China movie quota lawyerWhat a wild ride it’s been for the Chinese film industry! Until July 27, it had been a year of one depressing story after another. Downward-trending box office, high-flying entertainment companies imploding, deals to purchase foreign assets falling through, the biggest movie studio on the planet sold to a real estate developer, the can’t miss co-production The Great Wall tanking. Even the Transformers franchise couldn’t save the day, with the latest installment performing well below expectations in China.

But on July 27, the action film Wolf Warrior 2 opened, and within 12 days of its release it had already become the highest-grossing film of all time in China. As of this writing the film has pulled in more than $720 million in China alone. The narratives are almost writing themselves, with pundits trying to explain why Chinese people are going in droves to see a jingoistic film about a Chinese special forces operative in Africa.

I’m not going to wade into those waters except to note William Goldman’s aphorism that when it comes to the film business, “Nobody knows anything.” The phenomenal success of Wolf Warrior 2 was anything but a foregone conclusion. The first movie was a surprise hit, earning about $89 million, but it’s not like people were lining up Episode 1-style for a sequel. Back in May, Wolf Warrior 2 was pilloried online when it came to light that its trailer had lifted footage from X-Men: First Class. Moreover, Wolf Warrior 2 was released on the same date as the government-backed propaganda film The Founding of an Army, and the latter was allotted the lion’s share of screens.

This movie – this particular movie – couldn’t have come at a better time for China. Hollywood is in the midst of negotiating the terms of foreign (read: Hollywood) films’ market access to China. American studios find China’s protectionism exasperating on multiple levels, with the biggest complaints being (1) the quota system, which only allows 34 foreign films (largely US studio films) each year on a revenue-sharing basis (2) the low percentage of receipts allotted to the foreign studio (currently 25%) for such revenue-sharing films, and (3) the foreign studio’s inability to control the release date. The last point is more serious than might immediately be apparent – not only does the Chinese government determine when each film will be released (via a largely opaque process), it also imposes unofficial blackouts during which no new foreign films are allowed to be released.

Aside from discussions about WTO obligations and fair play, US studios’ best argument for expanding access to the Chinese film market has been an economic one: Chinese audiences want to see American movies (and don’t particularly want to see Chinese movies), and with thousands of new screens every year, Chinese movie theaters need movies people want to see. In other words, limiting the number of American movies hurts the Chinese economy.

Setting aside the fallacy that the Chinese government’s interests are aligned with those of Chinese theater owners, the success of Wolf Warrior 2 upends all of those arguments. Wolf Warrior 2 was released on the first day of a blackout period, and it is already the most successful movie in Chinese history. It is a Chinese-made movie, with purely (even exclusively) Chinese content, and Chinese theaters are raking in the money – and not having to send any of it overseas. The Chinese government will likely infer that Wolf Warrior 2’s success is not in spite of their protectionist policies, but because of them. And President Trump’s saber-rattling about a trade war isn’t likely to improve their attitude.

I certainly hope the U.S. negotiating team is able to make some headway, but U.S. studios and production companies shouldn’t assume anything. They need a backup plan, and right now the best one seems to be investing in and otherwise creating productions in China solely for the Chinese market. A number of studios and production companies are already going down this road, and I think it’s the smart play. Better to be an investor in the next Wolf Warrior than to be shut out completely.

China trademark registration
Do these look similar to you? Because they sure do to me.

We first wrote about the Under Armour vs. Uncle Martian dispute last May. At the time it seemed like just another story about a blatant Chinese ripoff, destined to be forgotten with the next month’s news cycle. But the story has kept on going, and was back in the news recently with the report that Under Armour had conclusively prevailed in its trademark infringement case against Tingfeilong Sporting Goods, the Chinese sports manufacturer behind the “Uncle Martian” brand.

According to Under Armour’s lawyers, on June 19, 2017 the Fujian People’s Higher Court issued an injunction requiring Tingfeilong to stop using the infringing “Uncle Martian” trademarks, destroy all infringing products, pay RMB 2,000,000 in damages, and publish a statement to “eliminate the adverse effect” of its infringement. This ruling followed a preliminary injunction issued on November 2, 2016.

The court’s ruling is surprising in two ways. First, it’s surprising that the court issued an injunction at all. Chinese courts are known for being reluctant to issue injunctions because they don’t have the same enforcement power as U.S. courts (China has no equivalent of the U.S. Marshals Service), and issuing an injunction that they know will be ignored just makes them appear weak.

Second, it’s surprising that Tingfeilong continued using its Uncle Martian logo — the infringement is about as blatant as you can get short of an outright copy, and the social media commentary in China was withering. When I wrote about this case last year, I speculated that Tingfeilong’s strategy was to get a bunch of free publicity for their cheesy product launch and the “Uncle Martian” name, then quietly drop the infringing logo and continue selling products using the “Uncle Martian” name. That may still be their strategy, but the penalty may be enough to put them out of business. Assuming they end up paying it. Tingfeilong has appealed the June 19 ruling, and I could imagine a settlement that involves Tingfeilong agreeing not to use the infringing logo so long as they can still use the “Uncle Martian” word mark. Or maybe other shenanigans are afoot – according to the CTMO website, the “Uncle Martian” word marks are now owned by another Chinese company, Quanzhou Changwan Trading Co. (泉州昌万贸易有限公司).

In an interview with Law360, Under Armour’s US counsel offered three lessons from the case. I’ve paraphrased those lessons below in underlined text, with my further comments afterward in italics.

  1. Chinese courts are willing to grant injunctions. Obviously this case is a step in the right direction, but one case is hardly enough to establish a trend. China is not a common law system and a ruling by the Fujian Higher People’s Court’s does not set a precedent. That we even have to discuss this point is noteworthy; in any court system providing meaningful injunctive relief, this case would be a slam-dunk. But it’s not the case that this sort of relief will be readily and easily available. As I understand it, the key to this case is the significant and indisputable evidence of infringement presented by Under Armour at the time it requested an injunction. To submit that amount of evidence takes a lot of time and effort – it’s not just pasting a bunch of screenshots into a complaint. Note that the Uncle Martian knockoffs were first announced last April, and the preliminary injunction wasn’t issued until November. I’m sure Under Armour would have loved to have a TRO in May – as would have happened in the US or EU — but there’s no way they could have prepared the evidence in time.
  2. Local counsel is crucial. Unquestionably true. Non-Chinese firms are not allowed to practice law in China, so it is legally impossible to proceed without a Chinese local counsel. And as with any case here in the US, the better the local counsel, the better your odds. But as the Law360 article implies, to an increasing degree in China what makes local counsel “good” is not their connections with local government officials or their guanxi but rather their expertise in the legal field at issue. That is: if you have a trademark infringement case, hire a firm that excels at IP and has a history with those cases. 
  3. Chinese courts outside Beijing, Shanghai, and Shenzhen are issuing sophisticated, consistent legal rulings. Again, though this ruling is certainly a step in the right direction, one ruling does not make a trend. And the facts in this case were pretty much served up on a silver platter for the court. It would be a stretch to call this a sophisticated ruling, when it was obvious to just about everyone who commented on social media that this was trademark infringement. Another key point is that if you want any shot at enforcing a court ruling in China, you need to file your case in a court with jurisdiction over the defendant. If the company knocking off your products is based in Xi’an, you probably will need to file in Xi’an, like it or not. It should go without saying that you will be better off filing in a second tier city court that has jurisdiction than getting your case tossed out of a court in Shanghai for lack of jurisdiction. 

I would add one additional takeaway, which is implicit in the commentary on the Uncle Martian ruling and hopefully second nature to anyone reading this blog. The only reason Under Armour was even in a position to file this lawsuit was because Under Armour had already registered its trademarks in China. This was not a case of an American company trying to prove that its trademarks were famous in China; this was simply a company enforcing its trademark rights that already existed.

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.

We work with a number of clients who have goods manufactured in China – everything from plastic beach balls to sophisticated home electronics. We provide those clients with a wide range of business and legal advice, and often also end up drafting agreements for them: NNN agreements, development agreements, mold agreements, manufacturing agreements, and more. In the course of assisting these clients, many will ask if we can help them find a factory to manufacture their products.

The answer is no. First, it could end up being a conflict of interest (or at least appearing like one) if we have a relationship with both sides of a transaction. Even if both parties agree with full disclosure, it’s rarely worth the hassle. Second, recommending factories is outside our expertise. Even though we have done deals with hundreds of factories in China, there are exponentially more that we haven’t even heard about. Why would we? We’re lawyers, not sourcing agents.That said, we are always happy to recommend to our clients sourcing agents with whom we have worked and respect.

But China factories? Nope.

China Due DiligenceLast week the news broke that Dalian Wanda, the powerful Chinese real estate developer and entertainment company, was selling off its half-built movie studio, a massive complex under construction near Qingdao.

It was the latest in a string of bad news days for Wanda, most of which have been precipitated by the Chinese government’s increasingly strict controls on outbound investment. Wanda’s $1B purchase of Dick Clark Productions fell through in March of this year. The chairman/CEO and the head of China operations of Legendary Entertainment, the film production company that Wanda bought in 2016 for $3.5B, both left this year and have yet to be replaced. Legendary’s recent films (with the exception of Kong: Skull Island) have tanked everywhere but China. Wanda quietly withdrew its attempt to fold Legendary into its existing film operations and list the reformulated company on a Chinese stock exchange. Wanda announced an ignominious sale of its theme parks less than a year after announcing Wanda was going to clean Disney’s clock.

And looming over it all, the Chinese government has made it clear – in increasingly public fashion – that Wanda’s ability to borrow money will be highly constrained.

Both Legendary and Wanda’s subsidiary AMC Theaters issued public statements in the past week that they were not dependent on Wanda for funding; the Western markets were not impressed.

No doubt many people in Hollywood are engaging in a bit of schadenfreude right now. Wang Jianlin, the founder and chairman of Wanda, is a bit like the LaVar Ball of Chinese entertainment (albeit with $30 billion more to his name). He was brash, but plenty of people wanted to do a deal with him when he had assets to burn and was talking about taking a stake in every major studio. Now they’re not sure what to think.

I don’t feel any joy at Wanda’s apparent retreat from the movie business, if that is in fact what’s happening. Yes, they’ve had substantial setbacks and remain highly leveraged, but Wanda is still a huge company and a major player in real estate development, which has always been its core business. It controls more movie screens than any other company in the world, and it still has a sizable film production division. Wang is a shrewd businessman and not to be underestimated. You don’t get to be the richest man in China without having a lot on the ball. Everyone thought he had overpaid for AMC Cinemas but the company has more than doubled in value since he bought it.

But Wanda’s proposed studio in Qingdao never made much sense to me. I lived in Qingdao, and it is a wonderful city. But it has scant connection with the Chinese film industry, and little to recommend it as the site of the world’s largest studio. Wanda promised moviemaking on a grand scale, including enormous soundstages, multiple backlots, and a 40% subsidy for anyone making a movie there. But the reality on the ground never seemed to match the rhetoric, and few (if any) filmmakers not associated with Wanda or Legendary have filmed there.

What was the reality on the ground in Qingdao, anyway? My colleague Steve Dickinson (who spent nearly a decade in Qingdao) and I could never figure it out. The studio complex is almost an hour’s drive south of the city proper, with nothing of note in between but for a few factories. When we visited the site a few years ago, you would never have known that a huge film studio was being built. It just seemed like a pure real estate play: swarms of agents descended on anyone who got close, thrusting brochures for as-yet unbuilt apartment towers. Tour buses stopped by regularly and disgorged passengers who had no knowledge of, or interest in, the studio. And this was well after the glitzy announcement with Nicole Kidman, Leonardo DiCaprio, and John Travolta in Qingdao.

The Qingdao studio complex is now being sold to Sunac, another Chinese developer. Will the studio be completed by Sunac? Was it ever going to be completed? Who knows? Wanda certainly had the money to build it, and Wang loves movies. The ultrawealthy have a long history of bankrolling films, from Howard Hughes up to Megan Ellison. Perhaps this is just a strategic retrenchment. Wanda’s strategy with the Qingdao studio complex wasn’t much different from that of many Hollywood players: if you can’t sell the steak, sell the sizzle.

The recent headlines characterize Wanda’s troubles as if they were the result of poor business judgment. I don’t think that’s fair. This story isn’t about Wanda. It’s really a story about China’s reluctance to let foreign entertainment companies compete in a free market. Just look at what’s happening in Chinese movie theaters right now. A foreign movie blackout is in place, and the screens are being inundated with The Founding of an Army, directed by Hong Kong legend Andrew Lau (Infernal Affairs, which Martin Scorsese remade as The Departed) and starring a cavalcade of Chinese stars both young and old. If history is any guide, The Founding of an Army is guaranteed to do big business at the China box office, regardless of how many people actually see it. For the previous two movies in this series (The Founding of a Nation and The Founding of a Party), state-owned enterprises bought vast blocks of tickets for their employees.

One takeaway from all of this is that foreign entertainment companies (and even just foreign companies in general) need to be more careful than ever when dealing with Chinese counterparties. If the Chinese government interferes directly there’s little you can do, but up to that point you can do a lot to protect yourself. Just look at all the lawsuits being filed in Los Angeles against Chinese production companies – lawsuits which may be doomed to failure, because even if the plaintiff wins, the judgment won’t be enforceable in China.

Conduct due diligence. Make sure your contracts are written in Chinese and enforceable under Chinese law. Get an upfront payment so you can be sure the Chinese side can actually pay under the contract. And if something sounds too good to be true (like the 40% subsidy for filming in Qingdao), it probably is.

China CopyrightWhen I was growing up, I watched a lot of television. A LOT. I was a latchkey kid and every day after school my brother and I would come home and turn on KTVU and watch TV Powww! and Captain Cosmic shows like Ultraman. Ultraman, if you don’t know (Philistine!), was a Japanese science-fiction show that ran from 1966-67 but, much like Star Trek, circulated widely in reruns (leading to numerous remakes, spinoffs and movies) and had an outsize influence on subsequent sci-fi pop culture.

So when I read last week’s China Film Insider story about an allegedly unauthorized Ultraman film being produced in China, it felt like a personal insult. A Chinese fan-created Ultraman movie a la Axanar would be amazing, but the producer of this film, Chinese film company Blue Arc Animation, is just making a blatant ripoff.

Or are they?

Japanese company Tsuburaya Productions Co. Ltd., the creator of Ultraman, alleges that Blue Arc Animation has no right to make an Ultraman film in China. But Blue Arc contends that they got the rights from UM Corporation, another Japanese company. And UM Corporation contends that they own all foreign rights based on an alleged 1976 agreement in which Tsuburaya’s president Noboru Tsuburaya granted to Thai filmmaker Sompote Saengduenchai the exclusive, perpetual foreign rights to Ultraman. Sompote’s rights were then assigned to his son Perasit Saengduenchai, who in turn transferred them to UM Corporation, who in turn has licensed the rights to a number of companies all over the world.

Tsuburuya has consistently held that the 1976 agreement is a forgery, not least because Sompote didn’t even mention the existence of such an agreement until 1995, after Noboru Tsuburaya had passed away. The dispute has led to a number of lawsuits between Tsuburuya on the one hand, and Sompote and his successors in interest on the other. Back in the mid 2000s, Tsuburuya won several victories in Thai and Japanese courts, which seemed to bring things to a close, but not so much. The victories were only partial victories, and the key piece of evidence in Sompote’s favor is that the 1976 agreement, despite having a number of inaccuracies and other indicia of inauthenticity, was nonetheless chopped with Tsuburuya’s company seal. And so the litigation has continued. Most recently, UM Corporation sued Tsuburuya in a Los Angeles federal court on May 19, 2015, alleging copyright infringement, breach of contract, and intentional interference with contractual relations. I just checked the docket and the case, staffed by a number of big-firm LA litigators, is still going strong.

What does all this have to do with China? First of all, this should be a wakeup call for anyone with a Chinese entity who thinks they don’t need to know where their company seal is at all times.

Second, it’s an example of how NOT to license copyrighted content in China. What sort of due diligence did Blue Arc Animation conduct regarding the rights they were allegedly getting from UM Corporation? We have conducted due diligence on numerous film projects in China and our efforts have saved more than one high-profile project from guaranteed litigation over the source material.

Chinese courts are getting better and better about enforcing copyrights. The dispute between Tsuburuya and Blue Arc Animation hasn’t resulted in a lawsuit in China – yet – but Blue Arc Animation has to be wondering what, exactly they have gotten themselves into. Are the Ultraman copyrights registered in China under either their name or the name of UM Corporation? Do they have a licensing agreement with UM Corporation written in Chinese and enforceable under Chinese law? Is the licensing agreement registered with the Copyright Protection Centre of China? Unless the answer to all of these questions is “yes,” Blue Arc Animation will be hard pressed to prove that they have any rights at all. (And meanwhile, if Tsuburuya hasn’t already registered all relevant copyrights for Ultraman in China, shame on them.)

If you’re going to spend millions of dollars on a film project (or even just tens of thousands, as may be the case here), don’t buy a pig in a poke.

China patents and China copyrights
  Who owns your China IP? Get it in writing.

Conceptually, the basis of the “work made for hire” (often shortened to “work for hire”) doctrine is clear: employers should own (some) rights to work created by their employees, whether such work is protectable by copyright, patent, or some other IP right.

But legally, it’s as clear as mud. The “work for hire” doctrine actually only applies to copyrights. Patents are covered by the “hired to invent” and “shop rights” doctrines in the US, and by the “invention for hire” doctrine in China. And though the patent doctrines have some similarity with the respective copyright doctrines, they are not the same. Not even close.

Legal scholars have explored in some detail why copyrights and patents for employee-created work are treated differently in the U.S. (see here and here), and make the credible argument that a uniform doctrine should apply to both forms of IP. I am unaware of similar scholarship explaining why copyrights and patents are treated differently in China, but note that modern Chinese IP law is based on Western models, and was largely adopted as part of China’s (relatively) recent accession to the WTO. Suffice it to say, the default rules regarding copyrights and patents for employee-created work are different under both Chinese and U.S. law, and employers need to understand those differences or be caught unawares when it comes time to enforce their IP rights.

As I explained a couple months ago in this space, Chinese copyright law is quite employee-friendly.

Per Article 16 of the Copyright Law and Article 13 of the Regulations for the Protection of Computer Software, the default rule in China is that an employee will own the copyright to anything they create during the course of employment, except for (1) “drawings of engineering designs and product designs, maps, computer software and other works which are created in the course of employment mainly with the material and technical resources” of the employer and (2) computer software developed at the employer’s direction or as an inevitable consequence of the employee’s job description. For all other works, the employee will own the copyright; the employer has a two-year exclusive license to use the copyrighted material, and thereafter a non-exclusive license.

If an employer (say, a WFOE) wants a different rule to apply to its employees’ creations, it needs specific language in a signed contract with the employee that assigns all rights in any “work for hire” to the employer. Such contract should be in Chinese and governed by Chinese law, and signed at the beginning of employment.

Chinese patent law, by contrast, is rather employer-friendly.

Per Article 6 of the Patent Law and Rule 12 of the Implementing Rules of the Patent Law, the default rule in China is that an employer will own the patent rights to any invention for hire, which includes any invention created: (1) within the scope of employment, (2) outside the scope of employment but nonetheless assigned by the employer as a task, (3) within one year after the end of employment and satisfying either of the two previous conditions, or (4) mainly by using the employer’s resources. In other words, pretty much everything.

Employers do not need to sign a specific agreement with employees to own the patent rights to such inventions; nonetheless, it is always a good idea to do so, to avoid any confusion. If you’re an employer, the last thing you want is an argument with your employees about whether their creation is an invention protected by patent (and therefore your property) or a creative work protected by copyright (and therefore their property).

The bottom line is that all employers in China involved in creative work should enter into a comprehensive IP ownership agreement with each employee at the beginning of employment. The agreement should be in Chinese and governed by Chinese law, and should unequivocally establish the employer’s ownership of any works created by the employee, whether governed by copyright, patent, or otherwise. Putting all this in writing will protect the employer’s rights, and just as importantly, it will make those rights clear to both sides. A well-drafted agreement can stop a dispute before it even arises.

China WFOE formation
China WFOE formations: It’s funny because it’s true

Those of us who do China WFOE formation work must constantly fight the temptation to use the sort of hackneyed phrasing usually found in inspirational corporate desk calendars, tech startups’ mission statements, and ironically titled albums on Bandcamp. “Expect the unexpected.” “Embrace the contradiction.” “Winners never quit. Quitters never win.” But WFOE work can be so frustrating and counterintuitive that speaking in clichés often seems like the only appropriate response. Dignifying the Chinese authorities’ actions with measured analysis and rational thought is a path to madness, or at least extreme frustration.

The latest annoyance is that during the WFOE formation process, an increasing number of districts (even in China’s largest cities) are requiring the WFOE’s legal representative appear in person at the Public Security Bureau (PSB), passport in hand, to prove their identity. Setting aside the inefficiency of requiring a personal appearance, what makes this request truly bizarre is that the same local authorities have already required the legal representative submit an authenticated copy of their passport. The exact procedure for producing an authenticated passport copy can vary by state, but a typical example would be as follows:

  1. The WFOE’s legal representative goes to a notary public, photocopies their passport, and signs the photocopy in front of the notary.
  2. The notary then signs and stamps the photocopy.
  3. The notarized photocopy then goes to the county clerk’s office of the county in which the notary is commissioned, which produces a written document with a seal confirming that the notary is in fact a commissioned notary public.
  4. That document then goes to the Secretary of State of the state in which the county is located, which produces another written document confirming that the county clerk is in fact the official county clerk of that county.
  5. That document then goes to the U.S Department of State, which produces another written document confirming that the Secretary of State of the relevant state is in fact the duly elected official of that state.
  6. That document then goes to the Chinese Embassy in Washington, DC, which affixes a certificate on the back of the U.S. Department of State documents, authenticating that the documents were in fact created by the U.S. Department of State.

This process usually takes several weeks and costs a few hundred dollars, assuming everything goes smoothly. The procedures for countries in Europe are roughly similar.

The purported reason China requires so much rigmarole to prove the identity of the legal representative is because they receive so many forged documents, and the Chinese Embassy’s imprimatur is the only way to confirm authenticity.

See if you can guess why we are now being asked to produce the legal representative in person. Remember the clichés at the beginning. And … wait for it … yes, it’s because the Chinese authorities allege they have been receiving counterfeit Chinese Embassy authentications.

At its very core, this new procedure makes no sense. My colleague Steve Dickinson doesn’t get it either, noting: “The whole point of Embassy authentication is to guarantee the authenticity of the document: local country notarization and then embassy authentication is the “gold seal” for guarantee of document authenticity. If the PRC abandons that international practice due to its massive internal corruption, then the whole system China created to deal with these issues will collapse. No one benefits from that.“

The bottom line is that in to form a WFOE, the parent company will likely need to make the WFOE’s legal representative available to spend a couple weeks in China to make a personal appearance at one or more government agencies, producing their passport and signing documents as necessary. If the parent company is unable or unwilling to make the legal representative available, they take the risk of having their WFOE formation delayed, or perhaps even cancelled. Our lawyers in China, along with our local agent, are working hard to try to find a solution to this and there is at least a decent chance that we will. Yet this requirement seems to be spreading and based on the way things so often go in China, this requirement could very well become entrenched (or not) in the near future.

Ultimately, the only way to stay sane if you do WFOE formations is to keep a sense of humor about the process. You could get angry, but what’s the point? Like Homer Simpson says, “It’s funny because it’s true.”

China FapiaoI’m interrupting my series on grey market goods on China to discuss the new fapiao (tax invoice) system that came into effect on July 1, 2017. Though this new system is not directly aimed at grey market goods, it may nonetheless have an indirect effect.

A fapiao (发票) is both a receipt (i.e., proof of purchase) and a tax invoice (i.e., a way to determine the tax paid on a given transaction). Under the previous system, a buyer of goods or services in China simply had to provide its legally registered name (i.e., the name listed on its business license) to receive a valid fapiao from the seller. Abuse of the system was widespread; fapiaos were often inaccurate both in terms of amount and in the description of what was sold.

The new system imposes several additional rules, including the following:

  1. The fapiao must specify the goods or services being provided.
  2. The fapiao must bear a special fapiao chop from the seller.
  3. The buyer must provide its tax identification code or unified social credit code.
  4. Sellers/issuers of fapiao must link their internal fapiao data with the government to ensure that when the buyers/recipients of fapiao file their taxes, the amounts and the descriptions match up.

It’s hard to say with specificity whom the new requirements are aimed at, in part because there are so many potential targets. But on a certain level, this new rule should be viewed as part of China’s escalating clampdown on capital flight and tax avoidance.

One of the major ways Chinese factory owners get money out of China is to create a Hong Kong shell company and then route all payments for manufacturing at the mainland China factories to that Hong Kong company. The Hong Kong dollar is not regulated in the same way as the Chinese renminbi, and once money is in a Hong Kong account, it can be moved offshore with relative ease. There’s nothing illegal about this process per se, so long as the payments in Hong Kong are declared as income by the Chinese factory that actually did the manufacturing. I’ll leave it as an exercise for the reader to guess how often that happens.

A variation of this scheme is the overinvoicing of products imported into China from Hong Kong. For example, a shipment of goods valued at $100 would be invoiced at $1000. The Chinese company sends the full $1000 to Hong Kong, and the Hong Kong exporter deposits the difference (i.e., $900) in the Chinese factory owner’s Hong Kong bank account, less a service fee. Presto! $900 has been moved offshore. And the goods at issue have been transformed into grey market goods.

How will the new fapiao system affect foreign companies operating in China, especially WFOEs? For those already scrupulously following the rules, things shouldn’t change that much: a minor, but manageable increase in paperwork and logistics overhead. But WFOEs will need to be even more attentive when procuring or preparing fapiao. This puts more pressure on the general manager to oversee operations, especially staff who regularly deal with fapiaos (like sales agents). Easier said than done. It also puts more pressure on the parent company to appoint a general manager who is both (1) trustworthy and (2) understands that the parent company isn’t just giving lip service when it says it wants to follow the rules. And it puts more pressure on the entity handling the WFOE’s accounting and tax reporting. I don’t think that every WFOE needs to go out and hire a Big Four Accounting firm, but the WFOEs that have been doing it all themselves may want to rethink their strategy and hire an outside accounting firm. I know I would.

Grey Market Goods and ChinaIn this projected 4-part series we’ll take a closer look at grey market goods and China. In part 1, we discussed what grey market goods are and why manufacturers get so worked up about them. Today, in part 2, we’ll look at how grey market goods are regulated in China. In part 3, we’ll look at how grey market goods are regulated in the United States. And in part 4, we’ll look at grey market goods and Chinese factories, and what foreign companies can do to protect themselves.

Part 2: How Are Grey Market Goods Regulated in China?

One of the minor mysteries of modern China is how every mall has so many luxury-brand stores that seem never to have anyone shopping inside. I’ve read numerous explanations for this disparity, none of them entirely satisfactory: the shops are loss leaders in an effort to build brand loyalty in China; the shops are highly subsidized by mall owners to bring in other tenants and/or to give them face; all of the sales are made after hours to Party officials’ relatives and mistresses; people just aren’t paying attention at the right time.

But one answer for the empty stores, surely, is the enormous size of China’s grey market for luxury goods. In 2015, Chinese citizens spent $22.5 billion on luxury goods purchased in China – and more than twice that amount abroad.

As noted in part 1, grey market goods exist because there’s a market for them, and that market exists because grey market goods are either cheaper or have better availability. But in China there’s a third driver of the grey market: quality. It’s ironic because in the US, grey market goods have a strong whiff of caveat emptor; if you buy a product outside the normal channels you accept the risk that it might be lower quality. But in China, the calculus is flipped: because counterfeiting is so rampant, the chance of buying a fake is considered to be much lower if the goods come from overseas.

Historically, a significant proportion of grey market luxury goods in China have come via daigou, personal shoppers (usually young Chinese women) who live or travel overseas and purchase luxury goods for well-heeled clients in China. I’ve seen this in action: at Seattle Premium Outlets’ Burberry Store, you sometimes have to wait in line just to get in the store, only to be ignored when it becomes clear you’re not there to drop twenty thousand bucks.

Other grey market goods in China are purchased directly by consumers, either while traveling overseas, or from foreign reseller sites like eBay. Grey market goods can also be found on Chinese e-commerce sites like Taobao and 1688.com; these goods are usually purchased “on spec” overseas and then resold in China. (The daigou as impersonal shopper.) Baby formula and iPhones have, at various times, been extremely popular grey market goods in China.

Grey market goods are legal in China, or at least not an infringement of the brand owner’s IP rights. Indeed, Shanghai’s Free Trade Zone has a car dealership that specializes in grey market automobiles.

But many grey market goods in China run afoul of the law in another way: customs fraud. When the goods are brought into China, they are not declared at all or are declared at lower values. Defrauding Chinese customs is an essential part of many a daigou’s profit margin, because China has historically imposed significant duties on a range of luxury imports.

China has attempted to crack down on illegal grey market importation through a number of means, including (1) higher taxes on goods brought in by travelers as part of their luggage, (2) lower taxes on goods imported through legitimate channels; and (3) increased penalties for those caught falsifying customs declarations.

The effectiveness of these measures is a bit hard to gauge: some reports say the measures are eliminating large-scale daigous; others suggest that the enforcement is both haphazard and overbroad, and that when Chinese people attempt to order directly from overseas retailers, the packages are frequently rejected at the border, with the result being that people are even more reliant on daigous to get the products they want.

On a certain level, foreign brand owners might not be that concerned about grey market imports in China – Christian Louboutin gets paid whether a pair of pumps is bought in Shanghai or in Houston and then taken to Shanghai and resold. But they should be concerned, for several reasons. First, they want to be seen as cooperating with the Chinese government on tax and customs issues. Second, having to deal with so many purchases by Chinese travelers overseas is a drain on resources (staffing, marketing, logistics) and distorts the worldwide revenue stream. Third, sometimes the prices in China, even accounting for taxes and tariffs, are higher than they are abroad — although a number of brands have normalized prices in China in an attempt to dissuade gray market sales. Fourth, the daigou phenomenon increases the amount of intermediation between brands and their consumers, which is exactly the opposite of what companies want. How can you market to customers when you don’t know who they are? And how can you control your brand identity when you are not the seller?

In part 3 of this series, we’ll look at how the United States regulates grey market goods.

Grey Market GoodsIn this projected 4-part series we’ll take a closer look at grey market goods and China. In part 1, we’ll consider what grey market goods are and why manufacturers get so worked up about them. In part 2, we’ll look at how grey market goods are regulated in China. In part 3 we’ll look at how grey market goods are regulated in the United States. And in part 4, we’ll look at grey market goods and Chinese factories, and what foreign companies can do to protect themselves.

Part 1: What are grey market goods, and why do they matter?

Grey market goods are authentic goods sold by unauthorized means. Unauthorized does not necessarily mean illegal; it simply means the goods are coming from someone other than (1) the original manufacturer or (2) a third party to whom the manufacturer has granted permission to resell the goods.

E-commerce has made all manner of grey market goods readily available. When I purchase Gillette razor blades on Amazon for delivery in the United States, the cheapest sellers are all offering grey market blades packaged for sale overseas (typically, Asia, Eastern Europe or South America). Although it’s unclear if these blades are exactly the same as what I would buy at a drugstore in the U.S., the price difference is significant enough that I’m willing to take the chance. And that’s just one example. Any product that has a significant difference in price or availability across different countries is likely to be sold on the grey market. And the flow of goods could go in any direction; it just depends on price and the demand. As China’s consumer class has grown in strength, so has the market for grey market goods. Products as disparate as Apple’s iPhone and Pfizer’s Viagra did significant business in China as grey market goods before they were officially available there.

Grey market goods are hardly a creation of the Internet, though.

A Vancouver, BC man named Michael Hallatt grew tired of waiting for Trader Joe’s to come to Canada, and since 2012 he has operated a store in Vancouver called Pirate Joe’s that stocks nothing but goods bought at Trader Joe’s stores in Washington State. All of the goods are purchased at retail prices in Washington and then marked up for sale in Canada. Trader Joe’s has been trying to shut Hallatt down for years, and has sued him for trademark infringement, unfair competition, false designation of origin, and false advertising.

Two weeks ago Pirate Joe’s announced it was closing its doors, which would have made the lawsuit moot, but at the end of last week Hallatt reversed course and announced on the PJ’s website that he was back in business. What makes Pirate Joe’s story interesting for IP attorneys is how it calls into question the limits of grey market sales. Hallatt certainly seems to enjoy tweaking Trader Joe’s and skirting the edge of the doctrine, but as the Freakonomics blog pointed out in 2013, reselling Trader Joe’s goods is no different than reselling goods on eBay or at a yard sale. The case is still pending.

In another well-known story, Costco purchased large quantities of Omega Seamaster watches from an authorized reseller in Europe, then resold them in the U.S. as grey market goods. Because the prices in Europe were so much cheaper than the retail prices in the U.S., Costco was able to add its usual markup and still price the watches at a substantial discount. Omega sued, but after a protracted battle, Costco prevailed in 2015.

It may be self-evident that the reason grey market goods exist is because there’s a market for them: grey market goods are either cheaper than the goods available through standard channels (e.g., the Omega watches at Costco and the Gillette razor blades on Amazon) or they are simply unavailable through standard channels (e.g., the goods at Pirate Joe’s). A reasonable argument can be made that grey market goods are in fact good for many manufacturers, because they increase brand recognition and product loyalty. And profits! All of these products have been sold by the manufacturer at a price (if not a use) they deemed acceptable.

Nonetheless, grey market goods are often decried by original manufacturers for reasons including the following:

  1. Grey market goods are often difficult to distinguish from counterfeit goods, which harms the reputation of the brand and the manufacturer.
  2. Grey market goods are often customized for the particular market for which they are made, and are unsuitable for use in other markets. This too harms the reputation of the brand and the manufacturer.
  3. Grey market goods often have different warranty protection — or none at all — when sold or used outside the market for which they were made. This causes customer frustration and dissatisfaction.
  4. Grey market goods sometimes are of lower quality (hence the lower price), which harms the reputation of the brand and the manufacturer.
  5. Grey market goods often interfere with the business expectations of the original manufacturer and its licensees.

In Part 2 of this series, we’ll examine how China regulates grey market goods.