Photo of Dan Harris

Dan Harris is internationally regarded as a leading authority on legal matters related to doing business in China and in other emerging economies in Asia. Forbes Magazine, Business Week, Fortune Magazine, BBC News, The Wall Street Journal, The Washington Post, The Economist, CNBC, The New York Times, and many other major media players, have looked to him for his perspective on international law issues.

China employment lawyer

China employment law is technical and getting technicaler (yes, I made up that last word but you know what I mean). See China Employment Law: Local and Not So Simple. It is one of the most consistent problem areas for foreign companies doing business in China and it has become a massive growth area for our law firm. As we are always writing, China wants harmony and China is a communist country. Combine those two and you have a country that wants to keep its workers happy, especially as compared to your run of the mill foreign company that operates in China and competes with Chinese businesses.

All of this combines to mean that if you have employees in China or you are thinking of having employees in China it is of paramount importance you have at least some understanding of what is required of you as an employer in China. This book, for the low low price of less than $20 in paper form, gives that to you. It is also sold as a Kindle version for $9.99, but you really should spend the extra $10 to be able to have it in physical form in your office for you and anyone else to be able to consult easily whenever necessary. I am writing about this book again today because we just learned that it is now available at Barnes & Noble as well as at Amazon.

Disclaimer: This book is written by our lead China employment lawyer, Grace Yang and we get a cut of every sale.

Our typical attorney-client interaction on China employment laws usually goes something like this:

  1. Foreign employer company contacts one of the China lawyers at my firm because it terminated an employee and that employee has either sued or threatened to sue, oftentimes over a technical violation by the foreign employer.
  2. One of our China employment lawyers looks at the case and determines the foreign company employer violated Chinese law in the termination and the employee would almost certainly prevail in his or her claim. See China Employee Terminations: Don’t Get Lazy.
  3. We explain the above to the foreign company employer and we learn the company is violating China’s employment laws with all of its employees.
  4. The foreign company employer wants its violations excised.
  5. We then conduct an employer audit to determine what other employment problems need fixing. See China Employment Compliance and Audits: THE New Big Thing.
  6. The employer audit invariably generates a laundry list of problems that require fixing.
  7. We fix the employment law problems, one by one.

Foreign company employers have so many employment problems in China not just because China has started getting so tough with such problems and not just because there is probably but one employee in all of China who does not understand the leverage they hold over foreign employers –and that one employee probably will immediately find a lawyer who will tell them of their employee rights? The small to mid-sized foreign company typically goes into China with maybe one or two foreign employees and one or two Chinese employees, none of whom know anything about Chinese employment laws (on the local, regional or national level) and all of whom are — naturally — focused more on getting the business off the ground than on complying with the letter of the multiple sets of China employment laws. And anyway, at this point they are usually a tight-knit group of founding employees who view themselves as much as founders as they do employees and who all get along with each other and view their futures with the company as bright. As the company grows, little to nothing changes on the China employment compliance front, mostly because nobody realizes how important it is to make the changes and because even if they did, there is nobody in-house who knows how to do it. Plus, why spend money on complying with obscure employment laws when there has never been a problem necessitating that? So employment law compliance gets kicked down the road.

But then a problem arises and a China attorney at my firm gets called — usually by someone high up in the U.S. or the Europe or the Australia office as opposed to someone on the ground in China. The person who calls us is often the head of HR, the CFO or the CEO who is trying to find out what is going on with HR in China and is receiving only vague or nonsensical responses and is starting to worry.

All of the above is my long-winded way of saying foreign companies with employees in China need to get on top of their China employment situations and stay there. Employer audits are the way to go in most situations, but in the meantime and as a supplement, it is critical someone at your company understand China employment law basics. Someone at your company needs to know enough to be able to spot your company’s China employment law issues before they blow sky-high.

The China Employment Law Guide is the book for that and you really really really should buy it and put it on your shelf. And when I say put it on your shelf, I mean you should buy the softcover version (not the Kindle version) so you can literally put it on your shelf. Heck, get more than one copy and give it to everyone in your company who manages your employees or plays any role in their hiring or their firing. This book is meant to be used for background and for reference and as a decision-making guide.

Just a little bit about Grace Yang, its author. Grace grew up in Beijing and excelled at and graduated from China’s best law school there — Beijing University. She then came to the United States to attend the University of Washington law school where she again excelled and graduated. Grace is my firm’s lead China employment and labor lawyer and she is the lawyer at our firm to whom everyone else goes for China employment and labor law questions. Grace is a licensed U.S. lawyer (she is licensed in both Washington and New York) and she splits her time between Seattle and Beijing.

Anyway, did I tell you that you should buy the book? Of course I did and you should. And while on the subject of shameless plugs (hey, come on, how many of those have you seen in our more than a decade writing this blog?), I would be remiss if I did not also mention that Grace will be putting on a webinar on October 26 on Chinese Employment Law Landscape: Key Issues and Staying Compliant in the Local Market. This webinar is described as follows:

China’s employment laws are complicated and highly local. Foreign companies doing business in China face complex China labor and employment issues and questions every day – often without even realizing it. What works in the United States has very little in common with what works in China. Employment compliance has become one of the most important issues foreign companies face in China and it is the rare foreign company that gets it right. Employee disputes are becoming considerably more common and government enforcement is getting significantly more stringent. It virtually always costs less for your company to deal proactively with China employment law issues than to wait to address them only after they have come via a dispute. As such, it is imperative that you understand the framework of Chinese employment law and steps you can take to mitigate risk.

Please join Grace Yang as she helps you better understand the Chinese employment law landscape. She will focus on helping you recognize key China employment issues and give you guidance on how to solve real-life China employment law issues and problems.

WHAT YOU’LL LEARN

This webinar will cover the following:

  • The basics of China’s employment law rules
  • How to draft an employment agreement that works for your China locale
  • How to draft China employer rules and regulations (aka employee handbooks)
  • The other agreements you should consider for your China employees
  • Frequently contested issues, such as overtime, vacation days, commission payments, and leaves of absence
  • Employee terminations
  • HR audits
  • AND MUCH MORE!

YOUR CONFERENCE LEADER

Your conference leader for “Chinese Employment Law Landscape: Key Issues and Staying Compliant in the Local Market” is Grace Yang. Grace heads Harris Bricken’s China employment law practice and contributes a weekly column about China employment law issues for the multi-award winning China Law Blog. Grace received her B.A. degree in law from Peking University and her J.D. degree from the University of Washington School of Law. She represents both China employers and employees in their China employment law matters. Grace recently published a book entitled The China Employment Law Guide.

How can you miss it?

China WFOE ownership lawyer
Who should own your China WFOE?

Late last year, China revamped its WFOE formation rules and — as much as anything, these new rules have complicated ownership structures. The below is an email from one of our China corporate lawyers to a client

 

As we discussed today, the first task in forming a WFOE in China is to determine what entity will be the shareholder of the WFOE. The basic analysis for this is as follows:

1) You will be creating an entity that will perform services for a fee for its shareholder parent. For this type of WFOE, the normal procedure in China is for the shareholder to be the specific entity for which the WFOE will perform services. In this case, this entity would be ABC US. The Chinese WFOE would then be another of your company’s several direct subsidiaries. Direct ownership of the WFOE by the operating company parent is most common in single owner WFOEs, such as that planned for ABC US here.

2. The alternative you are considering is whether or not the shareholder should be a separate holding company not directly linked to ABC US. This is what is referred to in China as a Special Purpose Vehicle (SPV). It would be unusual but permissible to make use of an SPV in your situation. The analysis here is as follows:

a. Over the past decade, the Chinese government has become quite suspicious of SPVs. At one point, the government even moved to prohibit SPVs for WFOE formations. However, after recently adopting the new WFOE formation rules, the Chinese government now permits the use of SPVs. So the current Chinese government rules are neutral on the issue.

b. In the past, one reason investors used an SPV was to hide the true identity of the owners of the WFOE. Under the new rules, the investor must provide a complete organizational chart detailing ownership of the shareholder and identifying the actual controlling person. It is therefore impossible to conceal ownership. Accordingly, an SPV can no longer be used to conceal actual ownership from the Chinese government.

c. SPVs continue to be used in situations where there are several investors in the WFOE. Often these investors are resident in different jurisdictions. In that case, it is common to take all these investors into a single SPV. The SPV is then the single shareholder of the WFOE. Issues such as management, distribution of profits and purchase and sale of ownership interests are handled at the SPV level. In many cases, the SPV is formed in a tax haven such as Hong Kong to allow distribution of profits free of tax. These considerations do not apply in a single shareholder setting.

d. In terms of limiting upstream liability to the shareholder, there is no benefit in making use of an SPV. The WFOE will be a limited liability legal person. The limitation of liability rules apply in China in the same way as in the United States in that the financial liability of the WFOE is limited to the amount of investment. Liability beyond the investment amount occurs only in the case of illegal acts. In general this liability would be as follows:

i. The shareholder will be held liable if the shareholder does not contribute capital and the failure to contribute capital results in non-payment of taxes, non-payment of employee salaries or fraud against creditors.

ii. Directors will be held liable for instructing the WFOE to commit an illegal act. Examples of illegal acts are tax fraud or commission of a significant safety violation.

iii. Directors and the shareholder will be held liable if the WFOE terminates business and does not liquidate in accordance with the provisions of Chinese company law. The penalty here is that both the investor and the directors are placed on a blacklist and prohibited from doing other investments in China. In addition, individual directors will not be able to travel to China since they may be detained.

All of the above liability is very real. However, creating an SPV does nothing to reduce this liability. First, most of the liability falls on the individual directors, not on the shareholder. Second, the Chinese government will use the org chart/actual controlling person information to “pierce the corporate veil” to assign liability to what the Chinese government determines in its own discretion is the actual party/parties in interest.

Note that other reasons for liability arising from WFOE operations are so rare that they can usually be discounted. On the other hand, i, ii and iii above are common and care must be taken not to incur these forms of liability.

3. There may be tax or other operational or accounting reasons to create an SPV for China. In that case, as noted above, the Chinese government is neutral about the use of such SPVs. In considering whether to make use of an SPV, you should do a cost-benefit analysis. Most of our firms’ clients have found the SPV approach to be more trouble than it is worth in the single shareholder setting. However, your situation may be different and we should explore the tax ramifications before you make this decision.

 

Beware the fake China attorney
Beware the fake China lawyer

American Lawyer Magazine recently did an article, That Law Firm’s Website Might Not Be for a Real Law Firm on “a new white paper [that] examines a growing trend of fraudsters posing as attorneys or legal consultants online to exploit those seeking legal services.”  To which I can only say, well yeah.

To which I can only say, well yeah.

We actually first wrote about the fake lawyer phenomenon way back in 2006, in China: Where Even The “Law Firms” Are Fake (2006). In that post I talked about fake Chinese lawyers taking money from American companies for trademark registrations:

There are those who take money to file trademarks in China and then simply run away. A new client told me he had sent about $750 to what he thought was a legitimate China law firm to have his company’s brand name registered. As soon as the first $750 hit Shanghai, he was asked to send an additional $600 to “cover the filing fees,” which he did.

A week later the website was down and the Shanghai “firm” was gone.

It turns out this scam is actually pretty common and it also turns out that in every case of which I am aware the scammers were neither licensed Chinese lawyers nor licensed Chinese trademark agents. In other words, they are just people who run China trademark registration scams.

Since 2006 I have heard multiple accounts of foreign companies that paid for trademarks or employment contracts or manufacturing contracts  or company registrations or various other things China lawyers typically do for their clients, only to receive nothing in return and only to learn that the “Chinese law firm” or the “Chinese lawyer” they paid for their legal work never even existed. How many foreign companies believe their trademarks are registered in China when in fact they never were? How many think they have registered companies in China when they don’t? I don’t know the numbers, but I do know that the number of these fake law firms is on the rise, fueled in large part by foreign companies seeking to reduce their costs wherever they can.

In addition to fake law firms that simply steal your money, there are also a whole host of companies with no lawyers who advertise their China legal services on the internet. These companies (at least as far as I know) do not flat out steal your money but what they do can in some cases be almost as harmful. These companies lead their clients to believe they are communicating with lawyers when in fact they are not. This means that there is no attorney-client privilege and that the odds of whoever does your legal work knowing your situation and your goals and having the capability to draft a cross-border document that will work for you are about 1,000 to 1. Be careful of these companies as well.

So how can you avoid these things happening to you? Do some due diligence before you pay/hire a China lawyer, especially if you will be paying upfront for something like a China trademark or a China company registration where it may take you years to realize that you have been had. There are, for instance, some fast and easy steps you can take to confirm that your lawyers actually have a law license. I believe every U.S. state lists its licensed practitioners online and avvo.com also lists all or nearly all licensed lawyers. Here is my proof on Avvo that I am a real lawyer, licensed in Alaska, Illinois, and Washington. Most countries have something similar. Check to see how long they claim to have been in business as compared to how long they have had their website. One fake China attorney claimed to have more than 20 years experience but his website appears to have been online for a total of only 5 months.

Anyway, just be careful out there.

 

China Manufacturing Contracts
China Manufacturing Conmtracts: Like a Maze

Our China lawyers have in the last six or so months been getting more than the usual number of manufacturing contracts that involve U.S. based sourcing companies, oftentimes one in a close (ownership connected?) relationship with the China factory(ies) at which the product or products are going to be made. Figuring out the appropriate party(ies) with whom to contract can be quite complicated in these situations, as can the drafting of the contract(s) as well.

The below is an amalgamation of some recent emails we have sent to clients that are working through an American sourcing company with close ties to the China factory. I am running this because it should prove helpful to other companies in similar situations.

Please advise on the below for your relationship with US Sourcing Company A. Keep in mind that US Sourcing Company A is a U.S. company that will be working with Chinese subcontractors. So you must permit a first layer of subcontracting to factories in China. We can call that first layer the Primary China Contractor.

You should require US Sourcing Company A to provide you with the following:

1. The identity of each Primary China Contractor.

2. You will have essentially the following two choices regarding the appointment of the Primary China Contractor:

a. You will have the right (but not the obligation) to inspect the factory of the Primary China Contractor factory and to approve the Primary China Contractor business and its factory chosen by US Sourcing Company A. US Sourcing Company A must also first provide you with notice of any change in Primary China Contractor and this same procedure will apply to that change as well.

b. No Primary China Contractor can be used until you first approve it in writing. If the Primary China Contractor will change its factory location(s), American Sourcing Company A must give you prior notice of this and you must approve this in writing as well.

3. You will have access to the factory(s) of the Primary China Contractor at all times.

4. US Sourcing Company A must provide the NNN Agreement we drafted for you and your company’s Code of Conduct to the Chinese Primary Contractor. No work will begin until after the Primary China Contractor has returned to you a) an executed version of the NNN and b) a written and signed acknowledgement it has received and will comply with your company’s Code of Conduct. We will revise your NNN to apply in this situation and we will also draft a short acknowledgement for the Code of Conduct.

After deciding on the basic policy towards the Primary China Contractor, we must together consider the issue of how to deal with subcontracting done by the Primary China Contractor.

It is common for the Primary China Contractor to further subcontract out part or even all of the manufacturing process. Will you allow such sub-contracting or not? This is a complex issue:

Though this kind of subcontracting is common (and especially so in your industry) this process greatly increases your intellectual property risks. If the subcontracting process gets too extreme, no one really knows who is doing what. I have worked in situations where there were five layers: U.S. sourcing company and Primary China Contractor with three layers of subcontractors under the Primary China Contractor. It was a mess when things went wrong with quality and with control of IP because everyone pointed to everyone else as the source of the problem. On the other hand, without the extensive subcontracting, no product at all would have been produced for this client.

In theory, we will want the subcontractors to abide by your NNN Agreement and your company’s Code of Conduct. You may inspect the Primary China Contractor factory and find all is in compliance. But, if you allow for subcontracting below the Primary China Contractor, the Primary China Contractor may then subcontract work to a different factory(s) that is not compliant in any way. But, if you require the NNN and Code of Conduct from EACH subcontractor below the China Primary Contractor, you could end up with 30 or more executed agreements and the costs to go with that.

You need to decide how to deal with the issue of subcontracting by the primary Chinese contractor. Your options are as follows:

1. The Primary China Contractor is not permitted to subcontract. At all.

2. The Primary China Contractor is permitted to subcontract. The subcontractors are not required to execute the NNN Agreement or your Code of Conduct. The Primary China Contractor and the US Sourcing Company A are liable for violations by the subcontractors.

3. The Primary China Contractor may subcontract, but only on the same terms under which US Sourcing Company A is permitted to subcontract.

In theory, Option 3 provides you with the most protection. However, as discussed above, the logistics of Option 3 can be very difficult. In addition, many Chinese subcontractors will refuse to execute an NNN Agreement (or any other agreement) with a U.S. company with which it has no direct purchase/sale relationship. For this reason, most U.S. companies (especially those without a massive amount of purchasing leverage) usually settle on either Option 1 or Option 2.

Please consider the above and provide me with your initial choices on how to proceed or let’s talk some more about your various choices. You may wish to discuss the above issues with US Sourcing Company A as well. If US Sourcing Company A will not allow its Primary China Contractor to subcontract, the China subcontracting issue disappears for this particular contract.  However, this issue likely will come up in the future, so we should consider your basic company policy on the issue.

China Factory ClosuresChina factory closures are a hot topic. In the last few months, our China lawyers have received multiple emails from companies that were having their products made in Chinese factories that have been shut down due to environmental concerns.

And needless to say, we are not the only ones dealing with this issue. See More Thoughts on China Factory Closures and What if your supplier has to close due to China’s Ministry of Environmental Protection (MEP) cracking down on polluters?

To us though, the big issue isn’t so much what do you do if your factory in China closes, as those situations usually are governed by the actual facts on the ground. No, for us the more interesting question is what can and should you be doing now to avoid a situation where your China factory closes.

Lately, the China attorneys at my firm have been receiving emails like this:

I run a _________ company in __________ and I have come upon my own situation in which I would like to ask for a legal opinion. We were having our [widgets] made by a factory in Guangzhou that is part of a large Chinese company with more than a dozen factories throughout China. Unfortunately, this one factory that was making our [widgets] is the only factory this company has that makes [widgets].

To make a long story short the company is saying that the Chinese government has shut down its [widget] factory for “environmental reasons” and they will not be supplying us with our [widgets]. This is very bad for us because we now have a long line of very unhappy retail customers and many of them have told us they are done with us (even for our other products) because of our failure to deliver them the widgets we promised.

Can we sue this company in China?

Our typical response is usually something like the following:

Certainly you can sue but can you win? Without reviewing your contract with this company, I have no way to know what you can and should do. If you have a good contract (preferably in Chinese and chopped by the Chinese company) that makes clear that the company must provide you with products and that does not have a force majeure provision broad enough to include this factory being closed by the Chinese government for environmental reasons (even if the fault of the Chinese company) then we should consider pursuing litigation.

But what can you do to avoid a similar situation for your company? The following can help.

  • First off recognize that the Chinese government is more concerned with social harmony than with economic numbers and that is why it continues to shut down highly-polluting factories.
  • Many Chinese exporters, particularly those that compete with companies from lower-wage countries like Vietnam and Bangladesh, are suffering — in particular in low-tech, low-wage industries such as manufacturing of textiles, clothing, shoes and low-end electronics and toys. Some of these companies are claiming to have been shut down by the Chinese government when in reality they shut down on their own because they were losing money. Foreign companies that do business with Chinese companies in these industries must keep up their guard.
  • The key to weathering China’s onslaught of factory shutdowns will be for foreign companies to focus on due diligence at a company-to-company level.

Even though China’s low-end companies are suffering both from environmental shutdowns and rising costs, its high-end companies are getting bigger and deeper, as they strive to provide a product or a service (or a product and a service) that can compete anywhere. The existence of such Chinese companies is not new but these sort of companies are proliferating and growing in strength, and more Chinese companies are realizing that stepping up their game is the best way for them to survive. Co-blogger Steve Dickinson hit on this trend in his post The New Role Of Written Contracts For Product Purchases In China. In other words, the importance of choosing your China partner — which was always critical — has become even more so.

Our best advice to protect your financial interests is (1) document all transactions in simple, concise language so that if there is a fight over the failing Chinese company’s assets, it will be clear what actually belongs to you. If your Chinese factory is going to shut down after you have paid for your products and your Chinese factory has made them, you want to be able to walk away with them (2) do your utmost to determine the financial wherewithal of your Chinese counter-parties before you pay anything. These two steps aren’t foolproof, but if you do both you’re a lot less likely to get burned, shutdown or not.

None of these things are foolproof or even close, but if you do all of these things you are a lot less likely to get burned, slowdown or shutdown or not.

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

I speak often on China IP before all sorts of groups and companies and after I give my spiel on the topic, I always (if at all possible) open the floor up for questions. Both live and via webinar, the one question I am nearly always asked is some variant of when I think China will “start improving its protection of IP.”

My answer is usually something like the following:

First off, China is already improving on its IP protection and it has been doing so for at least the last decade, slowly but surely. China’s trademark protection is already pretty good and its protection of copyrights and patents has consistently improved. But what do you mean by IP protection? Do you mean government enforcement against counterfeiters? Do you mean the laws as written that allow a private party to sue for infringement? Because China’s IP laws as written have been pretty good for quite some time? When I say China’s IP enforcement has been consistently improving, I am usually referring to the whole package in terms of what a foreign company can do against a Chinese company that has been violating the foreign company’s IP rights.

What I said long ago is that when China’s powerful companies start caring about their IP rights will be when China as a whole will really accelerate in its caring about IP rights. And here’s the thing. There are plenty of powerful companies in China that now do care about IP rights and that number just keeps rising and for that reason alone I expect IP protections to improve substantially in China over the next 2-5 years.

Your thoughts?

China IP protectionOf course they do, but not always and not for every company doing business in China or with China.

Let me explain.

I just read an article on Engadget, entitled EU withheld a study that shows piracy doesn’t hurt sales, and subtitled, “The $430,000 study’s conclusions perhaps didn’t fit what it wanted to hear.” To grossly summarize, the study indicated that of books, movies, music and games, only blockbuster movies were negatively impacted by piracy. The study indicated that game sales may actually be aided by piracy.

I have from time to time been known to question the dollar losses often attributed to counterfeiting as well. The most commonly cited number is that United States companies lose $600 billion a year to counterfeiting. But the problem with this number is that it is based at least in part on an analysis that says every counterfeit purchased gives rise to a dollar lose equivalent to the real item that was counterfeited. This is usually true (especially when the buyer does not realize it is buying a counterfeit), but is this really true when someone buys a fake Rolex watch for $55 or a fake Gucci purse for $15? I don’t think so.

But let me be crystal clear here. I am not in any way condoning piracy or counterfeiting as both of those things are not only economically damaging, they can reduce innovation and be downright dangerous. Do you want fake brakes in your car? How does counterfeit medicine sound to you? No, all I am saying is that the extent and the damages caused by these things — as a whole — is sometimes over-dramatized. And that, as I will explain below, can have real-world business consequences.

Piracy and counterfeiting and the lack of strong IP protection in China are huge issues. They are a huge issue for some companies, a big issue for some companies, an issue for some companies, and really not much of an issue at all for other companies. Nonetheless, for most (not all) companies they are not a valid reason for ignoring China entirely.

Really, only a small percentage of companies need to worry much about IP theft in China. It exists, of course, but how much impact does it really have on your business? With very few exceptions, my firm’s China clients have either not been hit with piracy/counterfeiting or are too focused on making money from their own products to worry about it much. It is not nearly as much of an impediment to profits as believed.

Too often companies are so afraid of being copied that they fail to do things they should be doing. I can tell you that far more of my law firm clients have expressed the wish that they had gone into China to manufacture or sell their products sooner than have suffered negative IP consequences from having done so.

And on the flip side, every few months a company will come to one of our China lawyers overly concerned with their China IP protections after having read our blog. Oftentimes, they will believe they are too late and other times they will give us a long list of the IP protections they are convinced they need, usually including one or more of the following:

  1. NNN Agreement
  2. Product Development Agreement
  3. Contract Manufacturing Agreement
  4. Trademark Registration
  5. Trademark Registration with China Customs
  6. Design Patent Registration
  7. Copyright Registration
  8. And much more

And maybe 10 percent of the time they are coming to us with an astronomical quote from some other law firm for all of the above contracts and IP registrations. But here’s the kicker. Well under 1 percent of the time does a company need all of the above, and even less than that does it need all of the above immediately. Most of the time, in fact, the typical company doing a typical China deal or transaction usually needs less than half of these. And guess what? Probably 25 percent of the time none of the above makes sense for the company either because none of these things will be effective or because the company is too early (or worse, too late) or because the company would simply be better off spending its money elsewhere, at least in the short term.

So the point of this winding post is simply this: there is no one size fits all when it comes to best practices for protecting your IP from China and you should not let scare tactics and big numbers scare you into believing otherwise. Instead, treat China and China IP protection the way you treat the rest of your business and weigh the costs and the benefits of your IP actions accordingly.

 

China sourcing agentsMany companies start outsourcing their products from China using a broker/sourcing agent. Tomes have been written about the pros and the cons of using a sourcing agent versus dealing directly with a Chinese manufacturer and I have no intention of rehashing all that here. My relatively succinct and simple and mostly unhelpful view is as follows:

About 45 percent of all sourcing agents are corrupt. About 45 percent of all sourcing agents are incompetent/worthless. About 10 percent of all sourcing agents are invaluable.

I cannot tell you how many times a client has retained one of our China lawyers to assist in making the switch from using a sourcing agent to going direct with a brand new and far cheaper factory only to have the old factory tell our client it can now reduce its prices by 30-40 percent because it will no longer need to kickback 30 to 40 percent to the sourcing agent. I also cannot tell you how many times a client or a potential client has given us some completely invalid reason as to why their sourcing agent is so clearly different from the rest. We commonly hear that such and such sourcing agent must be good and honest because it is being used by some competitor or because it has an office in the United States. If only it were that clear-cut.

One of the legal issues we often must resolve is whether our client who is using a sourcing agent would be better off contracting with that sourcing agent for the manufacturing of its product, or contracting directly with the Chinese factory, while still paying the sourcing agent for its services. One of our China lawyers recently explained to a client some of the things the client should consider in determining whether to contract with its sourcing agent or to contract directly with its Chinese manufacturer, as per the below, with any identifiers stripped off:

You raise the usual and standard issues related to this kind of contract. To start, it makes no sense to have essentially the same a contract with two parties. You must choose with whom you are going to contract. Will it be your sourcing agent or will it be the Chinese factory? You must contract with the entity that will issue the invoice for the product and in this case (unless we change things), that is your sourcing agent. But if you contract with your sourcing agent, you can and you should also have a contract with the Chinese factory that deals with issues like ownership of intellectual property, ownership and control of the materials, non-circumvention and non-compete and similar. See China NNN Agreements. However, many Chinese factories are not willing to enter into that kind of contract if they are not the direct seller of the product.

The old way was to enter a contract with the sourcing agent, loading all of the liability on it. Since Sourcing Company X is a U.S. company, operating in this way is pretty much just like making a purchase from any U.S. company that outsources its manufacturing around the world. The question is: can Sourcing Company X perform? Does it have the resources to do the work and the asset base to deal with any problems?

As you have figured out, there can be many problems with the “old way.” If you are purchasing from a huge company like Apple, you don’t really care about who their ultimate suppliers are because you know Apple will do the work and you know Apple will stand behind the products and has the resources to handle pretty much anything that can go wrong. For a small company like Sourcing Company X, your analysis is quite different and is more difficult.

There are two issues: First, what happens when everything goes right? If Sourcing Company X takes care of everything, then using them makes sense. Many companies fail to consider what happens when things go right. If you end up doing all the work in China, why bother with Sourcing Company X.

Second, what happens when things go wrong? As you know, things going wrong is standard operating procedure for China manufacturing. If there is a defect, can you rely on Sourcing Company X to fix things? If there is a late delivery or a short delivery, can you rely on Sourcing Company X to address this in a way that does not require your staff travel to China? Can Sourcing Company X ensure that the fabrics and other materials are properly processed and securely stored and maintained in China in a situation where you have no direct contract with the China factory? What if the China factory goes bankrupt: what happens to the materials then? Will Sourcing Company X remain liable in that situation?  Can Sourcing Company X ensure all payments will be made to the factory and to the suppliers of the factory? Can Sourcing Company X ensure that the Chinese factory and its suppliers and the suppliers to its suppliers will not steal your IP or circumvent you by going directly to your customers? If circumvention happens, will Sourcing Company X aggressively take care of the issue and does it have the financial resources to cover for liability?

On these issues, if you conclude that the answer is yes in each case, then you should contract with Sourcing Company X. The more difficult situation is if you conclude that Sourcing Company X may not be fully able to deal with these issues. In that situation, you then have to consider whether you are better off with a contract with a Chinese company that will require you to litigate in a Chinese court to deal with the issues or better off with Sourcing Company X here in the U.S. and insured here as well. See also China Contracts, But With Whom?

As you can see, the matter is complex. In my experience, I find large companies with a presence in China prefer to contract directly with the Chinese factories. And this is the modern trend. However, smaller companies that do not have the time or the people on the ground in China still often use companies like Sourcing Company X to secure their products from China. The problem with companies like Sourcing Company X is they often refuse to enter into a reasonable contract. If Sourcing Company X is willing to enter into a reasonable contract, that is one matter resolved in its favor.

 

We have to assess two issues: a) can Sourcing Company X really perform and b) if you contract with a single Chinese factory, does that really put you into a better position if something goes wrong. You will need to make this decision based on your own business judgment, since you are the one with direct contact with the players. We can help you with this by conducting due diligence/background checks on the two companies.

Please let me know if you need more information from me on this matter.

 

 

China Law: Don't fight the trend
China Law: Don’t fight the trend

China Bystander (a very thoughtful deep-dive type China blog that has been churning out truly excellent posts since 2007) just did a story, entitled, China Cracks Down On Cryptocurrencies. The story begins with what I see as its money quote:

The default position of Chinese authorities is that if it exists, it should be regulated. Cryptocurrencies are a prime example.

Exactly.

I was a big fan of uber-investor Martin Zweig who would often talk about how the “trend is your friend” and how “you don’t fight against the trend.” That advice applies to Chinese law and business. A CEO I know will every five years put the basics of China’s Five Year Plans on a small card, get the card laminated and then keep that card in his wallet at all times. He does this so that he can easily check all of his iany’s proposed actions against the Five-Year plan to make sure it coincides with it or at least does not contradict it. In other words, he makes sure his company acts in harmony with China’s plans, not against them. Smart. Very Smart.

Our China lawyers constantly get phone calls/emails from potential clients (it is almost always potential clients and not actual clients) convinced they have found a “workaround” for some Chinese law and they want us to confirm their workaround will work. When we immediately express our serious doubts, they express their serious doubts about hiring us. This indicates to us they do not really want an objective answer to their question regarding the viability of their workaround, they just want confirmation of it, preferably in writing and they move on.

Anyway, this sort of interaction happens quite often and the following are the most common instances:

1. Getting more than $50,000 out of China. We get at least 2-3 emails every week from someone wanting to know if we can help their Chinese counter-party get x millions of dollars out of China, usually to buy real property or to invest in an American or European business. See Getting Money out of China: It’s Complicated and while you are at it, you might as well check out parts 2, 34, 5 and  6 of that series.

About half of those emails include some “new” idea for getting the money out and about half of those involve a long explanation as to why that idea is legal under Chinese law. Our response is essentially to point out that if it were easy to get money out of China legally, people would be doing it AND their Chinese counter-party would be contacting a Chinese lawyer to do it, not having the American/European side do the contacting. About half the new ideas involved cryptocurrencies, usually Bitcoin. Our position on all of these ideas, especially the Bitcoin ones, has always been that if China is not now blocking them, it will soon and those who facilitated such transfers when the facilitating was perceived as relatively good could face serious consequences.

Starting a few months ago we started getting communications from frantic foreigners whose bitcoin accounts had been frozen in China asking our help to unfreeze them. Starting about a month ago, we started getting communications from people who were having their associates arrested for actions tied in with Bitcoin (but not for using Bitcoin directly). Things like conducting business in China without an entity and without paying taxes. More than one caller who had millions of dollars in Bitcoin frozen AND one or more associates on the ground in China would insist that they were not conducting business in China because all they were doing was sending money out of China and that is not conducting business.

What people need to realize about China law is that when it comes to something like this, China is just not a particularly big fan of these sorts of arguments. In other words, don’t fight the trend.

2. Using Third-Party Hiring Agencies to Avoid Having to Form a China WFOE. Nope, not going to recommend this. No way, no how. Way back in 2015, I wrote an article for Forbes Magazine, entitled, China’s Tax Authorities Want You. In this article, I talked about the illegality of foreign companies hiring Chinese “independent contractors” directly, rather than by forming a WFOE and having their WFOE do the hiring. This is illegal 999 times out of 1000 and China hates hates hates companies that do this. China hates this because it means it does not collect the approximately 40% of salaries employers are supposed to pay in taxes and social benefits nor does it collect the approximately 25% of salaries that is to be paid by China employees.

Couple the hate with the opportunity to collect large amounts of money and you can see why China is hyper-zealous about hunting down companies engaged in these arrangements. Far be it though for foreign companies to simply comply by forming a China WFOE and using their WFOE to hire employees in China legally. No, they want us to tell them whether it is legal for such and such third-party hiring agency to hire employees for them in China.

The answer is really complicated because it depends on so many factors, including the third party hiring agency (a whole boatload of companies (mostly foreign companies operating outside China) have jumped into this business without being licensed to engage in it and much depends on who you which to see hired, their position, the number of people you wish to see hired, the length of time you intend for your third-party hiring agency to employ someone and then on top of all this, the city and perhaps even the district. In the end, it would almost certainly cost more to 1) conduct due diligence on the hiring agency 2) figure out the legality of the specific situation, 3) pay the 10 to 15% premium/commission these third-party hiring agencies typically require, and 4) deal with the contracts between you and the third-party hiring agency and the contracts between the third-party hiring agencies and the employees you want to be hired (because the third-party hiring agency drafts these contracts to protect itself, not your company).

Most importantly, the odds are overwhelming that what is being proposed is illegal in any event and if it isn’t clearly illegal, it will be so disfavored that you could end up getting in trouble anyway. And again, that’s the point. Don’t fight the trend.

3. China Representative Offices. China does not like them and way back in 2010, I wrote a post, entitled, The Slow Death Of The China Rep Office. They are still alive and China still does not like them and they almost never make sense for a foreign company looking to go into China. China does not like them and our China lawyers do not like them because they are legal only under very limited circumstances. Since the Chinese government does not like them, you are at some risk even if you are just on the legal side of the legality/illegality line and you are also always at risk of China’s tightening its Rep Office laws and shutting you down. The trend says don’t do it.

4. Variable Interest Entities/VIEs. Way back in 2011, in VIEs In China. The End Of A Flawed Strategy, we made clear our distaste for VIEs and why our law firm refused to handle that sort of work. This position angered many (especially those who were profiting off VIEs) but our position was based on the strong belief that China would eventually make clear its prohibition against them and at that time those who had gone into China as VIEs would suffer. It took longer than we expected, but it did happen in 2015 and we wrote about that in China VIEs Are Dead. Done. Over. Stick A Fork In Them and as we had predicted, the consequences were dire for many companies. Again, the trend.

As China attorneys, we see our job as more than just knowing what the law says now. Our job also encompasses our knowing how the Chinese government is likely to view what our clients are proposing to do (both now and in the future) and counseling our clients on that as well.

Our job is to help our clients stay on trend.

Your thoughts?

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

One of the questions our China attorneys pretty much never get is the following: I have been using factory X in China for the last seven years to make our widgets and though it was rocky at the start, we eventually built up a great relationship and they have been doing a great job for us for the last five or so years. But the reason I am calling you is because they have asked us about becoming the exclusive China distributer for our widgets and I was wondering whether you think that is a good idea.

Everything but the final question about whether we think it a good idea happens often; the asking us whether it is a good idea is the part that never happens, but maybe it should.

Let me explain.

We are China lawyers, not China business consultants and for that reason we are not the logical people to ask about something like how to choose a distributer in China. But we have been in the China law business for so long that certain things have become obvious to us even though we lack an MBA. And the issues involved in granting an exclusive distributorship to your Chinese manufacturer is just one of those things that is almost always not the best way to go.

But what I usually am thinking (and often say) is something like the following:

I understand that you have a really good relationship with your widget manufacturer and I am not in any way downgrading the value of that, because that is of huge value. But if you are truly serious about maximizing your widget sales in China you maybe should consider whether using your manufacturer as your exclusive distributer is the best way to do that. I say that for two reasons. One, the typical Chinese manufacturer knows zero about consumer marketing, distribution or sales. They know only how to manufacture which is not the same thing. They are usually engineers, not businesspeople or salespeople or logistics people. Two, it is rarely a good idea to grant anyone an exclusive distributorship in China for the simple reason that China is a big country and the odds are slim that the company best at marketing and selling your widgets in Shanghai will be the same company as the company that would be best at doing those things in Chengdu. See China Distribution Agreements: Exclusivity Is NOT Required.

But if you do not want to spend the time and money to find another possible China distributor because all you want is either to keep your manufacturer happy or just make a few extra dollars, then what you are proposing should be fine.

Your thoughts?