue in China is not protection from disclosure to the general public. The Chinese company that steals your idea does not do so to reveal it to the general public. It steals your idea to use for its own benefit. This means that your contract with Chinese companies must make clear that whether the information you provide is a secret or not, the Chinese company agrees not to use the information in competition with you. Now that you know what is really required for China, you can see why US-style NDA agreements are far removed from what is needed to protect your IP from China.

The second fundamental problem with typical NDA agreements is that they are not enforceable in China. Chinese law allows for protecting trade secrets and for contracts that provide NNN protections. But if such a contract is going to be effective in China it usually should be written in Chinese, governed by Chinese law, and exclusively enforceable in a Chinese court. We discuss this issue in more detail in Section III below.

II. Use an NNN Agreement Written for China 

You need a China-centric NNN agreement to protect your IP in China. The three “Ns” that make up a China NNN agreement are: non-use, non-disclosure, and non-circumvention. Consider each in turn.

Non-use means the Chinese factory agrees by written contract not to use your idea or concept or product in a way that competes with you, the disclosing party. The key here is that this obligation arises by Chinese contract, not from some abstract property rights arising under intellectual property law. A contractual provision prohibiting use will protect you not because your concept is classified as some form of intellectual property such as trademark, copyright, patent, or trade secret. Rather, it will protect you because the Chinese factory cannot use your work because if it does so it will be in breach of its contract with you. Getting a Chinese factory to sign a contract with a non-use provision means you will not need to look outside that contract for you or for China’s courts to be able to control the Chinese factory.

The next “N” in a China NNN agreement is non-disclosure. In most instances, you need not be terribly concerned with your Chinese counter-party making your secrets public. The Chinese factory usually has no interest in letting the general public in on its good thing as it typically wants to use your idea or concept for its own purposes. But as we mentioned above, this is usually all that a standard NDA can accomplish, and it cannot usually even accomplish that in a China context.

If you prohibit a Chinese factory from using your protected information, the clever Chinese entity will not directly breach the non-use prohibition; it will instead disclose the concept to someone in its “group” and then deny having breached the non-use prohibition because it did not directly use the protected information. For this reason, it is important to understand the type of group with which you are dealing and to make clear in writing that: 1) disclosure is specifically prohibited within the group and 2) if there is infringement by any member of the group, the factory that made the disclosure will be fully liable.

Usually some education on this issue is required because Chinese companies often do not view disclosure to a member of their group as violating a non-disclosure prohibition. The following are some of the most common situations we see when dealing with Chinese factories:

  • It is common in China for an extended family to own a group of small- to medium-sized companies and for the family to consider all of these companies as the same entity for disclosure purposes.
  • Chinese factories typically use a team of constantly changing subcontractors. Some of these subcontractors are part of the family group, some are related by co-ownership, some are viewed as related due only to their roles or even their physical proximity. Chinese factories often will assert that they must disclose to these subcontractors to provide costing for your product.
  • Many Chinese factories are part of a large and extensive “group company” arrangement involving numerous subsidiaries owned by a single parent. Members of the group do not see other members as outsiders for disclosure purposes.
  • Chinese state-owned enterprises often do not regard other SOEs as separate competitors. SOEs are all state-owned and so information held by one SOE should be freely shareable with another SOE. This is particularly true in sectors with a public service focus, such as healthcare and aeronautics. Since all SOEs in these sectors are pursuing the public good, there is no reason for them not to share your information with their brother SEOs.

Non-circumvention is the third and last “N” and its importance varies with the situation. Your Chinese factory knows you are purchasing product from it at the China price and then adding a big margin before you sell the product in a foreign market. How would you be impacted if your Chinese factory seeks to sell your product to your customers at 50% less than you charge? What if your Chinese factory were to start selling your product to the rest of the world? In industries where quality and service are critical, many of your customers would probably stay with you. But in other industries, this is less likely to be the case. The best way to prevent circumvention by your Chinese supplier is by having a China-appropriate non-circumvention provision in your China NNN Agreement.

III. Use an NNN Agreement a Chinese Court Will Enforce

Your NNN agreement should usually be written to be enforceable in a Chinese court with jurisdiction over the Chinese defendant. This means that Chinese law is the governing law, Chinese is the governing language, and exclusive jurisdiction is in a Chinese court with jurisdiction over the defendant. The fundamental reason for this China-focused approach is that in cases of infringement or circumvention, you must be able to move quickly against the Chinese defendant. Most of the time, any other approach will make the agreement unenforceable or delay enforcement for so long as to render the agreement useless.

Consider the following basic issues:

  • U.S. judgments are not enforceable in China. So a provision that provides for U.S. jurisdiction renders the agreement unenforceable in China and therefore nearly always useless.
  • U.S. arbitration awards are technically enforceable in China, but Chinese courts have a poor record of enforcing foreign arbitration awards. Chinese courts are generally of the view that disputes with Chinese companies should be resolved in China.
  • Arbitration in China is subject to delay and uncertain enforcement. Arbitration panels also have no power to seize assets or take other action to force the infringer to cease its infringing conduct.
  • Though Chinese law allows for a foreign law to govern a contract the Chinese courts will require the parties to prove every element of foreign law. Since interpretation of foreign law is virtually always subject to dispute, this leads to long delays.
  • Though Chinese law technically allows for English as the governing language of a contract, most Chinese courts will not deal with foreign language documents and when they do, they will use a translation done by a court appointed translator Disputes over translation are common, again leading to long delays. This also means that you will essentially not know what your own contract says until you get the court translation of it.
  • Chinese courts do not allow forum shopping. Litigation must occur in the court with jurisdiction over the defendant, usually the city where the defendant is registered or where it normally conducts business. Any provision that provides for jurisdiction in another court will be ignored.

Second, the NNN Agreement must be written so that the Chinese company genuinely fears that its breaching the agreement will have immediate and negative impact. The first step is to make the NNN agreement enforceable, as described above. The second step is to ensure that the NNN agreement provides for contract damages in a specific monetary amount for every act of breach.

A contract damages provision provides two benefits. First, it forces the Chinese party to realize that it will face real and quantifiable consequences if it breaches the NNN agreement. Second, a specific monetary amount provides for a specific minimum level of damages. This sum certain amount then provides a Chinese court with the basis for a pre-judgment seizure of assets. A credible threat of your seizing assets greatly increases the likelihood of the Chinese company abiding by your NNN agreement and of your being able to quickly bring the Chinese company to heel if it does not.

An NNN agreement must include a sum certain contract damage provision that a Chinese court can and will enforce by ordering seizure of the defendant’s assets. Care is required, however, because the Chinese legal system does not allow for punitive damages and it also does not allow for extensive consequential damages. It is therefore important to set the contract damages at an amount that reasonably substitutes for the damages that result from a breach of the agreement.

Because Chinese companies know that breaching a well drafted China-centered NNN Agreement, will likely lead a Chinese court to order a freeze on their assets, we encounter the following three responses from Chinese factories to our NNN agreements:

  1. Some Chinese companies refuse to sign. These are the companies that planned to steal the foreign technology from the very beginning. This sort of situation has in the least few years become incredibly rare.
  2. Some Chinese companies will enter into serious discussion about what they believe should be excluded from the NNN Agreement. This is usually a positive result because it often generates productive discussions regarding technical issues.
  3. Most Chinese companies execute the NNN agreement and then treat their NNN obligations seriously. This does not mean every Chinese company will abandon years of bad practice and begin behaving well. But it usually means that when a Chinese company violates the NNN agreement, litigation is not required. In most cases, a reference to the NNN agreement and the credible threat of litigation/asset seizure is enough to induce the Chinese company to step back into line.

The above illustrates the general approach our China lawyers take when drafting any agreement involving China. We do not want to see our clients have to litigate, but to be able to reduce the likelihood of having to go to court it is essential the Chinese side believe it would be relatively easy for you to sue and prevail. China appropriate NNN agreements do exactly that.

Quick Question Friday, China Law Answers, Part XIII

Posted in China Business
Will all Chinese manufacturers rip you off? No.

Will all Chinese manufacturers rip you off? No.

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

We get some variant of the following “question” at least twice per week. It always comes via email and it is never from existing clients:

Question. I’ve just been ripped off by __________ [Chinese company]. Fortunately only by $211 but I would never buy anything from China again. Why do all Chinese lie?

Response. So let me get this straight. Are you saying that based entirely on your one failed purchase of one item from one person in China (for $211) nobody in the world should trust any of the approximately 1.5 billion people in China enough to buy anything from them, even though billions of dollars in transactions are done with China every day without incident? Because if that is what you are saying my response to you is that I know tons of Chinese (both in China and in the United States) who I have known for a decade or more and worked with for a decade or more without my ever having detected even the slightest hint of dishonesty. I have been engaged in international law for decades and I have found it far more reliable and efficient to judge people as individuals rather than to group them together and just assume that I can judge them based on their nationality.

About ⅓ of the time, I get back a response attacking me. About ⅓ of the time I get a chastened response where the person essentially backs down and admits to having let anger over this one incident get the better of them. About ⅓ of the time I get back no response at all.

News flash: China is diverse and not all Chinese are the same.

Your thoughts?

China Sinosure: What You NEED to Know

Posted in Legal News
Sinosure is scary, but it can be vanquished.

Sinosure is scary, but it can be vanquished.

Nearly all Chinese companies that provide credit to foreign businesses do so because their invoices are insured by Sinosure. Sinosure is a massive China-based export and credit insurance company, as explained by Wikipedia:

Sinosure offers coverage against political risks, commercial and credit risks. This includes short-, medium- and long-term export credit insurance, investment insurance, bond and guarantee business, debt and capital retrieval business and credit assessment business. Investment guarantees cover political risks such as currency and remittance restrictions, expropriation and nationalization, sovereign breaches of contract and war.

Sinosure also provides support for export financing. In March 2011, in reached an agreement with J.P. Morgan to provide a wide array of financial services to exporters, with SINOSURE covering J.P. Morgan’s exposure.

Sinosure also covers SMEs (since 2005, even those with export volumes of under 2 million dollars a year that are unable to bear the political and commercial risks of international trade. The company also provides coverage for foreign investment by Chinese companies, this time most often by large SOEs.

Foreign companies typically do not deal at all with Sinosure unless and until they have a payment dispute with their Chinese product supplier. When that happens, Sinosure usually steps in and threatens to sue. Sinosure does this by hiring debt collection lawyers in the debtor’s country to pursue the debts of the Chinese manufacturers it insures. Sinosure has in the last few years, and especially in the last year, gotten quite aggressive in pursuing collection outside of China.

Sinosure usually enters the picture as follows:

  1. Foreign company (for purposes of this example, a U.S. company) buys $2 million of widgets from Chinese manufacturer for export to the United States.
  2. U.S company pays Chinese company $1.4 million upfront for the widgets, with the remaining $600,000 to be paid upon approved delivery.
  3. The widgets that arrive in the United States are of poor quality.
  4. The U.S. company refuses to pay the remaining $600,000.
  5. The Chinese manufacturer and the U.S. company seek to work out a deal and while that is happening, the U.S. company gets a threatening letter from a U.S. law firm claiming to represent Sinosure.
  6. The Chinese manufacturer will insist it never contacted Sinosure and that the U.S. company should just ignore Sinosure. The Chinese manufacturer will deny that Sinosure has any authority to act on its behalf and it will tell the U.S. company to just pay the Chinese manufacturer and if it does so all will be fine. In the meantime, Sinosure is claiming that if the US company just pays Sinosure, all will be fine.
  7. Oftentimes, even sub-suppliers start contacting the U.S. company to get paid.

Here are some basics you should know if anything like the above happens to you:

  1. Do not expect the law firm representing Sinosure to have any awareness of why you have not paid your China manufacturer.
  2. Do not expect the law firm representing Sinosure to know the correct amount you would owe to your China manufacturer, even if you did actually owe your China manufacturer anything at all.
  3. Do not expect the law firm representing Sinosure to care about ##1 and 2 above. At all. It’s only goal is to get you to as quickly as possible pay as much as possible so that its contingency fee is as much as possible.
  4. Do not even think about settling with Sinosure without making 100% certain that your doing so will actually resolve ALL claims against you. Do not pay Sinosure without a proper written agreement (in Chinese) that makes clear that you have resolved all of your claims against Sinosure and against any Chinese manufacturer that might be able to argue you owe it money. This agreement needs to work in both China and the United States and it must be signed by all parties (including your Chinese manufacturers) or you could face very troubling additional lawsuits down the road. Sinosure’s lawyers will deny the importance of this but that is because they just want to get paid.

What then should you do if you are contacted by a law firm representing Sinosure?

The first thing you should do is take seriously. If you do not pay Sinosure, it will add your name to a list of foreign companies it will cease to insure. This virtually always will mean that none of your China suppliers (past, present or future) will extend you any credit on your purchases. So the next time you need to order $2 million in widgets, you will need to pay the full $2 million upfront. This is not tenable for most companies because having to do this increases both the risk of getting bad product and the amount that will be lost from getting bad product. But that is exactly what will happen to you if you just ignore Sinosure.

Here are a few more things you should know about dealing with Sinosure’s debt collection attorneys:

  • If you are not paying your Chinese supplier because you are having cash flow problems, Sinosure will not listen.
  • If you are not paying your Chinese supplier because your supplier gave you bad product, Sinosure will “listen” if you do certain key things to “make” Sinosure listen. Sinosure’s lawyers will probably tell you that your reason for not paying does not matter, but that is just because they want you to pay so that they can get their contingency fee quickly. Like I said, it will be incumbent upon you to make Sinosure listen.

My firm’s international litigators have developed a whole host of strategies for dealing with Sinosure, with the specific strategies varying depending on the situation and risk tolerance of the companies we are representing. I cannot reveal those strategies publicly for the simple reason that we do not want Sinosure or its lawyers to know them. You instead will just need to trust me when I say that when Sinosure comes calling you have plenty 0f options beyond just letting Sinosure roll all over you or losing your ability to buy on credit from China.