Basics of China Business Law

China employment lawyers
China employment law: it’s a maze out there.

It is usually very difficult to back out of or even change a China employment contract once a China employment contract has been signed, it is particularly difficult for the employer to unilaterally change any of its terms, especially the important terms such as the employee’s wages and position. China employers that try to change employment contracts often find themselves in arbitration or in court, paying legal fees and fighting against damages and oftentimes bad publicity as well.

A case in Zhejiang province illustrates the difficulties employers can face when they try to change an employee contract. In this case, the employer and an employee entered into a fixed-term employment contract that was to run from April 2012 until April 2015. The contract stated the employee’s position as assistant to the general manager, with pre-tax monthly wages set at 11,000 RMB. The contract also provided that if the employee met certain evaluation criteria at the end of the calendar year, he would get an additional 30% in monthly wages, which would make his annual wage 190,000 RMB. In July 2013, the employer unilaterally demoted the employee to HR administrative staff and reduced his monthly wage to about 3800 RMB. The employee handed over his unfinished tasks to his colleague immediately after he learned of this decision and filed for labor arbitration the very next day. The following month, the employer issued a written decision terminating this employee’s contract on the basis that he had failed to show up at work for six consecutive days.

The employer’s policy stated that employees would receive periodic evaluations (with A being the highest score, and E the lowest) and if an employee received 2 Ds or 3 Cs or 1 E during a 6-month period, the employer would consider the employee incompetent at his/her current position, and would then have the right to demote or adjust the employee’s position and reduce or adjust the employee’s pay.

The employer argued that the demotion of this employee was because of poor evaluation results: the employee had received three Ds three months in a row, from April 2013 to June 2013. However, the court said that because the evaluations conducted concerned the employee’s fundamental rights, including labor remuneration and work position, the employer must come forward with definitive and strong evidence to justify the demotion and salary reduction. The court ruled that it was inappropriate for the employer to make such significant changes based solely on three poor evaluation sheets and the evidence supporting the employer’s unilateral decision was not sufficient.

The employer also argued that even though it unilaterally amended the employment contract, it did not give the employee the right to unilaterally terminate the contract without prior notice and if the employee had wanted to terminate the contract, he should have given 30 days’ written notice, his failure to provide such notice constituted absenteeism justifying his terminating for failing to show up at work for several consecutive days. The court did not side with the employer on these arguments either, finding that because the employer had received notice of the employee’s labor arbitration claim it had no basis for issuing a termination notice based on the employee’s not showing up at work.

The court held that an employer may in some circumstances amend an employment contract, but amendment of significant issues such as an employee’s salary or work position should be done through mutual consultation. The court also stated that under ordinary circumstances an employee must give 30 days’ written notice for unilateral termination, that was not the case here since the employer unilaterally amended essential employment terms without first consulting with the employee, where the employer had failed to provide the labor conditions or protections required by Article 38 of the PRC Labor Contract Law. According to the court, the employee had every right to unilaterally terminate his employment contract without notice. As expected, the court also held that the employer’s inappropriate conduct was the basis for the employee’s departure and the employer must pay severance to the employee.

The employee also brought a claim for 30% of his wages from January through July; which according to his contract, he would be entitled to receive only if he passed the year-end evaluation. The court ruled that because the employee had to leave his employment because of employer abuse, he could not receive his year-end evaluation and for that reason, the employer must pay the full amount of the employee’s wages, including the 30% bonus. Long story short, the employer lost big time.

Even though unilateral salary reduction is possible in China, there are many hoops to jump through to accomplish this and the evidentiary burden for an employer to succeed with this is quite high. This case is yet another instance showing how Chinese courts are very protective of employees’ basic rights.

Bottom line: You as employer need to think long and hard before you take any unilateral action involving your employees in China. Unilateral amendment of an employment contract is just as difficult and risky as unilateral termination of an employee and it rarely is the most effective solution to employee problems. As Confucius said, more haste, less speed (欲速则不达). Or as our China employment lawyers are always telling our clients, please, please, please come to us before you make your employment decisions, not after!

 

Employee probationChina employee probation is one of the most often misunderstood China employment law issues. Many employers understand employee termination in China is difficult because China is not an employment-at-will country. But far too many wrongly believe things are otherwise for employees still on probation. Needless to say, this mistaken belief often leads to big problems.

Consider this scenario: an employer hires an employee on January 1st and sets a 2-month probation period, well within the legal maximum probation period. The employer conducts employee evaluations and carefully preserves evidence demonstrating the employee’s failure to meet the conditions of employment clearly specified in the employment contract. The employment contract was in Chinese and was properly executed by both parties. In other words, everything has been done right. But then the employer sends the employee his termination notice on March 1, one day after the employee’s probation period ended.

Should this employee pursue a claim against its former employee, what will happen will depend on the locale, but many courts in China will rule that the employer’s late termination notice means it cannot use “failure to meet the conditions of employment during the probation period” as a basis for unilateral termination without severance pay. This scenario is based on real cases and shows both how technical China’s courts can be when it comes to employee protections and how one day does make a difference!

Clever employers will argue that even though it notified the employee of its termination decision after the probation period had ended, its reasons for such termination occurred DURING the probation period, so it should not lose on a technicality. But this “technicality” matters for purposes of China employment law. Over two decades ago, after receiving a request from a provincial labor department seeking guidance on how to determine an employer’s right to terminate an employee for failing to meet the conditions of employment during the probation period, China’s Office of the Ministry of Labor issued a formal reply stating that after the probation period has passed, an employer cannot use probationary rules as grounds for terminating a labor contract. Many China courts still either explicitly or implicitly abide by this guidance statement.

Probation issues tend to be rife at foreign companies in China and our employer audits invariably reveal such problems. The issue goes beyond making sure you terminate an employee before the probation period ends. It is important you also check your overall HR practices regarding  probation periods across your organization. Are you using probation correctly? Are you setting your probation periods so short as to make employee terminations practically impossible? Are you preserving the evidence necessary to support a termination? If you don’t fully understand how employee probation actually works in China, you may end up worse off making your termination based on that as opposed to just waiting.

China lawyersIn my first post on payments from China, I discussed the risk that payments from China will not be made due to failure to obtain approval from the transmitting bank or from the Chinese government. In this and my next post, I will discuss the general ways to mitigate those risks. In this post I will discuss the basic principles. In my follow up post, I will give specific examples keyed to the four basic types of transactions I outlined in the first post.

The basic rules for dealing with payments from Chinese entities are as follows:

Rule Number One: Always put the the burden of dealing with Chinese banks and government authorities on the Chinese side. And always put the burden of a successful resolution on the Chinese side. China is the rare country where its resident businesses will try to shift the burdens of its own governmental actions onto a foreign party. This is not acceptable. A country resident must be liable for the actions of its own government, since the country resident is the only party to the transaction with any real chance to influence the actions of its local government and banking institutions. Think about this for a minute: are you or your Chinese counter-party more likely to be able to persuade a Chinese bank and/or Chinese government official to get money out of China? If your Chinese counter-party is trying to put this burden on you, this is a red flag and a good indicator it knows it likely will never get the money out.

In the area of payments, this means two things:

First, the Chinese side must take on the burden of paying China taxes and fees. That is, all payments to you on the foreign side must be net payments, free of the imposition of taxes and fees on the Chinese side. If a tax is or fee is imposed by the Chinese bank or local tax authority, the Chinese side must pay this tax/fee, with the payment to the foreign side being unaffected. If the payment to the foreign side is $5 million, the foreign side must be paid $5 million. It makes no difference to the foreign side whether the tax/fee imposed in China is zero, 10% or 100%; the foreign side still receives its $5 million payment.

The reason for this is obvious. First, the Chinese side must be motivated to have the tax or fee reduced. If the tax or fee is simply passed on to the foreign entity, no such incentive exists. Second, there is little consistency in the taxes and fees imposed by Chinese foreign exchange banks. The same transaction my be treated differently from region to region and from bank to bank. Even within the same region and the same bank, treatment may change from transfer to transfer. This means it is difficult to predict the amount of any tax or fee that may be imposed. The Chinese side must take the risk of this uncertainty; it is unreasonable to impose the risk on the foreign party.

Second, the Chinese side must take on the risk that payment will be approved within strict timelines. These timelines should be tight. The Chinese side should not be given 30 days to pay. Ten days should be the maximum and five days is better. The reason for imposing a tight deadline for payment is that it is critical you determine as early as possible whether the Chinese side will be able to make payment. Due to the capricious nature of Chinese banks and taxing authorities (especially in the last year or so with China’s increasingly tight capital controls), approval has to be determined for every payment. You should do no work nor take on any risk until after receipt of the applicable payment from China is confirmed, and I mean really confirmed.

Your contract should provide that if payment from your Chinese counter-party is delayed for any reason — including for lack of approval by the Chinese bank or government authorities — you have the right to terminate the underlying transaction. Chinese parties will often argue that failure to pay due to bank or government lack of approval should be treated as a force majeure event that excuses the Chinese side from enforcement. That is, the Chinese side will argue that the foreign party is not permitted to terminate and even call for a force majeure provision in the contract making this explicit.

This provision might then mean you are required to perform under the contract even though no payment is made by the Chinese side. This is not, of course, what the standard doctrine of force majeure provides. However, the Chinese side will often seek to insert this absurd provision. As clever negotiators, they will insert this in an otherwise standard force majeure clause. Since this type of clause is treated as “boilerplate,” the language is often not read carefully, leading to very unpleasant results for the foreign party. For this reason, I routinely refuse to allow any form of force majeure clause to be included in any contract I draft for China. We also have more than once been contacted by foreigners whose contract says one thing for force majeure in China and something very different in English, but the Chinese controls. Do not let these sort of things happen to you!

Rule Number Two: Force early payment. It is important to test as early as possible whether the Chinese side actually has the ability to make a payment. The test is made by providing for an early payment from the Chinese side in an amount large enough to force the Chinese side to go through the full approval procedure with the Chinese bank and with government authorities. A small, token payment is not sufficient.

One purpose of the initial payment is to ensure your written documentation related to the transaction is acceptable to the foreign exchange bank. For example, for any payment that can be classified as a royalty, a number of issues can arise concerning the documents, including the following:

  • The bank may require the underlying agreement be registered with the applicable government regulatory body. This is common for technology transfer and licensing agreements.
  • The bank may require the transaction itself be approved by Chinese government authorities. This is standard for outbound investments. Approval is also normally required for licensing in the publishing and audio-visual fields.
  • The bank may impose various requirements on the written contracts. Typically the bank will require the main agreement be written in Chinese. Many banks also will require an written, signed invoice for each separate installment payment.
  • The bank may work with the local tax office to impose various taxes and charges on the payments. Both the amount of tax and the processing of tax payment can be confusing and can cause delay.

By requiring an initial payment from the Chinese side, the parties can isolate the problems and correct them before the foreign side begins work or takes risks by relying on the ability of the Chinese side to actually make payment. Our China lawyers are constantly getting called by American and European companies that have not received payment under their contracts with a Chinese entity and in many of those instances it is because their contract has not been drafted in a way that will permit payments to leave China.

Your receiving the first payment is NOT sufficient to pass the test. You as the recipient must also check that payment for the following three things:

— First, was the payment actually made by the Chinese side from China (not Hong Kong), or was it made by another entity, perhaps located outside of China?

— Second, was the payment made through a standard Chinese foreign exchange bank, or was it made through some irregular payment mechanism such as a credit card or through a U.S. financial institution or by bitcoin?

— Third, was the payment made in a single lump sum, or is the payment an aggregate of a number of separate transfers?

All of the above are common and these sorts of irregularities show the Chinese side did not obtain China-side approval for payment. This means the Chinese side failed the test. You now know you are facing significant risk for the later, more substantial payments, unless, of course, the Chinese side for whatever reason will be able to sustain its irregular payment methods beyond its first payment, which is rarely the case.

Rule Number Three: Never get behind on getting your payments. Always get paid first. Get paid before you manufacture and ship your product. Get paid before you start the service work. Get your royalty payment at the beginning of the year, not the end. For the sale of your business (or shares in your business) and the sale of real estate, use a tight closing date with a substantial pre-closing escrow deposit.

In some cases, it is not possible to get all payments in advance. In such cases, you should limit your risk should to loss of profit and avoid getting hit with the loss of your out of pocket costs. For example, in the sale of expensive and highly customized equipment, your should set your risk of non-payment by ensuring the initial installment from China will cover all of your manufacturing cost. The risk for the final payment is then limited to your potential profits, and not to your out of pocket costs in material and labor.

A similar approach should be taken in other fields. For example, license payments may be split into a beginning of year fixed payment, with a variable payment based on sales or earnings paid at the end of the year. This approach ensures you will receive at least some payment that can cover your costs and give you a basic level of profit. It is never advisable to depend substantially on a final payment from a Chinese company; it is almost always better to agree to a smaller, secure fee than to seek a higher fee that shifts the payment risk away from the Chinese side.

The critical point is to recognize there is always payment risk when dealing with payments from Chinese companies. To succeed in selling to Chinese entities, you must recognize the risks and mitigate against those risks as I describe above. In my next post, I will describe some of the strategies our Chinese lawyers recommend for specific types of transactions where payments will be received from a Chinese entity.

UPDATE: And do not for a second believe that even China’s biggest and best-known companies are immune from payment problems. Today’s papers are proof this is not so. See today’s big China story: China cracks down on Dalian Wanda’s overseas deals.

China fraud lawyersFraud tends to increase when the economy is good, but revealed when the economy is bad. Or as Warren Buffet once, said, “Only when the tide goes out do you discover who’s been swimming naked.”

I mention all this because in the last few months our China lawyers have been called in to help on more suspected fraud cases than maybe any time in our law firm’s history. I wish I could discuss those cases, even elliptically, but I cannot, for fear of tipping off those who are suspected. So I will instead re-hash old blog posts on this issue with — when necessary updated information. The point of today’s posts and those that follow is to help arm you with information so you can better discern China-related frauds (really frauds anywhere) on your own, or at least get you to the point where you realize you need to do something to act on your suspicions.

But I would first like like to discuss a company called Sino-Forest and start out doing so with a giant WE TOLD YOU SO, obliquely on here but not so obliquely to our clients. There, now that that’s out of the way, let me tell you about Sino-Forest. Sino-Forest was at one time a high-flying Chinese company that traded publicly in the United States. We first hinted at our suspicions of Sino-Forest back in 2011 in a post entitled, How To Really Really Investigate A Chinese Company. Another reason for my writing this post today is because the Ontario Securities Commission hearing panel just “found that Sino-Forest Corp. and four individuals, among them former CEO Allen Chan, engaged in ‘deceitful or dishonest conduct’ that constituted fraud, according to a decision released Friday.” One of the ways we as China attorneys spot China company frauds is when a company claims to own something or be engaging in some sort of business that cannot legally be true in China. This leads us to conclude the company is either lying or operating illegally, neither of which makes for a good investment or business partner.

I feel compelled to warn you that this is going to be a fairly long and fairly technical post and more posts on China fraud will follow. But if you even have an inkling that you are in any way dealing with a fraud, I will tell you — with all the humility I can conjure — that this post and those that follow it (starting tomorrow) are must reads.

I will start out by talking about some of the main issues to consider when looking at Chinese companies that trade publicly overseas, by quoting liberally from Thinking Clearly About Chinese Companies Listed On US Stock Exchanges. Or, If A Tree Falls In A Sino-Forest…., a post my fellow blogger Steve Dickinson wrote way back in 2011. I note that what reeks of fraud in publicly traded companies generally holds true for private companies as well. Steve’s post provides good background on risk assessment:

I have been doing a lot of consulting lately for investment professionals concerned about the issues recently raised by Muddy Waters LLC about Sino-Forest and other Chinese companies listed on North American stock exchanges through reverse mergers. I have found that most of these investment professionals are confused about what is going on with Chinese companies listed on foreign stock exchanges and their confusion is causing them to improperly evaluate the true risks of investing in Chinese companies.

The fact is that there are risks concerning every Chinese company that lists outside of China. China is a developing country based on socialist market principles that are unclear even to the Chinese. It is a certainty that even the best managed and most profitable Chinese company will not be managed and operated in a manner that would be typical of a well-managed U.S., Canadian or Western European company. This is going to be true of pretty much any company from the developing world. However, it is also important to account for major distinctions concerning Chinese companies that have listed outside China.

There are basically three kinds of companies that list their shares outside China:

The first group is made up of well established Chinese companies that form the heart of the Chinese industrial and service economy. These companies are typically state owned enterprises already listed within China on the Shanghai and Shenzhen stock exchanges. Examples of such companies that have listed on the New York Stock Exchange are:

  • Aluminum Corporation of China Ltd
  • China Eastern Airlines Corporation Limited
  • China Life Insurance Company Limited
  • China Mobile (Hong Kong) Limited
  • China Netcom Group Corporation (Hong Kong) Limited
  • China Petroleum and Chemical Corporation
  • China Southern Airlines Company Limited
  • China Telecom Corporation Limited
  • China Unicom
  • Guangshen Railway Company Limited
  • Huaneng Power International Incorporated
  • Jilin Chemical Industrial Company Limited
  • Petro China Company Limited
  • Semiconductor Manufacturing International Corporation
  • Sinopec Shanghai Petrochemical Company Limited
  • Suntech Power Holdings Company Limited
  • Yanzhou Coal Mining Company Limited (ACH)

It makes sense to ask whether or not these companies are actually profitable. It may also make sense to ask whether these companies are working on behalf of their investors, both Chinese and foreign. However, it is absurd to even consider whether these are “real” companies, with real assets, real operations and real cash flow.

The same is true of many other lesser known privately held Chinese companies that have listed in the United States. Whatever an investor may think about how they run their business, there is no question that they are in business and are working actively to make money for someone.

The next group are typified by companies that operate in China under unique structures such as the VIE (variable interest entity) structure that is common in the Internet sector. Many people are surprised to learn that Alibaba, Baidu, Sina, Tudou and other foreign listed Internet companies do not actually have any direct Internet operations in China. This is because, as foreign companies, they are not permitted to operate directly in China’s Internet sector. They therefore operate through Chinese companies that they create and then “control” through elaborate contractual arrangements. Though one can certainly raise many questions about the security of these contractual relationships in terms of calculating the real worth of these companies, there is no question about whether or not these are “real” companies. Alibaba and Baidu and their related companies dominate the Internet sector in China and operate vast numbers of businesses. Since they operate on the Internet, these businesses are relatively easy to monitor to determine whether or not they really exist. In addition, in their public filings in the U.S. and Hong Kong, these companies clearly describe every detail about the structure of their business and clearly state the possible risks arising from their unusual business structures. This means that while the VIE approach to doing business in China raises unusual risks, it would be difficult to claim that their structures are not well described and that their risks have not been exposed. More importantly, one cannot say that their business structures are designed to conceal a business that does not really exist or that operates on a scale far small than reported.

Muddy Waters and its followers are not claiming that their target companies fall into either of the above two categories. Muddy Waters states quite clearly that it believes that Sino-Forest and others are absolute frauds. The claim is that these companies have used complex structures and claims about the unique nature of doing business in China to hide the fact that they are complete frauds. The claim is that they are not doing any real business in China at all. The claim is that they have no income, no employees, no factories, no nothing. They are empty shells, created to take money from naive foreign investors.

I do not know whether these claims are true and I am not personally aware of any proof that any of the Chinese companies listed in the U.S. and Canada are complete frauds. I have found, however, that many investment professionals are confused about the accusations against Sino-Forest and others. In an attempt to make a case that they have not been completely duped by the fraudsters, the investment community seems to want to argue that Sino-Forest and others should be treated as though they were members of the two groups of companies I describe above. In this way, they can excuse their analysis by claiming that the company practices of Sino-Forest and its ilk can be “excused” by the unique characteristics of the Chinese business environment and regulatory system.

This position is a mistake. The claim against Sino-Forest is not that it has a complex business structure required for doing business in the Chinese market in wood products. The claim is that Sino-Forest has used this argument as a smoke screen for creating a company that is a complete fraud. The claim is that Sino-Forest owns little or nothing in China. The claim is that Sino-Forest has earned little or nothing in China and has no prospects for any real earnings in the future. This has nothing to do with the nature of the Chinese system. The claim is a simple assertion that Sino-Forest is a hollow shell and a fraud.

I do not know whether this claim against Sino-Forest and other Chinese companies that have listed as reverse mergers is true or false. However, this claim is quite different from the concerns that can be raised against Chinese companies that come within the two categories I enumerate above and two mistakes arise from this confusion.

First, legitimate companies under the first two categories are unfairly questioned and their stock is unfairly attacked. I am not contending that their stock is properly valued. However, the accusations against Sino- Forest and others should have no bearing on evaluating the business of these companies.

Second, Sino-Forest and others are given too much credit because investors assume they must be using legitimate business practices that are employed by the legitimate companies that fall into the first two categories.  Many people who have discussed the Sino Forest matter with me assert that Sino-Forest must be using a VIE structure. They argue that since Alibaba and others use a VIE structure, the Sino-Forest system must be acceptable. Though I do not understand Sino-Forest’s so-called “authorized intermediary” structure, I can say for sure that it is not a VIE structure. Therefore, Sino-Forest should not be assumed to be engaging in an unusual and risk but otherwise well known business practice. This is just an example of wishful thinking common in the investment community.

In tomorrow’s post, I will discuss some due diligence you can and must do to avoid becoming a victim.

 

China employment lawyers
China employment contracts. Don’t wait.

Our China employment lawyers often get questions from employers on what they should do to onboard new hires. The number one rule with a new employees is to have a written employment contract with them, assuming you have already done the following:

  • You checked your new hire’s credentials, made sure his/her previous employment relationship ended properly (you usually can do this by checking your new hire’s proof of termination of employment relationship document), confirmed your new hire completed the hand-over and exit procedures required by his/her former employer, and made sure there are no encumbrances or restrictions on your new hire coming to work for you, such as a signed non-compete agreement;
  • You extended an offer letter to the new hire, which was accepted.

Do not wait until your new employee requests a written employment contract to present one. You essentially have only one month after hiring to ensure that your employee has entered into an appropriate written employment contract. It is therefore a best practice to get your employees to sign a written employment contract — along with a signed acknowledgement of having received your Employer Rules and Regulations — before they start working for you. Sometimes it may be impractical to do all this in the timeframe you have and it is better to wait than to get pressured into signing something you have not fully reviewed or fully understand. We have had to clean up too many sticky employment situations where foreign companies signed employment contracts drafted by their employee based on something downloaded from the Internet. You need to firmly say no to such a contract, because any contract you sign will become a legally binding document and it is much more difficult for an employer to back out of such an agreement than for your employee.

If your employee is failing to sign your employment contract within the first month of employment, you should notify that employee in writing that you will terminate their employment before the first month is out unless they sign a written employment contract. This is usually necessary because in most places in China, once you go past a month without an employment contract with one of your employees, you will be at a perpetual disadvantage as against that employee.

Bottom line: The first month of your employee’s commencement is critical. Having a high quality dual-language employment contract tailored for your industry and your locale in place before your employee’s first day at work will avert HR headaches down the road.

 

 

China NDAAmerican and European companies constantly come to one of the China lawyers at my firm seeking to “shore up” their China IP protections. These are mostly companies that have been doing business in China or with China for months or years and have now decided they are doing well enough financially there to start paying to protect what they have. Let me start out by being clear: it is nearly always better to be late than never when it comes to protecting your IP, both regarding China and otherwise. But let me also be clear that it is also nearly always better to take action to protect your IP before you do anything with China at all.

Far too many of the foreign companies that come to my law firm seeking to “shore up” their China IP protections actually have no China IP protections at all in place. But they wrongly believe otherwise.

Many of these companies do not realize that unless they register their brand name as a trademark in China they are at real risk of losing their right to use their own brand name in China, even if just on their own product or packaging made in China for export elsewhere. See China: Do Just ONE Thing: Register Your Trademarks AND Your Design Patents, Part 1. Some of these companies think they’ve already protected their brand name from trademark “theft” in China, but our own trademark search reveals they have not. See China Trademarks. Register Them In China Not Madrid and China Trademark Registration: Keep it Real.

But by far the most common misbelief regarding China IP protection we encounter is the foreign company that believes its United States style NDA protects their IP in China when it most emphatically does not. See Why Your NDA Does Not Work For China. When I tell them that these NDAs do not provide any protection unless the China company that signed it has assets in the United States their response is almost invariably something along the lines of, “well it is at least better than our having nothing. My response to that is silence and then I say something positive and forward thinking, but ultimately noncommittal like, “well, fortunately, we can now start taking substantive action to protect your IP from China.”

But what I am thinking is, “wrong, your NDA is actually WORSE than nothing.” And here is why.

  1. Your China counterpart knows the NDA it signed is worthless and your using that NDA tells it that neither you nor anybody working for you (within or outside your company) has even the most basic knowledge of what it takes to protect IP in China. In other words, you are ripe for the picking.
  2. Your NDA is pretty much a free pass for your China counterpart to steal your IP with impunity and this is true for multiple reasons, though one reason usually stands out. Your NDA no doubt says all disputes will be resolved in an American court under United States law. Now let’s suppose your China counterpart steals your IP and you want to sue. You now must sue in a United States court and that means you have almost certainly cut off any possibility of recovering anything as against your China counterpart. For why this is the case, check out Enforcing Foreign Judgments In China — Let’s Sue TwiceChinese Companies Can Say, “So Sue MeWhy Suing Chinese Companies In The US Is Usually A Waste Of Time, and Enforcing US Judgments in China. Not Yet.
  3. If you had no NDA you could at least threaten to sue or actually sue your China counterpart in China for statutory trade secret or other potential IP violations. But your NDA agreement actually precludes that.

Sorry.

If you want to protect your IP from China you need an appropriate China NNN Agreement. It’s that simple.

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 insurance and indemnificationWebster’s Dictionary defines indemnification as “to make compensation for incurred hurt, loss, or damage” and our clients often request indemnity to protect against a product that injures people or infringes on some third party’s intellectual property right. Seeking such indemnification makes complete sense because the last thing you want when you buy $250,000 of some product is to find your own company on the wrong end of a massive lawsuit for personal injuries or patent infringement. If you are going to have a product manufactured for you in the United States or in the European Union, you commonly include one or more indemnification provisions. In addition, it also usually makes sense to require your manufacturer have enough insurance to be able to pay you on any indemnification claim.

Less so when buying products from China.

The issue of products liability insurance is significant for China, yet in our standard manufacturing agreements with Chinese companies we typically do do not reference insurance. The reason for this is because products liability insurance that would cover U.S. or European based products liability/government recall claims is generally not available in China. Most Chinese factories carry no insurance at all for this type of claim. This lack of insurance is a reason for the “China price.” For entities that want to be covered by insurance for U.S. or European based products liability claims, the best solution is usually to purchase such insurance from a U.S. or a European insurer. The cost of such insurance then illustrates why the China price is often not as low as it seems.

Some of our clients insist on including a standard U.S. or European style insurance provision in their manufacturing contracts with Chinese factories. This usually elicits one of the following three responses from the Chinese manufacturer:

  1. The honest Chinese factories usually refuse to agree to this requirement/provision because they know they probably will not be able to secure this insurance.
  2. Some Chinese factories agree to sign but then also state that they will raise the price of their product(s) to account for the added cost of the insurance. In this case, what they usually mean is that they will purchase the insurance from a U.S. or European insurance company and they will pass on the price of the premium to the U.S. or European buyer.
  3. Some factories will sign but then not obtain the insurance.

We have seen Chinese companies provide fake policies to try to trick Western companies into believing they have insurance. If it is going to cost you the same amount to have your Chinese manufacturer secure sufficient insurance coverage to protect you, but you run the added risk of being tricked about the existence of the coverage, you really do need to ask whether this request even makes sense.

And here’s another thing to consider if you think you are going to be protected by your indemnification provision and/or your Chinese counterpart having secured insurance for you. With China cracking down so hard on hard capital leaving the country (See Getting Money Out of China, Part 6 and the five posts that proceeded that), there is a good chance that even if there is someone in China wants to pay you in the United States or in Europe they will be unable to do so.

In a more general way, one of the risks you will face in getting your products from Chinese manufacturers is that Chinese tend to be either underinsured or not insured at all. This imposes significant risks most U.S and European buyers do not take into account. For example, say you pay a 30% deposit/prepayment for your products and then the factory burns down, and your work in progress is lost. In this case, it would be very rare in China for the factory to have insurance that would cover you for this loss. Say you make the mistake of purchasing your product on FOB terms. In this case, your shipping insurance does not cover the product until after it is loaded on the ship. Say the product is lost in a vehicle accident on the way to the port or in an explosion at the port. Again, it is unlikely the Chinese factory will have insurance covering the situation and once again your deposit is lost. In the U.S. or in Europe, the odds are great these sorts of things would be covered by an appropriate insurance provision, naming your company as an additional insured, but this type of insurance is generally not available in China. So the only way to cover the risk is to purchase your own insurance, which again raises the actual cost of purchasing from China. Most smaller companies either do not understand the risks they take or they take the risk intentionally. In either case, they are underestimating the true cost of purchasing products from China.

As you can see, these various insurance/indemnification issue are quite difficult for China and there are no easy answers.

What do you do to minimize these China risks?

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.

Multi-level marketing in ChinaMulti-level marketing* is hot. Selling products to Chinese consumers is hot. All this means multi-level companies are interested in going into China. But as the following portion from a memorandum one of our China lawyers wrote, multi-level marketing in any form is prohibited in China. This prohibition is based on the Regulations for the Prohibition of Pyramid Selling (2005).

Article 7 of the Pyramid Selling regulations prohibits certain multi-level marketing sales as follows:

  • Payment to promoters based on the recruitment of other promoters, rather than based on sales to customers.
  • Requirement that recruiters and promoters pay a direct fee or indirect fee to participate.
  • Creation of a multi-level relationship where promoters on higher levels are paid based on the performance of promoters at lower levels.

The prohibition on such multi-level marketing is absolute and is not related to the product or service. Any kind of compensation related to such multi-level marketing systems is prohibited regardless of the type of business. There are no exceptions. To comply with the prohibitions on certain multi-level marketing sales, any compensation system for Chinese employees must follow the following basic rules:

  • Employment must be concluded pursuant to a written employment agreement. The first term of the typical employment agreement must typically be for from one to six years. After the expiry of the first term, the employer can decide whether or not to continue the employment relationship. If employment continues, there is no fixed term. It is very difficult to terminate employees. Many disputes arise regarding such terminations after the first term. If there are any irregularities in the compensation system, such irregularities will be used by the employee to extract a benefit from or harm the employer as an act of revenge. For this reason, extreme care in following the law in this area is required.
  • Employees must earn a base salary per month at least equal to the local minimum wage.
  • An employee’s remaining salary can be based on commissions and bonuses. The commission/bonus system must be carefully designed so as not to violate the prohibition on certain types of multi-level marketing sales. The rules for payment must be clearly stated and must be followed carefully. Most importantly, the commission/bonus must be based on sales to third-party customers. A commission/bonus cannot be based on recruitment of new employees or the sales performance of employees other than the recipient of the bonus.
  • It is acceptable for the bonus of a manager to be based on the performance of that manager’s group or division within the company. However, this performance must be based on sales to customers and not on recruitment or on services/sales to other employees or divisions of the company. It is, however, easy for such bonuses to fall afoul of the multi-level marketing sales regulations, and foreign companies are regularly fined for breaking the rules in this area. Care in designing this type of bonus is therefore required.
  • Employees must be provided with a suitable work location. It is, however, acceptable for the employees to choose to work from home. Employees can make direct sales calls to business customers. Employees may make contact with non-business consumers in public locations. Door-to-door direct sales to consumers are typically (though not always) prohibited.
  • All income of employees must be properly reported and all taxes and social benefits must be paid to the appropriate Chinese authorities, including tax and benefits on commission/bonus payments. PRC taxes and benefits are quite high. The amount varies by district but generally approximates 40% of the total salary paid.
  • It is not permissible for Chinese individuals to own shares of a WFOE. Thus, no part of the compensation can be based on the promise of future share ownership in the WFOE. In the same way, without specific approval, no Chinese individual can own shares in a foreign company. Thus, a promise of participation in a future IPO cannot form a part of compensation.
  • Under very limited circumstances, it is possible to create an employee stock option plan that will provide for ownership of the foreign parent of a WFOE. Such plans must be formally approved by the relevant government agencies. As with the United States, China taxes the capital gains on this kind of stock transaction and there is a regulatory burden involved in ensuring that proper reporting is done. This is especially the case for non-public companies that are providing for stock in a future IPO. Thus, while such a system is legally possible in China, the program must be carefully prepared and must be approved in advance.

As is true of so much about doing business in China, there are workarounds, but none are great.

* Multi-level marketing (sometimes called network marketing) is usually defined as a strategy that encourages a company’s distributors to recruit new distributors by paying the  distributors a percentage of their recruits’ sales.