China Law Blog - China Law for Business

Though we often talk generally about what it takes to form a company in China, a reader recently pointed out to me that we have never set out the basic steps one must take to do so. The following sets out the basic steps a foreigner usually must take to form a Wholly Foreign Owned Entity (WFOE) in China. For more information on what is required to form a company in China, check out How To Start A Business In China -- WFOE and How To Start A Business In China -- The Minimum Capital Requirements For A WFOE.

 Forming a WFOE in China typically requires the following:

1. Make Sure Your Business is Legal For Foreigners. Determine if the proposed WFOE will conduct a business approved for foreign investment by the Chinese government. For example, until recently, China prohibited private entities from engaging in export trade. Be sure your business will be legal.

2. Provide The Proper Documentation. The investor in the WFOE must provide the documentation from its home country proving it is a duly formed and validly existing corporation or Limited Liability company, along with evidence showing who from the investor is authorized to execute documents on behalf of the investor. The investor also often must provide documentation demonstrating its financial adequacy in its home country. 

3. Investor Documents Needed. The Chinese government normally requires the following documents from the investing business entity:

• Articles of Incorporation or equivalent (copy)
• Business license, both national and local (if any) (copies)
• Certificate of Status (original)(U.S. and Canada) or a notarized copy of the Corporate Register for the investor or similar document (original)(Civil Law jurisdictions)
• Bank Letter attesting to the account status of the investor company (original).
• Description of the investor's business activities, together with added materials such as an annual report, brochures, website, etc. The first four of these must be in Chinese. The last one may be submitted in English, with a Chinese summary.

4. Consider Forming a Special Purpose Company to Own the WFOE. Many investors create special purpose companies to serve as the investor in China. China's company regulators have become accustomed to this process. However, the Chinese regulators will often still seek to trace the ownership of the foreign investor back to a viable, operating business enterprise. It is common to form a Hong Kong company for this purpose and there are often tax benefits in doing so. 

5. Secure Chinese Government Approval. In China, unlike in most countries with which Western companies tend to be familiar, approval of the project by the relevant government authority is an integral part of the company registration process. If the project is not approved, the company will not be registered. 

6. Compile and Provide These Documents for Chinese Government Approval. The following documents must usually be prepared and then submitted to the Chinese government:

• Articles of Association. This document will set out all the details of management and capitalization of the company. All basic company and project issues must be determined in advance and incorporated in the Articles. This includes directors, local management, local address, special rules on scope of authority of local managers, company address, and registered capital.
• Feasibility Study. The project will not be approved unless the local authorities are convinced it is feasible.This usually requires a basic first year business plan and budget. We typically use a client produced business plan and budget to draft up the feasibility study (in Chinese).
• A Lease. An agreement for all required leases must be provided. This includes office space lease and warehouse/factory space lease. It is customary in China to pay rent one year in advance and this must be taken into into account in planning a budget because the governmental authorities will be expecting this.

7. Compile and Provide These Additional Documents for Chinese Government Approval. You will also usually be required to provide the following documents:

• Proposed personnel salary and benefit budget. If the specific people who will work for the company have not yet been identified, one must specify the positions and proposed salaries/benefit package. Benefits for employees in China typically range from around 30% to 40% of the employee base salary, depending on the location of the business. Foreign employers are held to a strict standard in paying these benefit amounts. The required initial investment includes an amount sufficient to pay salaries for a reasonable period of time (usually one year or more) during the start up phase of the Chinese company. These documents must be in Chinese.
• Any other documentation required for the specific business proposed. The more complex the project, the more documentation that will be required.

8. The Approval Process. It usually takes two to five months for governmental approval, depending on the location of the project and its size and scope. Large cities like Shanghai tend to be slower than smaller cities. The investor must pay various incorporation fees, which fees vary depending on the location, the amount of registered capital and any special licenses required for the specific project. Typically, these fees equal a little over 1% of the initial capital. On large and/or complex projects, the approval process often involves extensive negotiations with various regulatory authorities whose approval is required. For example, a large factory may have serious land use or environmental issues. Thus, the time frame for approval of incorporation is never certain. It depends on the type of project and the location. Foreign investors must be prepared for this uncertainty from the outset.

if you comply fully with the above, your chance of getting your WFOE approved is nearly 100%.

Every few months we get a call from someone wanting to shut down their China WOFE (Wholly Owned Foreign Entity a/k/a WFOE or Wholly Foreign Owned Enterprise). Interestingly, these calls usually come from companies who have been in China for a long time (average time, maybe ten years). Their reasons for seeking to leave China are all over the map but usually involve a decision relating to their China operations lack of profitability or lack of cost-effectiveness. Surprisingly often, they say that they might return to China in three to five years. And that is the problem.

If both you (and I will define that later in this post) and your company will never ever again be returning to China AND if both you and every other foreigner in your company will never again be returning to China, closing down is easy. Essentially, just close down.

A friend of mine who does business in China found himself not being allowed to go out of the country because of a lawsuit filed against him by a Chinese company. They are saying that he owes them money while all the while they have been cheating him (cutting corners on products, using low quality materials instead of the good quality materials agreed upon, late shipments which causes cancellation of orders). He was not notified beforehand of this lawsuit against him before he came and only found out about it when he
was about to return home and was stopped at the border crossing. Is there a way he can be allowed to leave China while the case is pending?

We have written about this same thing numerous other times:

• China Hostage Situation. Now IS A Good Time To Pay Your Debts
• China, We Have A Problem. A Mostly True Story.
• How Not To Get Kidnapped In China
• Shutting Down A China Rep Office Without Going To Jail

If you have any foreigners in China and you want to shut down your business, either get all of those foreigners out and have them never again return, or shut down your business correctly.

How then does one shut down a Chinese business correctly?

There are essentially three ways.

1.  Formally dissolving the company.  This is done by paying all existing debts, including especially all debts to employees and to the government. Doing this correctly (and complying with China's myriad labor laws) involves going through a long drawn out government audit and typically takes at least a year and is far more complicated and time consuming than you would think. The advantage to shutting down this way, however, is that in the end you satisfy the government and both your company and its employees could return to China the next day (or whenever) and legally open a new business. Without a formal dissolution, there is a good chance that neither your company, nor any of its employees of whom the Chinese government is aware, will be able to return to China problem-free.

2.  Filing for bankruptcy liquidation. if your company does not have the funds/assets to pay its debts, it may liquidate under China's bankruptcy laws. We have many times looked at this option for our clients and many times we have been of the view that this option would have been a legally viable one. However, none of our clients have yet to pursue this option because in every instance it was determined that it would be cheaper and easier to go through a formal dissolution per the above. I am not even aware of a foreign owned Chinese company that has pursued bankruptcy in China. Are you?  

3.  An informal petering out.  Due to the time and costs involved in the two scenarios mapped out above, we have "created" a third option for our clients. This option makes the most sense for those companies that really do think they will be back in China within the next few years. This option involves the compamy doing the following, at minimum:

1. Terminating all Chinese employees with an agreed upon severance package and a signed release of any and all claims they might have against the company. It is critical that this be done pursuant to China's labor laws.
2. Either buying out any lease(s) or letting any existing lease(s) expire. We have generally found that Chinese landlords are not terribly willing to give decent discounts for one time lease termination payments. 
3. Paying all government taxes, pensions, etc. and remaining current on the same.

After completing the above, the WOFE still exists, but is essentially dormant. At this point, it must still pay its taxes (which should be minimal) and still comply with any and all government reporting requirements.This is at best a temporary solution because doing this does not stop the cost meter from running entirely and there will almost certainly come a point where the government will either start imputing higher taxes or demand a formal shutdown. The biggest benefit of this method is that it is fairly cheap and if you really are uncertain as to whether to stay or go, it will buy you time while at the same time, clearing off your books so that any subsequent formal shutdown ought to go just a bit quicker and easier. The beauty of this option is that if you do eventually decide to revive your China operations, there is already an existing company in place by which to do so.

What do you think?

I have always had trouble getting my head around the fact that to secure approval of a Wholly Foreign Owned Enterprise (WFOE or WOFE) in China, the WFOE must first lease appropriate space. But how can a yet to exist entity do anything, much less lease space?

In my email box this morning, in an e-mail from co-blogger Steve Dickinson to a client in the process of forming a China WFOE, explains how. To set the scene a bit more, the client just sent Steve a copy of its proposed lease:

This is a set of standard lease documents for leasing to a Chinese entity or to an already existing WFOE. The lease document makes no provision for dealing with the situation of leasing to an entity in preparation for formation of a WFOE. In fact, the lease document requires you to provide a business license before you execute the lease. Obviously, you cannot do that since your WFOE does not yet even exist.

You should contact the landlord and ensure that the landlord understands your exact situation. If the landlord understands and agrees that it understands and will cooperate, then we can add the language necessary for the lease to be acceptable for WFOE formation purposes. The landlord should be aware that the lease will initially be in the name of the WFOE shareholder and then will be transferred to the WFOE upon successful formation of the WFOE. The landlord must agree to that transfer in advance and must agree to cooperate fully in the WFOE formation process. In addition, the landlord must warrant that the premises can be approved for the use to which you intend to make of the premises and that the lease will be registered with the applicable government real estate administration in _______. Of course, this means that the landlord will need to make all tax payments and provide tax receipts to you as the tenant. Note that the lease cannot be entered into until you know the identity of the shareholder of the WFOE.

Please discuss this with the landlord and then advise on how you wish to proceed.

I like this explanation. 

If you are an American company doing business in or with China, it behooves you to have at least some familiarity with the Foreign Corrupt Practices Act (FCPA). But where to turn for that?

I'm going to tell you: Michael Kohler's FCPA Professor blog, in a post appropriately entitled, FCPA 101.

The post is logically organized around questions one should have about the FCPA and it does a superb job of setting out the FCPA basics. If you want to know the answers to any (or better yet, all) of the following questions, go to FCPA 101:

• When and why was the FCPA enacted?
• Has the FCPA been amended since 1977?
• What are the FCPA’s main provisions?
• Who is subject to the anti-bribery provisions?
• What do the anti-bribery provisions prohibit?
• What does “anything of value” mean? 
• What does “foreign official” mean?
• What does “obtain or retain business” mean?
• Does the FCPA have any exceptions or affirmative defenses?
• Can a third-party subject a company to anti-bribery violations?
• What do the books and records and internal control provisions prohibit?
• Which agencies enforce the FCPA?
• How do the enforcement agencies typically find out about FCPA issues?
• Why has FCPA enforcement increased?
• How are FCPA enforcement actions typically resolved?
• How are FCPA fines, penalties, and sentences calculated?
• Are companies that resolve FCPA enforcement actions “bad” or “unethical”?
• What about the bribe-takers?
• What is the FCPA Opinion Release Procedure?
• Do other countries have "FCPA-like" laws?

I recommend it.

This post is part I of what is going to be a multi-part, somewhat irregular series on protecting your IP in China. This part I and tomorrow's part II, were written by Steve Dickinson, and are based in large part on a talk Steve gave last week in Qingdao. Over the last couple of years, "creative services" have been probably the greatest growth area for our firm and so our intellectual property and licensing work has only continued to grow in importance.

For pretty much all of our creative services clients (these are companies mostly in the software, gaming, entertainment, media, art and film industries) intellectual property makes up the overwhelming bulk of the value of their business. Therefore, it is always a surprise to us how many of them seem to treat their intellectual property in China is an optional or secondary matter when it really should be the first issue they consider when approaching the China market. Though IP is usually of somewhat less importance for our clients not in creative services, they too tend to undervalue its importance. 

This series is intended to emphasize the importance of protecting IP in China and to set out a program for for creating, protecting and monetizing intellectual property. Without a clear program on this issue, disaster is certain to follow in China.

The first step is to get clear what we are talking about when we use the term “intellectual property.” IP is not patents, trademarks, copyright etc. These are simply tools for protecting intangible assets. It is the same for real property: a deed is not land, it is a tool used to establish and protect an ownership interest in land.

So what is intellectual property?

• A better term is intangible property or intangible assets. This includes everything about your business that has value that cannot be reduced to a physical asset or to a monetary cash flow.
• For creative industries, IP can include virtually all of the assets of the business:
  • Music
  • Film
  • Books and magazines
  • Research and analysis
  • Design of any kind: interior design, clothing design, product design
  • Architecture and engineering
  • Software of all kinds: industrial, retail, video games, phone “apps”
• For traditional industrial firms, it includes
  • Inventions
  • Formulas
  • Industrial processes and know how
• For all businesses, it includes:
  • Brand and image
  • Business planning and corporate strategy
  • Pricing plans

For most modern businesses, intangible property forms a major portion of their value. For many businesses, such as those in creative services, it forms the core of the value of the company. Consider the stars of the modern business world: Apple, Microsoft, IBM, Boeing, Siemens, Nestle, General Electric, Dow Chemical, Starbucks, Amazon, SAP. Is their value in their real estate holdings? In their factories and office buildings? No, the value of these companies is almost entirely in their intangible assets.

However, even for hard asset, resource based companies, IP is still a major component in their company value. Take the mining companies that have dealt with China for the past ten years. A major portion of their value lies in their pricing plans, their internal data on their resources, their techniques of extraction and transport, their future exploitation plans and the like. This explains why the primary battle between these companies and the Chinese over the past several years has centered on the attempts of both sides to acquire data to aid in the struggle over control of the market.

The message is obvious: active and careful cultivation of your intangible assets is mandatory to survive in the modern business world. This means taking the steps necessary to secure the rights, to protect the rights, and then to secure the rights for your own use or to package those rights for monetization.

Most businesses are constrained by the traditional categories for intellectual property and do not effectively consider the tools that available to protect intangible assets. There is much more to IP protection than the traditional IP tools.

The traditional intellectual property tools are:

1. Patents
2. Trademarks
3. Copyrights
4. Trade Secrets

Though these tools are essential in the IP world, there is a far wider set of techniques that can be used, including the following:

1. Secrecy and refusal to disclose
2. Licensing and trade secrecy agreements: limited and controlled disclosure
3. Trade secrecy and related agreements with employees and joint venture partners
4. Physical techniques such as encryption and related data protection techniques

Many companies believe that since they have done what is necessary to secure their rights in North America and Europe, there is nothing special they need to do in China. This is a mistake.

The key concept is that all IP protection is local. You cannot rely on what you have done elsewhere. You must deal with your IP by making use of the Chinese system. You must act within China for both creation of rights, enforcement of rights and monetary exploitation of rights. You must deal with China the way it is, rather than hoping to rely on a perhaps more perfect system that simply does not exist in China.

Since all IP protection is based on local law and practice, you must adopt an effective and realistic protection program for the country in which you are operating. If you are in China, you must consider the situation in China. The fact is that China is currently the most dangerous country in the world with respect to protection of intangible assets does not mean you can afford to throw up your hands and do nothing. China's IP risks can be managed, if 1) you assess the risks in a realistic way and 2) you take practical steps for protection.

Tomorrow, we discuss specifics.

Got the following question regarding FICE (Foreign Invested Commercial Enterprise) today that I worth answering via a post:

As a company we have been planning how we step things up in China for several years and your comments have had a major influence on our thinking. I do have a question. I have heard about a corporate structure that you never seem to mention. FICE, Foreign Investment Corporate Entity I believe does not allow for manufacturing but does allow for multiple sites, whereas WOFEs are I believe single site operations. Does it truly exist? Why is it never mentioned as an option? Appreciate the info.

A FICE is a WFOE that is authorized to engage in wholesale and/or retail trade. The approval requirements for these sorts of entities tend to be much stricter than for a manufacturing or service WFOE. Additionally, approval of a FICE usually must come at the provincial level, not the local level. There are some provinces that do not even accept applications for a FICE. Shanghai and Beijing have the authority to approve the establishment of a FICE and most FICE operations are formed in those two cities for that reason.

Foreign Invested Enterprises (FIEs) mostly consist of Wholly Foreign Owned Entities (WFOEs) and Joint Ventures (JVs). All Foreign Invested Enterprises must set out the nature of their business during the licensing phase of the entity registration process. There are all sorts of possible categories, including Regional Headquarters, Service, Purchasing Center, Research and Development Center, Investment/Holding Company, Service Company, Manufacturing Company and Foreign Invested Commercial Enterprise (FICE).

In the end though, a FICE is nothing more or less than a type of WFOE or JV.  

If you want to greatly increase your chances of being able to enforce your contract with your Chinese counter-party, you should do the following (you should do a lot more than this, both within and outside your contract, but I am limiting this post to just those things directly related to being able to enforce the contract and its terms)

1. Have a written contract (see this, this and this);
2. Have that written contract be in Chinese;
3. Have that written contract set out clearly how disputes are to be resolved and, even more importantly, pick the right forum for those disputes;
4. Have that written contract set out in excruciating detail what the Chinese company must do to be in compliance with the contract;
5. Set out the liquidated damages the Chinese company must pay if it fails to comply with the contract;
6. Make sure the Chinese company signs AND seals your contract. 

This post is going to focus on the signing/sealing requirement, because it matters and because American (that includes Canadian) and British companies seem to get this wrong way too often.

In many countries, including the United States, apparent authority is a pretty broad concept. Grossly simplified, it means that if an employee reasonably looks as though he or she has authority to enter into a specific contract on behalf of the company, the company will be bound to that contract. Here is an example. At my law firm, our legal assistants/paralegals are always ordering office supplies from Office Depot in fairly small increments -- maybe USD$50 to $150 at a time. And our law firm always pays these Office Depot bills. If my law firm were to refuse to pay a $75 bill tomorrow by claiming that we had never authorized the Office Depot order, Office Depot could sue us and they would surely win. They would win because we have clearly let the outside world believe that our legal assistants and paralegals have authority to make such orders on our law firm's behalf. But what if one of our legal assistants ordered $50,000 in computer equipment sent to his or her house? Would we have to pay? Almost certainly not. 

But that is the United States. China has a much more limited apparent authority concept and it can be so prone to dispute that you may better off pretending that it does not exist.  

For written contracts in China to be effective, one of the following must be true: 

1. The company's legal representative signed it. Chinese law provides that a company's legal representative has apparent authority to bind the company. This means that even if that representative lacks the actual authority to bind the company (maybe because the board of directors or the shareholders never gave the representative the authority to contract with you), the legal representative's signature will bind the company. There is, however an exception to this and that is when you know that the legal representative lacks the authority to bind the company.
2. The contract is appropriately sealed.  An appropriate seal (oftentimes called a chop) is applied to the contract. It does not matter who applies the seal, so long as it is the right seal. This means it must be sealed either with a contract seal that sets forth the name of the company or, as is more commonly done, with the Company Seal. Each Chinese company has only one company seal (no copies).

Chinese companies are notorious for trying to get out of contracts by claiming they never actually signed them or that they were signed without the proper authority and so if your contract is big enough and important enough, you should consider doing all of the following to minimize even further the likelihood of the Chinese company seeking to get out of your contract: 

1. A signature from the company's legal representative. Of course, you must first confirm from the company's business license who exactly is the company's legal representative.
2. A resolution from the company's board explicitly approving the contract and authorizing the legal representative to sign it. 
3. The affixation to the contract of the company seal or the company's contract seal.

What do you think?

If you had told me ten years ago that I would some day be writing on transfer pricing, I would never have believed it. Heck, if you had told me ten years ago that I would one day be writing on transfer pricing, I might have considered going into a different field. Even three years ago I would have just laughed. 

I am not laughing right now and believe me when I tell you that I am writing this post only because I deem it absolutely necessary. Too many companies are missing the boat when it comes to transfer pricing and by doing so they are costing themselves a lot of money.

So to minimize my pain, I am going to get right down to business by listing the three things you need to know about transfer pricing as related to your China business. Spoiler alert: If you are just buying product from or selling product to China, you can (mercifully) leave now; this post relates only to those who are actually doing business in China.

1. Definition of Transfer Pricing. Wikipedia very nicely defines transfer pricing as follows:

Transfer pricing refers to the pricing of contributions (assets, tangible and intangible, services, and funds) transferred within an organization. For example, goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary. Since the prices are set within an organisation (i.e., controlled), the typical market mechanisms that establish prices for such transactions between third parties may not apply. The choice of the transfer price will affect the allocation of the total profit among the parts of the company. This is a major concern for fiscal authorities who worry that multi-national entities may set transfer prices on cross-border transactions to reduce taxable profits in their jurisdiction. This has led to the rise of transfer pricing regulations and enforcement, making transfer pricing a major tax compliance issue for multi-national companies.

Transfer pricing comes into play in China for transactions between related companies. KMPG provides a good definition of what constitutes a related or associated company in China:

Twenty-five percent ownership, be it direct or indirect ownership, or control. This applies whether one party owns another or two parties are owned by a third party. The formula for calculating indirect shareholding percentage has been changed: 25 percent ownership is now counted as 100 percent when multiplying the shareholding percentages of each level of indirect shareholdings. Other criteria including loans, control of management, or other types of control can also be taken into account.

2. Why Transfer Pricing Matters. NOW. I could write pages and pages as to why it is imperative that you deal with transfer pricing now and why these issues have come to the fore all of a sudden in China. But I won't. What I will tell you is that China has over the last year or so been cracking down on transfer pricing and that crackdown just keeps accelerating. China is striving to increase its tax revenues (that's a given) and transfer pricing is a great way for it to do so by tapping foreigners for money. 

3. What Must You Do About China Transfer Pricing. NOW. Again, I could write pages and pages on this. But I won't. I will just say that if you have or will have a related Chinese entity you should look at your prices between your foreign entity and your Chinese entity because if those prices are not reasonable enough to get past the Chinese tax authorities, you will likely be facing serious problems. Just a few examples. If your Chinese entity (let's say it's a WFOE) is buying $1 widgets from the home entity back in the United States or England or wherever and paying $50 for those widgets so that the profits from sales will go to the United States or England and not to China, the Chinese tax authorities will probably step in and re-calculate your Chinese taxes as though you paid $1 for the widgets. You also face penalties. On the flip side, if your Chinese entity's profits is only $10,000 from making $100 million in product for the home entity, the Chinese tax authorities will probably impute much higher profits (than the $10,000) to your Chinese entity. It will then tax the Chinese entity on the imputed profits and you will be facing potential penalties as well.

But the main thing you need to know about transfer pricing in China (or anywhere) is that it is very complicated and the rules relating to it and the levels of enforcement seem to be perpetually toughening. So if you are doing business with a related or associated company in China, you should be working with accountants experienced with China's transfer pricing laws and you should be doing so before you have a problem.

If you wish to learn more about China transfer pricing, I urge you to read any or all of the following reports from the Big Four: Deloitte, Ernst & Young KMPG, PwC.

What do you think?

From time to time I get calls from start-up companies about to embark on manufacturing in China. They are calling to ask what they need to do "to protect themselves."

I tell them about NNN Agreements and how they can help prevent potential manufacturers from replicating their product. And I tell them about how important it is that they have an OEM Agreement with their Chinese manufacture

Then I tell them how if they do nothing else, they should immediately register their trademarks in China. This one usually surprises them and they often think I have misunderstood what they are planning for China. They at first do not understand why I am emphasizing the need for their filing a trademark in China when they have no plans to sell their product in China. I then explain the following to them:

China is a first to file country, which means that, with very few exceptions, whoever files for a particular trademark in a particular category gets it. So if the name of your company is XYZ and you make shoes and you have been manufacturing your shoes in China for the last three years and someone registers the XYZ trademark for shoes, that other company gets the trademark. And then, armed with the trademark, that company has every right to stop your XYZ shoes from leaving China because they violate its trademark.

Then they understand.

UPDATE: As noted by the Korean Law Blog, the same holds true for Korea.

Client just sent me a link to a United States Government internet "brochure" on "Protecting Your Intellectual Property Rights in China" along with a note saying "this is what you are always saying." It is what I am always saying, and though this information appears to be about ten years old, near as I can tell, all or virtually all of it is still current and still on point.  It provides a very clear, blissfully short overview of China's intellectual property laws and then provides an excellent list of what it calls "major players" in China intellectual property. For anyone starting out in China and confronting the issue of how to protect your intellectual property (IP) there, I highly recommend this site.  

Danny Friedmann of IP Dragon wrote a great post entitled, "How to prevent and act upon intellectual property rights infringements in China" that very nicely (and succinctly) sets out exactly how to accomplish that. 

Friedmann states that intellectual property infringement is prevalent in China "and a challenge for every company in every industry" but those companies that "take adequate precautionary measures," "anticipate infringements," and "aggressively enforce their rights ... can substantially minimise their risks and damages." Danny is absolutely right.

Friedmann advocates companies do the following to protect their intellectual property in China:

1. Be prepared.
2. Do your homework. Know the people with whom you are doing business. Get them to sign a "confidentiality agreement [non disclosure agreement, or NDA] beforeyou hand over any sensitive business information." Make sure your contract is clear on who owns what IP rights. "If a potential business partner refuses to sign the contract, find another business partner."
3. No registration equals no right. With the exception of copyrights, if you do not register your IP in China, you almost certainly have no IP protection. In other words, you must register your trademarks and your patents in China to have your trademarks and patents protected in China.
4. To trust is nice, to control better. Know what is going on with your IP in China at all times and use "several anti-counterfeit technologies." In other words, do not rely solely on the law to protect your IP in China. 
5. Be ready to enforce.  The post then describes the various enforcement options, including administrative, civil and criminal, and where to go for additional information.

A very good post and a must read for anyone interested in protecting their IP in or from China.

Every couple of weeks my firm gets an email or a phone call from a small business that is seeking to justify forming a Rep Office in China instead of a Wholly Foreign Owned Enterprise (WFOE). These small businesses typically go into advocacy mode explaining why their business can and should be a Rep Office in China. They then go on to explain that they simply cannot afford to form a WFOE in China due to the minimum capital requirements, the legal fees, and the taxes. 

They then want me to condone their Rep Office plans but I never do.

In fact, the increasing number of these requests has caused me to get even blunter than usual, and my most recent response exemplifies this: 

What you are describing doing as part of an RO [Rep Office] is definitely not proper for an RO. Not even close. 

In terms of minimum capital required, because it is Dongguan, it is likely to be pretty high. Sorry. 

You pretty much have two choices. You can operate completely off the grid and risk getting shut down, or you form a WFOE. Probably the worst thing you could do would be to form an RO that operates illegally because they you are just drawing attention to yourself.  

I get the sense that the people contacting us on these things are hoping that they somehow have found THE loophole that nobody else has found and that if only they can get the blessings of an attorney for what they are doing, that their operating illegally will somehow not be illegal. I wish I had some magic oil I could sell (for a helluva lot of money) that I could sprinkle on illegal China businesses to make them legal, but I have no such thing.

Those who think they are going "sorta" legal by forming what is clearly an illegal Rep Office in China are very similar to those who think they are "sorta" protecting themselves legally by doing a "sorta" joint venture with their girlfriend. I wrote about those people in a post, entitled, "Operating Illegally In China. Half-Assing It Does Not Help." In that post, I described the following email I had recently received from my co-blogger, Steve Dickinson:

We had one of these the other day and it precipitated an email from my co-blogger, Steve Dickinson, to me, which went as follows:

If these people are going to go illegal in China, they should go 100% illegal. That is, enforcement either through really strong family connections (your father knows her father) or enforcement through gangsters and the like. I know people who have succeeded this way but I don’t know anyone who has succeeded with an illegal contract. This is not because contracts don't work in China, because you and I have won enough China contract cases to know that they do.

It is because the Chinese judges are totally on to these sorts of arrangements and they know they violate or seek to evade Chinese law. They therefore have and will continue to deem such contracts void. Why do people live in this fantasy world thinking that somehow they are so different or that they have discovered the solution? Why do they think a Chinese court would enforce a contract designed to evade the law?

Take an alternative example. Remember John Smith’s [yes, it is an alias] company we formed in Beijing a few years ago? Not sure if you remember this, but that investment was with his Chinese wife. However, we did that as a very formally organized WFOE and left the wife and her family with the irregular side of the deal. His US company is the only shareholder and he runs the board. His company has had no trouble and he has had no trouble because he is legal and secure. His US LLC [and with it, the China WFOE] were just purchased by _______ [a pretty big name U.S. company]. The reason the purchase was successful is that the whole company was "clean" and therefore it could be purchased by a foreign public company.

I then concluded that post with the following:

As lawyers we are never going to tell our client to go full illegal, but in my role as a blogger, I have to think going full illegal would probably make better sense than paying a lawyer to draft a void contract. I think people know this, but their rightful discomfort at operating illegally makes them want to clutch on to something that will allow them to justify (however falsely) their actions.

The same holds true with respect to forming a Rep Office when a WFOE is required. Forming the Rep Office in that situation will just serve to let the Chinese government know where you are and what you are doing and will make it easy for them to realize that what you are doing requires a WFOE. On top of that, as I am always saying, you should not form a Rep Office with plans to form a WFOE in a year or so "if everything works out." You should not do this because you will end up paying THREE times as you will pay for forming the Rep Office, pay for shutting down the Rep Office (and this is not cheap), and then pay for forming the WFOE.

What really drives me crazy about all this though is that on at least three occasions, companies for whom we have refused to form Rep Offices have written me to tell me that "so and so" company formation company is willing to form the Rep Office for them, as though this mere fact means that my firm was wrong in declining to take money to do something we know will eventually not work.

And though I take no happiness from this, I will note that one of the three companies that went ahead and formed a Rep Office against our advice did contact us about a year later to tell us that the Chinese government was now making them form a WFOE.

For more on what is involved in forming a company in China, check out the following:

• How to Start a Business in China: WFOE
• How To Start A Business In China -- The Minimum Capital Requirements For A WFOE
• The Slow Death of the China Rep Office

Doing business in China? Don't do it half right because you are only increasing your risk. 

What do you think? 

Last week, I gave an hour long talk before the Pacific Northwest Chapter of the International Association of Outsourcing Professionals (IAOP). My talk was entitled, “The Legal Myths, Realities, Traps and Benefits to Outsourcing to an Emerging Market,” but I should have called it everything you need to know about the law of outsourcing, crammed into an hour.

The following is the written version of the speech I gave. Please realize this was a speech and not a paper and read it accordingly. I would ordinarily break something like this up into a series of posts, but there really was no logical way to do that with this and so I am giving you the whole (very long) thing in one fell swoop.

INTRODUCTION

I am going to start by telling you a little bit more about me so you can better understand where I am coming from when I talk about international outsourcing and, more particularly, outsourcing to an emerging market.

I am an international lawyer and what that means is that I focus on legal matters involving multiple countries.

In the last ten years, about 50% of my work has involved China, about 10% has involved Russia, 10% Korea and 10% Vietnam, with the remaining 20% percent involving mostly India, Turkey, Thailand, Indonesia, Malaysia, and various countries in Eastern Europe and in Latin America.

So as you can tell, the bulk of my work has been with emerging market countries.

My clients have been a fairly even mix of tech, service and manufacturing companies and I have written and reviewed countless international outsourcing agreements for all three types of business. I have represented both companies that were contracting for outsourcing and companies that were contracting to provide outsourcing. I have been at this long enough to have taken part in what I see as the evolution of outsourcing from the United States. This means I started out mostly dealing with contract manufacturing of goods and then started working on the contracting of technology services and BPO outsourcing. In the last few years, I have been handling an increasing number of outsourcing contracts involving medical clinical trials and professional services.

For the last five years, I have also written a blog on China, which has put me in touch with hundreds of companies involved in doing business internationally, many involving international outsourcing to emerging market countries, especially China. This has given me a much wider perspective than I would have received from my law practice alone.

My talk today is going to be based in large measure on my experiences and on what I have learned from talking with clients and other businesses that are engaged in international outsourcing with emerging market countries.

I am going to focus more on how things really are than on what the law says about how things should be. The distinction between what a country’s laws say and how those laws are actually enforced in the real world is a very important one, particularly when dealing with an emerging market country where the laws are often very good, but the enforcement of them is often very poor.

My goals will be to highlight the legal issues related to outsourcing to an emerging market country and to provide approaches and methods for dealing with those issues.

 DEFINITIONS/SCOPE

What exactly is international outsourcing?

For purposes of my talk today, I will be defining it as using another company to provide your company with a service or a product. I am intentionally being very broad and simplistic here because the legal issues involved in international outsourcing typically apply across the board to most “outsourcing” situations and I do not want to get bogged down in making fine distinctions between the various types of outsourcing.

The “international” part of “International outsourcing” simply means that at least two of the companies involved in the outsourcing be from different countries. International outsourcing does not include a contract between a US company and the US arm of a foreign company when all of the outsourcing work will be done in the United States, because in that situation, no international law issues are likely to be implicated.

I am going to give my own intentionally broad definition of what constitutes an emerging market country because I tend to disagree with most lists and definitions of emerging market countries, both because they so often include what I see as developed countries, like South Korea, Poland, and Chile, and because they so often fail to include a country like Viet Nam, which has been one of the fastest growing countries over the last five years and will, I am convinced, be one of the fastest growing countries over the next five years as well.

In broad and simple terms, my definition of an emerging market country is any country that is growing fast, is able to feed its people, and is not yet highly developed.

Now, I fully realize that all or nearly all of you here today are primarily or exclusively involved in technology outsourcing, so when possible, I will focus on international technology outsourcing. However, from a legal perspective, the big picture issues involved in outsourcing the manufacturing of a shirt button in China are surprisingly similar to the legal issues involved in outsourcing the writing of complex software code to India.

 

In both cases, the primary issues usually revolve around:

• Receiving quality in a timely manner
• Protecting Intellectual Property and Confidentiality
• Setting forth an appropriate mechanism for resolving disputes

 RISKS/BENEFITS

In choosing whether or not to outsource, U.S. companies typically weigh the perceived benefits of outsourcing versus the perceived risks.

The perceived benefits typically are one or more of the following:

• Reduced Costs
• Having an outside company handle the non-core aspects of the business
• Better quality/operational performance
• Around the clock work force

All of these benefits can be realized by outsourcing to an emerging market country, particularly the lower costs and the 24/7 work force.

But of course, there are risks to outsourcing as well, including the following:

• Your vendor will do a bad job

• Your vendor will do a bad job, yet still expect full payment

• Your vendor will steal your data

• Your vendor will steal your Intellectual Property

• Your vendor will steal your trade secrets

• Your vendor will sell your data or IP or trade secrets to one of your competitors

• Your vendor will use your data or IP or trade secrets to compete with you

• Your vendor will cost more than expected in the short term due to transition costs

• Your vendor will cost more than expected in the long term

• Your company will lose its innovation edge because someone else is doing its key work

• Your vendor’s personnel tomorrow will be different from your vendor’s personnel today

• Your company’s morale will be negatively impacted by your outsourcing

• Suing and collecting meaningful damages from your vendor may be difficult

• Politics will impair the project

• The price will change due to currency fluctuation

• An inability to secure visas will impair the project

• Crime will impair the project

• You might face export control issues

• You might face Foreign Corrupt Practices Act issues (FCPA)

• You might get snared in your vendor’s labor/employment law issues

• You might get snared in your vendor's bankruptcy

Nearly all of the above risks are present even when you outsource domestically, but nearly all of these risks will be greater when you outsource overseas and nearly all of these risks will be even greater still when you outsource to an emerging market country.

Let’s look at a few of these risks and how going to an emerging market country makes them even greater.

Let’s take the first one: your vendor doing a bad job. If you are outsourcing to a country with a really different language and culture, the chance of a miscommunication is greatly increased and bad communication can cause your vendor to do a bad job.

I can give you a very real example of how this can easily happen, even if your company has strong language skills. A few years ago, my firm was handling a lawsuit in China. We were representing a United States company owed money by a Russian company and we knew the Russian company would be shipping its product to Dalian, China. My firm has two U.S. trained lawyers who are completely fluent in spoken and written Chinese (one here in Seattle and one in China) and a Chinese lawyer who speaks pretty good English, so we were pretty much covered.

We put our lead China lawyer on the case and he and I were handling the matter together. His Chinese is so good that he at one time taught law at China’s best law school -- in Chinese. We then brought in a really good Dalian lawyer to assist us on the case and we asked her, both in English and in Chinese, whether we would need to post a bond to seize the Russian company’s product when it hit China and she said “no.” I passed this information on to my client and we thought we were done with that issue. Then, a few weeks later and only a few days before we were to file our complaint, the Chinese lawyer told us that our client would need to come up with around $200,000 for “counter-security.” We simply had not realized that our Dalian lawyer would consider a bond to be different than a counter-security because the word “bond” is usually used to cover all sorts of required payments in this sort of situation. And on the flip side, our Chinese lawyer just assumed we knew all along that we would need to post a “counter-security” because she just assumed that those were required everywhere.

So even though both parties spoke the language of the other quite well and even though both parties were international lawyers, a miscommunication occurred.

Can miscommunications occur domestically? Of course they can…. But they are more likely when the language and the culture are very different.

Let’s talk a bit about the fourth one on this list: theft of Intellectual Property (IP). Emerging market countries do not respect IP as much as developed countries. There is no getting away from that.

In the 1800s, the United States, which could be said to have been an emerging market country at that time, was notorious for its IP infringement. IP enforcement tends to correlate very closely with income because countries do not tend to enforce IP laws until their own native companies have started building up their own IP and pushing hard for IP enforcement.

Each year, the U.S. Trade Department comes out with a list of countries it believes to be the worst IP scofflaws and the following countries made its Priority Watch List and its Regular Watch List:

PRIORITY WATCH LIST

• Argentina
• Canada
• Chile
• China
• Costa Rica
• India
• Indonesia
• Mexico
• Philippines
• Russia

WATCH LIST

• Poland
• Ukraine
• Vietnam

As you can see, China, India, Indonesia, Mexico, the Philippines and Russia are all on the priority list. IP protection in Vietnam is no better than any of the countries on the priority list and I think the only reason it didn’t make the priority list is because it is newer to the international marketplace and because it is not as economically developed as some of the countries on the Priority Watch List. Canada is obviously a very interesting one. It is on there because it is such a developed country and it is our neighbor, and it has a few really strange IP laws, including, I believe, that it is not a crime to import clearly counterfeit goods. The point of my showing you these lists is to highlight how virtually all of the outsourcing powerhouse countries are on these lists; and if they are not, they should be.

So turning over your IP to an outsourcing company in an emerging market country means you will likely be taking on risks that you would not be taking on if you were turning that IP over to a company in Fargo, North Dakota.

REDUCING THE RISKS

How then can you protect your company from the risks of doing business with a company in an emerging market country?

There are three main ways and all are critically important.

• Due Diligence on the company you are thinking of using
• A good contract with the company you end up using
• Quality Control monitoring every step of the way

Note how only the second of these three is explicitly legal. I am going to talk about the first two. I am not going to talk about Quality Control (QC) because I figure you all are much more knowledgeable about that than I am.

Let’s first talk a bit about Due Diligence.

It is absolutely critical.

I have already done a fair amount of talking about various countries, but to a large extent it is not the country that matters, but the company with which you are doing business.

First off, countries do not tend to be monolithic. Take China, for example. Shanghai is in most respects more like New York than it is like a tiny city in a remote Chinese province. If you have to sue a Chinese company in China, you will be far better off suing in Shanghai where your judge will likely have a law degree from a top university and view his task as ruling fairly. If you sue a Chinese company in a remote province, your judge’s “legal” credentials might consist of a fourth grade education and a prestigious war medal.

The same is true of Russia, where Moscow is more like New York than it is like Magadan. I was once stranded in Magadan in January when the city had no heating oil, so you are going to have to trust me on this.

Second, and even more importantly, the reputation of the particular company with whom you do business should trump the reputation of the country in which that company is based. I am always telling my clients that no matter how good a contract I write and no matter how good the court system is of whatever country is going to enforce that contract, if you enter into a contract with a crook, you are all but guaranteed to face major problems. Conversely, if you enter into a contract with a company that wants more than anything to do a good job for you so as to build up its reputation worldwide, things will almost certainly go well for you, no matter in what country that company is based.

So what due diligence should you do?

The quick, pat answer is whatever is appropriate in terms of the value of the contract. Your due diligence on a 30 thousand dollar outsourcing deal should be very different from your due diligence on a 30 million dollar deal.

You have to be serious about your due diligence, or don’t even bother. For example, if your potential outsourcing company says it did good work for some other company, don’t just believe it. Check it out.

A few years ago, an American company came to me wanting to sue a Chinese company for having provided bad product. When I asked this American company why it had gone with this particular Chinese company in the first place, the American company told me that it had picked this Chinese company because “so and so” had used them. The funny thing was that “so and so” had come to me maybe six months earlier wanting to sue this same Chinese company for bad product as well.

So I then asked the American company if it had ever checked with the first American company regarding its satisfaction with the Chinese company and they told me “no.” They had just assumed that the first American company was happy with the Chinese company simply because they were using them. The second American company lost about a million dollars because of this assumption.

I always recommend going over and visiting the company with whom you are contemplating doing business. Business is business and many of my clients have told me how surprised they were at how easy it was for them to distinguish good companies from bad companies by going and visiting them, even in countries where they did not speak a word of the language.

And don’t be afraid to push for the information you think will be helpful to you. American companies are oftentimes reluctant to be seen as pushing too hard for fear of indicating mistrust. In my experience, the legitimate foreign company actually welcomes the opportunity to prove it is bona fide and it will usually bend over backwards to get you the information you seek. On the other hand, the illegitimate foreign company will usually claim that what you are seeking is “never done” in their particular country.

This means that the way the foreign company reacts to your requests for information can be one of the best and cheapest indicators of the kind of company it really is.

The same is true of Non-Disclosure Agreements (NDA), which you should pretty much always require your foreign counterparty to sign before you reveal anything to them of any real importance. How your prospective outsourcing company handles your request for them to sign an NDA can tell you volumes about who they really are.

My law firm has done hundreds of non-disclosure agreements for China and we know what is acceptable to companies there. So when we draft one for our clients and their Chinese counterpart claims “this is not how we do things in China,” we tell our clients that this is how things are done in China and the only reason we can think of for why the Chinese company would be claiming otherwise is that it does not want to be tied down by a non-disclosure agreement because it plans to steal some of your information.

In fact, for every 100 non-disclosure Agreements we have done for China, I would say that around 50 of them are accepted without any changes, 45 are accepted with reasonable changes and 5 are rejected as not the “Chinese way.”  We actually like it best when the Chinese company comes back with suggested changes because we view that to mean that it is very concerned about not signing a contract that it cannot fulfill. When a company like this does sign a contract it does so with every intention of abiding by it. 

The best way to protect yourself against many of the risks I enumerated earlier is to deal with those risks in your contract. The differences between a foreign and a domestic outsourcing contract lie more in the way the contract should be written than in the issues that need to be resolved. In other words, the issues are mostly going to be the same, whether you are outsourcing domestically or internationally, but the big differences in the laws will usually necessitate that your international contract be written very differently from your domestic one.

What is the benefit of having a written contract with another company?

The most common reason given for having a contract is so you have something you can use to sue on if something goes wrong.

In most instances, if you get into a lawsuit over a contract or over someone having taken your IP, you have already lost. This is particularly true of litigation involving outsourcing agreements.

The second reason for having a contract is so you have a mutually agreed-upon blueprint setting out what is expected of the parties. This means that a well-written contract not only positions you to prevail in the lawsuit you hope never happens, it also helps you avoid problems with your foreign outsourcing company. The contract therefore helps the project go smoothly and that works to decrease the chances of a dispute requiring litigation.

So what should you be looking at in terms of your international outsourcing contract?

The first thing you should do is to make sure that what you are planning to do is legal. I am not kidding. What is legal here may not be legal there and you need to know that. We had a very sophisticated American company come to us after having spent half a million dollars on a market research firm that had told them the Chinese market was ripe for exactly what this American company planned to do in China. This American company was now coming to us to help them with their outsourcing agreement with a Chinese company that would be setting up and hosting their Chinese website and also to have us form their company in China.

They were very unhappy when we told them that China forbids foreign companies from operating on their own in the very business they were planning to start.

When it comes to the contract itself, I am always stressing how international contracts almost always require much greater specificity than domestic contracts. Courts in emerging market countries tend to be good at enforcing simple, clear contracts where the standards for default are objective and where the penalty requires little analysis. They tend not to be good at making contracts for the parties, as is common in the U.S. legal system. In the United States, suing on an oral contract or a contract written on a napkin can work out just fine. Don’t think that will be the case in an emerging market country where your not having your contract sealed may preclude you from suing on it.

It is therefore essential that you draft your contract with an emerging market company in such a way that it will produce a good result for you in whatever court you may find yourself. You do not want to base your court case in an emerging market country on a complex set of emails, oral communications and practice over time.

Not only does greater specificity in your contract make sense for foreign courts, it also makes sense for your outsourcing project itself. The cultural and linguistic differences between you and your foreign outsourcing company only increase the likelihood that the two of you will have different understandings about what is implicit in your deal.

For these same reasons, I usually try to avoid words like “reasonable” or “best efforts” in the contracts I draft for foreign countries. What is “reasonable” in Saigon might be very different from what is “reasonable” in Seattle. This is particularly true when it comes to quality. In China, you can pay 25 cents for a t-shirt that will be ruined when washed once. That being the case, it is pretty clear that what constitutes reasonable quality for a t-shirt differs between China and the United States, and there is no reason to think there will not be similar differences with other products and services.

Many years ago, I heard a story of an American who was renting an apartment in Shanghai. Whether this story is true or apocryphal, it is such a good illustration of how Chinese judges and arbitrators view contracts that it really doesn’t matter whether it happened or not. And, by extension, it is also a good story to illustrate how emerging market judges and arbitrators might view your contract.

The apartment this American was renting was a really nice apartment and it had a really nice expensive office chair -- high-end apartments in China are virtually always rented out fully furnished. One day, the really nice office chair broke and became unusable and the American tenant kept asking his Chinese landlord to replace it. But that wasn’t happening.

The lease on the apartment eventually came up for renewal and the American refused to renew it unless the landlord put in writing that he would replace the really nice office chair. The landlord agreed and after the new lease was signed, he came by and put in a $2 metal folding chair.

What would happen in the United States if this tenant were to sue the landlord over the landlord’s failure to replace the office chair with something pretty comparable?

The tenant would almost certainly win because the court would essentially write into the lease contract the provision that the replacement chair had to be a good office chair like the one it was replacing. What would happen if the tenant sued the landlord in a Chinese court?

The Landlord would almost certainly win because if you want something in your contract in China, you had better put it in there.

Why is this chair story relevant? It’s relevant because American companies too often fail to put enough into their contracts with foreign companies. Instead, they just assume that the courts or arbitrators will know what the parties intended and re-write their contracts accordingly. But it doesn’t work that way in China. And it doesn’t work that way in Russia or Vietnam or Korea or Turkey or just about every emerging market country of which I am aware.

Not so long ago, an American company came to me after having received a large shipment of laptop bags that weren't strong enough to hold a laptop. We called the Chinese company to ask about getting a refund, and they told us that if our client had wanted a bag strong enough to hold a laptop, they should have paid 50 cents more per bag for one that could actually do that. The American company should have specified in its contract that they wanted a bag that could hold x number of kilograms.

Damages are another difference between the United States and the typical emerging market country and, therefore, another matter you should consider addressing in your contract.

My eldest daughter is studying in Saigon right now and when she takes a taxi, she makes it a point to talk with the taxi drivers so as to improve her Vietnamese. The taxi drivers always talk of their desire to go to Los Angeles where they will make $2000 a month instead of the $200 or so a month they are making in Saigon. When my daughter explains to them that a studio apartment in Los Angeles will cost them $1000 a month and lunch out costs $10, they literally don’t believe her. They just can’t grasp those numbers.

When my daughter goes to the Ben Than market in Saigon to buy a purse, the vendor typically starts out asking $100 for a purse my daughter ends up buying for 5 or 6 dollars. Why does the vendor ask for $100? Because every once in a while a Western tourist will buy it for $50.

If you go to court in Vietnam or in a typical emerging market country, you will be dealing with something very similar when it comes to your damage numbers.

Let’s say you are a bank and you hired a Vietnamese company to write some software for you. You paid that Vietnamese company $500,000 and the software comes back three months late and it works, but is buggy. So you sue the company in Vietnam and you seek $3 million in lost profits and in the time your company had to spend fixing the software to make it work perfectly.

What is likely to happen to your case in a Vietnamese court?

The judge is almost certainly not going to award you the $3 million you seek. He or she will view that number as the equivalent of the $100 purse, and why not? On top of that, the judge is going to think you have already having saved a fortune by having done the work in Vietnam, so it is unlikely that he or she is going to have much sympathy for you. But the judge is likely to have sympathy for the Vietnamese company if he or she believes it tried its best but is just learning how to handle such big projects. The judge is likely to have sympathy for the Vietnamese company because he or she will likely think that you have not sought hard enough to resolve your issues with the Vietnamese company before suing. And working it out with the Vietnamese company would entail giving the Vietnamese company a lot more time to fix the problems.

In the United States we are always saying “time is money.” They don’t think that way in places like Vietnam and China where time is just an opportunity to throw more really cheap workers at the problem.

So your $3 million dollar case in Vietnam might be worth maybe only $30,000 when and if you win it.

So what can you put in your contract to help you get more in damages?

How about putting in your contract that you can sue your Vietnamese vendor in the United States? You’d get your $3 million from them easy if you could sue here, right? Wrong. If you sue here, you might very well get a U.S. judgment for $3 million, but will you ever collect on it? Vietnam, China, Russia, even Japan: none of those countries will just take a U.S. judgment and turn it into a domestic judgment in those countries such that you will be able to enforce it against your vendor there.

My firm constantly gets calls from American lawyers wanting to retain us to collect on a U.S. judgments they have received against Chinese or Russian companies. The American lawyers have usually charged their clients a pretty fair sum and they think all that is left for them to do is to take that judgment to a Chinese or Russian court. There, they think, they will get their U.S. judgment automatically converted into a Chinese or a Russian judgment and then they will get their money.

But it doesn’t work that way. Your United States judgment pretty much has zero value in either China or Russia, and in most other places in the world as well.

In fact, Chinese and Russian companies love it when you put a United States litigation requirement in your contract with them because they know that their own courts won’t enforce against them whatever judgment you may get. And even if you later realize that suing in the United States is not the way to go and you choose to sue the Chinese or Russian company in its home country, the court there will almost certainly toss your case out for being in the wrong jurisdiction because you signed a contract agreeing to sue in the United States.

So you have to be very careful not to write a contract that essentially blocks you from ever suing on it. And of course, on the flip side, if you put the United States in your contract as the jurisdiction for disputes, the foreign company can easily sue you right here.

Arbitration is oftentimes your best option and should in many cases go into your contract. Almost every country is a signatory to the New York Convention on Arbitration Awards, which means it will enforce U.S. and other foreign arbitration awards.

But arbitration has its shortcomings and sometimes you are better off putting a foreign court as your venue for resolving disputes. For example, if your biggest fear is your outsourcing company running off with your IP or your trade secrets, the fastest and best way to stop that is usually through the courts in the country in which your outsourcing company is based. Choosing the venue oftentimes comes down to figuring out the worst thing that could happen to you and then choosing the best venue for dealing with that.

Another possible solution to the bank software problem I described above is to put a liquidated damages provision in your contract, specifying exactly what the damages will be if the software is late and also what the damages will be if it is buggy – though you will need to define what late and buggy mean. But don’t put three million dollars as the liquidated damages amount; if you do, the court will probably bend over backwards to avoid having to issue a judgment in that amount. Put in $300,000 and you just might get it. Better yet, if your foreign outsourcing company believes you just might get $300,000, you will have positioned yourself well to get the software on time and bug free.

It oftentimes makes sense to put personnel requirements into your overseas outsourcing contract. Emerging market countries have rapid growth and with that growth it is common to see rapid job changing, which likely will not be good for your outsourcing project. One way to try to deal with this is to put in the contract a percentage retention rate that your foreign outsourcing company must meet to avoid a penalty or to get a bonus. You can get even more specific by listing out maybe the ten key people and setting a penalty if some number of those ten leave.

You should also consider the possibility of future currency fluctuations and think about what you should put into your outsourcing contract to protect you from that.

In 1995, a very sophisticated American client of mine sold a very expensive product to a Korean company for three yearly payments of “3.5 million dollars/2.7 Billion Korean Won.” By the time the Korean company was to make its final payment in 1998, its 2.7 billion Korean Won payment was worth only around about 1.7 million dollars, not the $3.5 million dollars the American company had expected. The American company (who had used its in-house counsel, not my firm to draft this contract) came to me to see if it could assert a claim against the Korean company for the approximately $2 million dollar shortfall it had experienced due strictly to the devaluation of the Korean Won, mostly during the Asian crisis of 1997. Since the contract was silent on whether the payments had to be in dollars or in Won, and since it seemed to provide for the Korean company paying in either currency, we determined that the best course of action for this American company would be to chalk this deal up to experience.

One common way to handle currency issues in international outsourcing agreements is for the outsourcing fee to be raised or lowered by half of the percentage change in the currency. In other words, the two parties split the fluctuation down the middle. But if you are going to do this, you need to have clear benchmarks in terms of what the currencies are worth and in terms of when their worth will be measured.

The key here though is that you think about the currency issues before you draft your contract and that you put something in the contract to provide for that – or not, depending on what is most likely to work in your favor.

Protecting your Intellectual Property is always important, particularly when your IP is either going overseas or will be created there. Every country has its own laws governing intellectual property rights within its borders and those laws can run the gamut both as between countries and as between patents, trademarks and copyrights.

Every type of IP asset -- trade secrets, trademarks, industrial designs, patents, copyrights -- may be involved in your outsourcing relationship and the best to protect those assets is to keep them right here in the United States.

But that isn’t always practical and that doesn’t always make business sense.

If you are going to “loan” your IP to a foreign company you should make it clear in the contract what belongs to you. It is not going to work for you to claim a few years from now that “everyone knew it belonged to us.” You should also think about registering that IP in the country to which you are sending it. Registering it here in the United States is not registering it “there”, particularly when it comes to patents and trademarks.

You are going to have to know and understand the IP laws of the country with which you are dealing. Putting in your contract that IP developed by your foreign outsourcing company belongs to you is not going to help you much if under the laws of the country with which you are dealing, the developed IP actually will belong to the employees or independent contractors who worked on it, rather than the company with which you have a contract.

International IP issues are almost always very complicated and it does not help that they can vary so considerably from country to country.

What if you do end up needing to sue your outsourcing provider in its home country? Is all lost? Maybe not.

Earlier this year, The World Bank came out with its 2010 Country Rankings regarding handling of Commercial Disputes, based on “procedures, time and cost to resolve a commercial dispute”:

• China 15
• Russia 18
• Vietnam 31
• Ukraine 43
• Poland 77
• Philippines 118
• India 182

How can China have done so well? Because cases there move much faster and cost far less to bring than in most other countries. The same is true for Russia and Vietnam. Whereas US courts grant extensive time for information-gathering, or discovery, almost all emerging market countries pretty much forgo discovery altogether. It bears mentioning that these rankings did weigh corruption.

Corruption is a much bigger factor in emerging market countries than in the U.S. and is something your company is going to have to address, particularly since the U.S. government has really stepped up its enforcement of the Foreign Corrupt Practices Act (FCPA) in the last few years.

You will need to be particularly careful in dealing with companies in Communist countries. The United States’ Foreign Corrupt Practices Act applies to payments to government officials and there are a lot of government officials embedded in companies in China and Vietnam and Cambodia due to the nature of their economic systems. Paying off a non-governmental employee could also land your company in hot water -- or you in jail -- because most countries have their own laws forbidding this sort of thing.

I am not aware of any country in the world that has a “but everybody else was doing it too” defense.

I often hear people say that contracts in such-and-such a country are not worth the paper they are printed on due to corruption. This is pretty much always wrong.

Take Russia for example. Among the countries with which I frequently deal, I see Russia’s judges as being the most corrupt. But even there, corruption has very definite limits. I have a lawyer friend in Russia who tells me that about half of the judges in his city are corrupt (and he knows exactly which ones are and are not). So is it worth having a good contract if your odds of getting someone who will enforce it are only 50%? Yes, and here’s why.

First off, I am going to assume that you are not going to want to get into the business of paying bribes. And on that, my only advice is never ever do that.

My friend’s Russian city is probably more corrupt than most other Russian cities with strong outsourcing and even if your chances of getting a fair hearing on your case in Russia are only 50%, that is high enough to warrant having a real contract.

But even if you do end up with a corrupt judge, you will still be far better off with a good contract on your side. Let me explain.

Let’s say you are suing your Russian counterparty for a million dollars. Should you go forward with the case if you get assigned one of the corrupt judges? Absolutely yes. If you have a great contract and you should clearly prevail, it is going to cost your Russian counterparty a lot of money to pay off the judge for a ruling in its favor. Even corrupt judges in a country with endemic corruption do not want to be seen as corrupt. If you clearly should have won the case, the lower court judge will be very worried about appearing to the appellate court to have been bought and paid for.

So now you are probably saying, “well that’s great, he is telling me to sue so that the Russian company will have to pay some Russian judge a lot of money, but I am still going to be out my $1 million.” Not so fast. If the Russian company is going to have to pay the judge $300,000 to avoid paying you $1 million, and if the Russian company is going to have to risk going to jail for bribery on top of having made the payment, and perhaps most importantly, if the Russian company is going to have to risk losing the case at the Court of Appeals level (and that court is usually made up of at least 3 judges and is usually in another city), don’t you think it would rather pay you $500,000 than pay $300,000 to a judge and risk paying the million on top of that if it loses on appeal?

And I know $500,000 is not the million you were owed, but it is a lot better than zero. In other words, even where corruption is rampant, you are better off having a good contract.

Here is how some of the more prominent countries for outsourcing fared on the most widely cited and probably most highly regarded corruption index, Transparency International:

• Poland 41
• China 78
• India 87
• Indonesia 110
• Vietnam 116
• Ukraine 134
• Philippines 134
• Russia 154

I hope I haven’t scared you too much.

Just received a very typical email from someone looking to manufacture product in China:

A bit of background on our company; we are a supplier and installer of _______ and following months of design and development have finally completed a prototype model of ___________ which we now want to manufacture in China. Following two months of research and talks with various Chinese manufacturers we found a company which manufactures ____________ based out of __________.

Before beginning talks with them, we asked for them to sign a confidentiality agreement which we are in receipt of. We are now looking to arrange sending over a prototype for them to reproduce and send back. Before doing so, however, I wanted to make sure we are not leaving ourselves in a vulnerable position.

On your blog you discuss an OEM contract. Could you provide some information on what this is and whether we need to look into this at this early stage?

I responded as follows:

You do not need an OEM Agreement until you are actually ready to start manufacturing. OEM agreements cover the manufacturing relationship and you are not yet at that stage.

At this point, what you probably need is an NNN Agreement as I am virtually certain the Confidentiality Agreement you had the Chinese factory sign provides you with little to no protection. Here is some information on NNN Agreements:

• Why Non Disclosures (NDAs) Alone Are Not Enough For China
• Why Non Disclosures (NDAs) Alone Are Not Enough For China, Part II. At Least Make It Enforceable

If you are going to be spending a lot of money to have the prototype made and want to be sure that when it is done you will own the prototype and/or the molds used to make the prototype, then you should have us draft what we call a mold agreement. These agreements are usually not necessary unless you are spending so much on the molds or on the prototype that you want to be certain that if something goes wrong between you and the Chinese factory, you will end up with the molds or the prototype.  

The other thing you will need to think about at some point is securing a Chinese trademark for your name. China is a "first to file" country and so if you are not the first to file for your trademark and someone beats you to it they will own “your” name in China. This means they will then be able to stop you from using their name in China and you will not be able to put your name on your products in China. Without being able to put your name on your product in China, you have to export them without your name on there and then add your name only once your product arrives in the United States. 

If you have any patents on your product, we should discuss that too. My firm does not do any patent work, but I would be happy to refer you to qualified attorneys who do.

If you have any additional questions, please let me know.

 

 

I am always saying that for every 100 China WFOEs and Joint Ventures my firm helps set up in China, it does one representative office. Why so few, when it is generally agreed that representative offices are the easiest type of offices for foreign firms to set up in China? Because the inherent limitations on China Rep Offices mean they seldom make sense.

Rep Offices "represent" in China the foreign company back home. Rep Offices are not a separate legal entity; they are the China representative of the foreign company. Most importantly, they are not allowed to engage in profit making activities. Chinese law limits them to performing "liaison" activities. They cannot sign contracts or bill customers. They cannot supply parts and after-sales services for a fee.

NOTE: This post does not discuss branch offices for banks, insurance companies, accounting and law firms, that are permitted to engage in profit-making activities.

Rep Offices are pretty much limited to engaging in the following:

-- Conducting research.
-- Promoting their foreign company.
-- Coordinating their foreign company's activities in China.
-- Other activities that do not and are not intended to generate a profit.

Because forming a Rep Office in China is faster, cheaper and easier than forming a Wholly Foreign Owned Entity (WFOE), companies oftentimes consider forming a China Rep Office as a way of "putting their tow into the water" there. These companies typically intend to switch over to a WFOE once it becomes clear China will be viable for them.

My firm generally discourage this Rep Office and then a WFOE plan because "switching" from a Rep Office to a WFOE is not really a switch at all. Making that switch in China will involve both shutting down the Rep Office and then forming a WFOE pretty much from scratch. Because the cost of forming a Rep Office, shutting down the Rep Office, and forming a WFOE, will be considerably more than just forming a WFOE, forming a Rep Office with the later intention of forming a WFOE does not usually make sense and most companies will be better off just biting the bullet and forming the WFOE straight away.

Other times, companies have come to my firm believing they need a China Rep office because they need a Chinese entity to sell their product into China. Oftentimes these companies can sell their product into China without having to create any in-china footprint at all. So long as they are not going to have much need for people in China, they oftentimes can get away without forming a company in China at all.

But there are definitely times where a Rep Office makes sense. By way of one example, my firm set up a Rep Office for a US company that sells US made equipment for around $2 million each. This company has no plans to start manufacturing its equipment in China so there would be no need to form a WFOE for that. It already had an arrangement with a Chinese company to repair its equipment sold into China, so no need to establish a WFOE for that purpose either. This company merely wanted an on the ground China presence to improve its sales and to let its customers and potential customers know it is serious about China.

Rep Office applications typically go through the Administration of Industry and Commerce ("AIC"), though some industries (banking, insurance, legal, accounting, airline, media, and some others) also require an additional approval from the Chinese government agency with jurisdiction over that particular industry. All applications must be submitted by a designated/authorized Chinese agent (often known as a Foreign Enterprise Services Company or "FESCO") in the locality where the proposed representative office is to be established.

The application involves submitting fairly standard corporate documents from the foreign company, along with a copy of the lease agreement showing the Rep Office is leasing legitimate business space in China.

MOFCOM usually takes around thirty days to approve a Rep Office. One interesting feature of China Rep Offices is that they are not permitted to hire employees directly; they must be staffed indirectly through a FESCO. Nonetheless, it remains the responsibility of the Rep Office to make sure its FESCO employees have signed off on Rep Office company policies, including on such things as confidentiality. In all instances where we have formed a China Rep Office for our clients, we also have drafted the employment agreements the FESCO must use with the employees. That way we can be certain the agreements best protect our client.

For more on Rep Offices in China, check out the following:

• Setting Up Your China Rep Office. What It Really Takes.
• The Slow Death Of The China Rep Office.
• Representative Offices In China. Things Just Got More Difficult/Expensive.....
• The China Representative Office (RO). Got WFOE?

Just got a call from a United States client who is being told it needs a seal on a relatively unimportant document to be filed in China. Their question to me was whether the seal is "really" required. I told them they had the following two choices:

1. Pay my law firm a lot of money to figure out both whether Chinese law really mandates the company seal for the particular document at issue and whether the government entity with whom the document will be filed really will require our client's seal; or

2. Rush order a company seal online for maybe USD $50. "Is it really that easy? She asked. "Yes," I answered.

Bottom Line: If you are going to be doing business in an emerging market country, make it easy on yourself and get your company seal now. 

I have a lawyer friend who is always saying "it's incredibly easy to get clients...what's difficult is getting paying clients." The same holds true for selling product to China. The tough part is getting paid. 

If you are going to sell product into China (or anywhere else internationally), you should consider employing the following to increase your chances of not getting stiffed:

1. Secure all of the payment in advance. Sophisticated buyers typically will not accept this unless you put up a performance bond or open a standby letter of credit so that it can get its advance payment back. Note, however, that it can sometimes be difficult for Chinese companies to obtain government approval to make full payment in advance.
2. Conduct due diligence on your buyer.
3. Secure some of the payment in advance. This obviously will not guarantee you full payment, but it is better to lose some as opposed to all from a sale. 
4. Secure a Documentary Letter of Credit. With this, you will be paid when there is documentary evidence you have shipped the product according to the terms and conditions of the letter of credit. Smart buyers typically require an inspection certificate to ensure the product complies with the specifications in the contract or the purchase order. This sort of letter of credit mitigates your risk because your buyer's bank has irrevocably guaranteed to pay upon presentation of the required documents.

  We generally recommend our clients secure this letter of credit from a major (not a tiny)   Chinese bank, such as Bank of China, China Construction Bank, Industrial and   Commercial Bank of China, China Development Bank, and Bank of Communications, or a   branch of a known American, Asian or European bank. WARNING:  We have seen more               than our share of fake letters of credit.

  To encourage exporting, many countries, including the United States, make it fairly easy             and cheap to purchase insurance to cover an improper non payment on the letter of                   credit.

There are all sorts of variations on the above, but these are the basics.

By Dan Harris and Simon Malinowski

Many years ago, a friend of mine who helped head up the international division of a well-known United States multinational asked me how I thought his company should go into a particular country (not China). I told him I would ask a friend of mine from that country who really knew how things worked there. This friend told me exactly how the multinational needed to enter and he assured me that if it did anything different, it would encounter big problems.

My friend told me that his company had never done what my guy was proposing and it would not do that in this country either. It didn't and one year later my friend confessed to me that his company had made a big mistake and they actually hired my in-country friend as a consultant (which he had not even suggested in his original manifesto).  Within months, the multinational's problems had disappeared and it is now very profitable in that country.  

When I made my friend take me out for an "I told you so lunch," he downplayed everything saying his company's mistakes had "only" cost them one year and less than USD $3 million.  He was not the least bit troubled by the whole thing.  

Many of my friends at BigLaw with China offices tell me their China operations are losing millions of dollars a year, but that they are in it for the long term and they need to be in China so they do not lose their existing clients to those who are already there. I have heard countless stories of BigLaw (really though it's not the top tier law firms to which this is happening but the mid-level firms) losing their shirts by discounting their rates in an effort to grab Chinese company business. The discount their rates to grab the client now, figuring they will be able to raise their rates on the next project. Instead, on its next project the Chinese company just finds another law firm willing to provide it with a deep discount.

I am always saying that my firm is too small to be able to pursue money-losing business for chimerical long-term gains because we have to keep the lights on in the short term even to be in existence in the long term. 

SMEs going into China simply cannot afford big mistakes. Generally, they have to get things right the first time.  

It is with that in mind that Technomic Asia's Business Podcast has just started a new series of podcasts on Small- and Medium-sized Enterprises ("SMEs") in China. Their first podcast (Kent Kedl interviewing Steve Crandall), entitled, "Small- and Mid-sized Challenges in China: An interview with Steve Crandall," focuses primarily on market opportunities available to SMEs in China and how not to get burned.

• China is a unique opportunity for SMEs.  Crandall notes that growth for SMEs in the first 6-18 months of their existence is usually slow in already well developed Western countries. On the other hand, China’s rapid development and growth leaves a lot of open market space foreign SMEs to maneuver and grow.

• If you’re going to do China, know China. China is not an entire market onto itself. For example, the social, cultural, and linguistic differences between, say, Guangzhou and Beijing could not be more apparent. Consequently, viewing China as an entire market is a mistake; it is more appropriate to look at it as a number of unique markets under a larger umbrella. The regional diversity, coupled with a good degree of autonomy between the provinces necessitates knowing your target markets.

Though China's regional diversity complicates entry, it also magnifies the market gaps that allow for growth.

• If you’re going to do China, do it right. Included in all of that regional diversity is the somewhat autonomous functioning of the regional government entities. In order to smoothly enter one of these markets, developing knowledge of and strong ties with the regional government is almost a necessity.

Successful entry into China requires serious due diligence and a comprehensive game plan. The risks are serious and significant for SMEs, and a failure to adequately prepare for them can be disastrous. Kedl and Crandall both point to IP protection and employment as potential minefields. 

Multinationals have a wealth of resources available to the, including the ability to withstand failed experiments. SMEs do not have this luxury and Crandall notes “they have to get it right the first time.” 

I have seen too many SMEs lose big due to one mistake not to vehemently agree with this podcast. The most common "lights out" mistakes I have seen have been the following:

• Purchasing product from China without a finely tailored OEM Agreement. The American company gets a massive shipment of bad product from its Chinese supplier and it has no real recourse against the Chinese company and insufficient resources to both secure new product and pay off its disgruntled customers.  

• Failing to properly register key trademarks in China. If you do not register "your" trademarks in China, someone else will. And then right when your largest shipment is a bout to leave China, you will get a call from the company that registered "your" trademark. They will be calling to let you know that unless you pay them a massive licensing fee, your shipment will never leave China.

• Thinking that because you have gotten away with functioning illegally in China for years (or because you know someone else who has) that you will never get caught. Absolutely not true. My firm has been contacted by a firm that was in China for twelve years before it was unceremoniously shut down for not being properly registered. We were also contacted by a company who was allowed by the local government to operate a business for nine years against all zoning regulations, but then shut down one month after a new administration took over.

• Failing to have a written (Chinese language) employment agreement with all employees and failing to have an employee manual (again, in Chinese) explicitly setting out the grounds for termination.  Though I have yet to see a company have to close down for these mistakes, I have seen many instances where companies subjected themselves to expensive and protracted (and always losing) litigation for these mistakes.

I could go on and on.  What have you seen out there? 

Yet another excellent post by Santiago Cueto at the International Business Law Advisor. It is entitled, "How to Avoid International Disputes: First, Be Good to Your Suppliers," and it provides absolutely critical for how to treat your suppliers.

I virtually never go a week without talking with a client retaining my law firm to write their OEM supply contract with a Chinese supplier and that means I virtually never go a week without saying that if "we do end up in a lawsuit on this, we are guaranteed to lose out no matter what." My mantra is as follows:

"The main purpose of this agreement is to prevent problems. It will help prevent problems by giving both parties a road map of where things are supposed to go and a road map of what each of you are supposed to do. It will also prevent problems by setting out a clear path for handling any dispute that arises. This tells everyone that the party that causes the problem can be fairly easily hauled into arbitration or court and there will be a price to pay for having caused the problem. But really, the whole purpose of that too is to prevent problems because, let's face it, if you do end up having to litigate against your supplier, that means things have gone really wrong and no matter how good a contract you have, litigation is never going to make you whole."

Or as Cueto told one of his clients who wrongly thought "fantastic" margins can cure all evils:

Be careful," I advised the client, "litigation can easily erase those 'fantastic' margins. Worse yet, your back- up suppliers may get wind of the dispute and cut you off. Now you're left scrambling for a new supplier while your customers are screaming for their orders." Good luck with that.

Cueto then talks about how companies so often "get the supplier issue backwards" by thinking that because they are the one ordering the product, they are in the dominant position and then sets out four ways to become a valued customer of your suppliers:

Always pay on time. For the sake of emphasis, I'll repeat this one: Pay your bills on time! You can negotiate for favorable payment terms before you place an order, but once the order is placed, don't renege or attempt to change the rules. If you can't, call up your suppliers and tell them why and when you will pay. Don't play games with suppliers' cash. You'll be absolutely amazed at the goodwill and benefits you will earn by observing this simple rule.
Provide adequate lead times. Try to give suppliers as much lead time as possible on your orders. Unless there's a compelling, competitive reason not to, share with them an honest projection of your needs and keep them abreast of any significant changes in that estimation. When developing your lead times, it helps to be knowledgeable about your suppliers' production methods and needs.
Personalize the relationship. Visit suppliers' offices. While you're at it, include them in some of your strategy meetings. Invite them to break bread and invite them to your office parties and picnics.
Share information. Keep the good suppliers aware of what's going on in your company. Tell them about changes in key personnel, new products, special promotions and so on. Many times, you'll find that good suppliers can be help you find new customers.

Though Cueto was writing about how to deal with suppliers everywhere, his advice holds true of China as well. Though China definitely has its fair share of terrible suppliers, I can tell you that many of my clients have had terrific long term (decade or more) relationships with their Chinese suppliers. I can also tell you that, without exception, they have manged to achieve this by pretty much sticking to the advice above.

This is part II of our series on what are commonly referred to as non disclosure agreements or NDAs. In Part I, "Why Non Disclosures (NDAs) Alone Are Not Enough For China," we talked about how far too many companies are using inadequate, off the shelf American NDAs in China. Those agreements are inadequate for three primary reasons. First, they typically fail to cover internal disclosure within a network. Second, they oftentimes fail to prevent the Chinese signing party from manufacturing or using the product or information sought to be protected. To remedy this, non-use provisions are required. Third, they usually fail to prevent the Chinese signing party from circumventing the foreign company by going directly to the foreign party's customers or clients. To remedy this, non-circumvention provisions are required.

But even if these NDA agreements were to account for the three issues discussed in Part I and more briefly above, most of the ones we see would still not be worth the paper on which they are printed because they are pretty much unenforceable in China. Let's let co-blogger, Steve Dickinson, explain:

Most NDA agreements I see are just modifications of the standard NDA used in the U.S. The non-disclosure provisions do not deal with the special problems of related parties in China and the non-use/non-circumvention is treated inadequately or not at all. Only a carefully thought out NNN Agreement (non-disclosure, non-use, non-circumvention) that treats all the issues is of any real use in China.

Even the best agreement is of no use if it cannot be enforced. This is the other major defect of the typical NDA agreements I review: the agreement is usually not enforceable. It is absolutely required that an NNN Agreement be enforceable in China. And yet, most of the NDA agreements I read are governed by U.S. or English law with enforcement by litigation in the U.S. or England or by arbitration outside of China. This approach is almost always useless. U.S. courts have no jurisdiction over Chinese companies, so a judgment from a U.S. court is of no value. Arbitration outside of China is expensive and slow and proof is difficult or impossible and denies access to injunctive type remedies that would be available for arbitration in China.

To greatly increase your chances of an NNN Agreement that will actually be enforced, the following nearly always makes sense:

1. The Agreement must include an accurate translation into the Chinese language.
2. The agreement must provide for enforcement through litigation in a Chinese court or through CIETAC arbitration.

To further ensure that the NNN Agreement will be enforced, the NNN Agreement should provide for specific monetary damages that will be awarded in the case of a breach. Though U.S. and other common law systems sometimes discourage using this sort of liquidated damage provision, the Chinese system is the opposite. Specific contract damage provisions are encouraged since they ease the court's work.

Most NDA type agreements rely almost exclusively on injunctive relief as the primary enforcement mechanism. This is a a major mistake in China. The preference for injunctive relief in common law systems (such as the United States or England) is because it is often difficult or impossible to prove the amount of economic damages that result from a breach. This is not really an issue under Chinese law where parties to a contract are encouraged to set a fixed amount for damages that will result from a breach. If written correctly, the liquidated damage amount sets a floor on damages, but if actual damages exceed that amount, it is permissible to seek damages for the excess. In addition, money damages and injunctive relief are not exclusive. A court or arbitrator is free to order that damages be paid and that the infringing/breaching party terminate the infringing action.

NNN Agreements that set forth a specific damage amount that will result from a breach make the cost of a breach clear to the Chinese manufacturer and if set high enough, will go a long way towards discouraging a breach. Having a properly written liquidated damages provision in your NNN Agreement also makes for quick and effective litigation/arbitration, which is much to the advantage for the damaged party.

Many Chinese manufacturers quickly sign the traditional poorly drafted and unenforceable non disclosure agreement without even thinking about it. Why is that? Because they know that their signing it comes with little to no risk.

When a Chinese manufacturer sees a well drafted NNN Agreement, they will sometimes resist signing. For some manufacturers, the reason is simple. Their whole reason for doing your outsourcing work is to acquire your technology and designs to use for their own products. So long as your technology is not protected by patent or trade secrecy law, and you have failed to require the Chinese manufacturer sign a strong NNN Agreement, the Chinese manufacturer is free to use your technology for its own purposes. Absent an agreement that prevents them from doing otherwise, it is perfectly legal for a Chinese manufacturer to use your unprotected information for their own products manufactured under their own trademarks. However, if an NNN Agreement makes clear that the Chinese manufacturer cannot appropriate your technology and contacts, then the manufacturer who wanted your OEM manufacturing solely for these reasons no longer has the motivation to enter into the arrangement with you.

Sometimes the manufacturer has more complex reasons for refusing to sign a well drafted and enforceable NNN Agreement. A well drafted and enforceable NNN agreement shows the Chinese manufacturer that the foreign party knows its way around China and that it plans to hold the Chinese manufacturer to the terms of their contractual commitments. For this reason, the Chinese manufacturer may reasonably decide it would be better off just manufacturing for those foreign companies that do not manifest an intent to hold the Chinese side to their commitments.

Therefore, using a well drafted and enforceable NNN Agreement does actually increase the risk that the Chinese side will refuse to sign. However, we see this as a good thing. If the Chinese side has a good reason for not signing, they will say so and the agreement can be modified to account for that. If the reason for the Chinese side refusing to sign is not a good one, the Chinese side will be forced to make this clear also. In either case, the foreign company benefits from finding out in advance what is really going on. This "advance notice" function is one of the main advantages of a good NNN Agreement; it forces both sides to face up to the real situation and to engage in a frank discussion of what is really required for a successful and long term relationship. This is a much better situation than ritually executing a meaningless agreement.

This latest recession has only caused even more small and medium sized businesses to look to cut costs by outsourcing their product manufacturing to China. Unfortunately, many of these companies now engaging in OEM (original equipment manufacturing) outsourcing to China are failing to take some or all of the minimal legal steps necessary to protect themselves. When problems arise, they can do little or nothing to protect themselves because they have no legal basis for protection.

China's legal system for resolving commercial disputes has improved greatly over the past ten years and taking a few basic legal steps can greatly reduce your risk. The cost of such protection is modest compared to the protection it will provide.

The following five basic steps will greatly reduce your problems with Chinese manufacturers, while improving your chances of recovering should any problems arise.

1. Create and properly register your intellectual property rights in the United States or whatever country or countries in which you sell the bulk of your products. If you do not have a firm basis for your IP rights under U.S. law, you will have nothing to protect in China. Before you go to China, be sure your intellectual property is protected under U.S. law or the laws of whatever country or countries in which you sell your products. Protect your brand identity by creating and registering your trademark, slogan and/or logo. Register your important copyrights. Carefully identify and protect your trade secrets, proprietary information and know how. Patent what you can.

Doing the above will mean that no matter what happens in China, you will at least be able to protect your product to the fullest extent possible in the country or countries in which you sell your products.

2. Register your trademarks in China. Registration can protect your future access to the Chinese market, prevent the export of counterfeit goods from China, and prevent a competitor from registering your mark in China, which would prohibit you from exporting your own product from China. For more on the necessity of registering your trademark in China, check out, "WHEN To Register Your China Trademark" and "China Trademarks -- Do You Feel Lucky? Do You?"

3. Use a written agreement to protect your know how and trade secrets in China. Small and medium sized companies usually do not have an extensive portfolio of patents. Their most valuable intangible assets typically are their know-how and their trade secrets, which cannot be protected by formal registration. Chinese law, however, permits companies to contractually protect their know how and trade secrets by contract. Such agreements may (and in most cases should) also address issues such as non-competition and confidentiality. Without such a written agreement, no such protection is available. For more on using non disclosure agreements (NDA) in China, check out, "Why Non Disclosures (NDAs) Alone Are Not Enough For China."

4. Product Quality and Payment Terms. The rule here is simple. Do not make final payment to your Chinese manufacturer until you are confident you will be getting an on time shipment of the correct items and quantities at the quality standards you require. This usually means you must incur inspection costs in China and provide for a clear procedure for dealing with these problems as they arise. You must take the lead on this. You cannot depend on the OEM manufacturer to do this for you.

5. Use comprehensive OEM Agreements with each manufacturer. Small and medium sized businesses often enter into OEM manufacturing transactions with a simple purchase order. This is a mistake. The purchase order will not protect you. Your protection depends on your securing a signed written OEM manufacturing agreement with each Chinese manufacturer with which you deal. The ideal OEM agreement will address all of the issues discussed above while also addressing other basic legal issues such as jurisdiction and dispute resolution. This agreement should be in both Chinese and English, since the Chinese language version will control in China. For more on this, check out, "China OEM Agreements. Why Ours Are In Chinese. Flat Out."

If you do the above, you will greatly increase the chances of good results from your China outsourcing. For some more tips on China product outsourcing (including non-legal ones), you should also check out, "The Six (Not Five) Keys To China Quality" and "Six More Keys To Quality Product Made In China."

By Steve Dickinson

Chinese employment law presents many challenges to U.S. employers. One issue that causes much confusion is the proper use of non-compete agreements with Chinese employees. Before China adopted its Labor Contract Law (“LCL”) in 2008, it was common for foreign employers to require all of their Chinese employees to enter into non-compete agreements. This blanket use of non-compete agreements was never a good policy under Chinese law. This is because the Chinese labor arbitration board and the courts view non-competes with great suspicion as an infringement on the basic employment right of the employee. This is not unlike how US courts view these agreements.

Consistent with this basic hostility towards employee non-competition agreements, the LCL provides for clear provisions on such agreements. On the positive side, the LCL makes it clear that “reasonable” non-competition agreements are enforceable. On the other hand, the LCL provides a set of rules for non-compete agreements that significantly reduces their utility for employers. We find that many employers ignore the new rules and continue to operate under the old system. This has two bad results. First, the employer believes it is protected when it is not. Second, the inclusion of a provision that openly violates the terms of the LCL weakens other provisions that arguably comply with the law. The only rational course of action is to proceed in careful compliance with the law.

Non-competition agreements are authorized by Articles 23 and 24 of the LCL. The basic rules are as follows:

* An employment agreement may include provisions intended to protect the trade secrets of the employer. A non-competition agreement may be included in support of such protections.

* The employer must pay reasonable compensation on a monthly basis to the employee during the term of the non-competition period. There is no definition of “reasonable compensation.” Commentaries suggest employees should be compensated in a manner equivalent to their salary with the company. Others suggest that compensation is only required at the level of the current minimum wage in the relevant jurisdiction.

* Non-competition agreements are limited to executives, technical personnel and other personnel who have access to trade secrets. Cases have held that senior sales staff are included in this category. On the other hand, blanket agreements that apply to all employees are invalid.

* The terms of the restriction must be “reasonable” in length of restriction, business scope and geographic area. A term in excess of two years is prohibited. The scope requirement is strictly interpreted. It is not sufficient that the employee is working in the same general area as the former employer. Competition must be specific and direct.

* If the employee violates the terms of the non-compete agreement, the employee can be held liable for a payment of contract damages to the employer. The amount of contract damages must be reasonable. Excessive damages that are clearly punitive will be rejected.

We have seen many cases where employment agreements contain provisions that violate the requirements of the LCL. By far the most common issue is failure to pay compensation to the employee during the non-competition period. Many foreign employers strongly object to the notion of paying an employee to abide by the terms of a non-compete agreement. This is especially true when an employee voluntarily resigns and then goes to work for a potential competitor. However, the law is very strict on this issue. Reasonable compensation must be paid on a monthly basis. Failure to pay or a delay in payment voids the entire noncompetition provision. The vast majority of employee non-competition claims are rejected for failure to make payment. The requirement applies even if the employee has found employment elsewhere and does not “need” the compensation for not competing.

Employers simply need to face the fact that non-competition agreements have very limited utility under Chinese law. The better approach is to deal with the whole issue under the terms of a trade secrecy agreement. Employees are bound by the terms of any trade secrecy agreement they execute. Employees who will truly be exposed to trade secrets should be required to execute a non-disclosure and non-use agreement. Such an agreement will make the use of trade secrets in their new employment a contractual violation subject to action by litigation. The main issue is that the employer must prove that the employee is actually making use of trade secrets in the new position.

The most common reason such claims fail is that there is in fact no trade secrecy violation. For example, a common claim is that sales personnel are making use of the client list of the former employer. However, client lists that are kept in an open Rolodex or in an open file or in an open access computer file are not secrets. In other cases, the employee in fact had no access to trade secrets applicable to the claim. For example, a common claim is made against sales personnel, but the trade secret is highly technical information concerning the product. In this case, sales personnel can successfully argue that though the product is the same, they had no access to or ability to use highly technical information related to the product.

On January 1, 2006, China implemented its New Company Law. At around that same time, China Law Blog's own Steve Dickinson wrote a scholarly article on the new law for the Pacific Rim Law & Policy Journal, entitled, 'Introduction to the New Company Law of the People's Republic of China." At around the same time, Steve wrote the China corporate law section for the international corporate deskbook, International Corporate Procedure We are reprising Steve's Pacific Rim article now as part of our new series, setting out the basics on China business law. This article was written in 2006, but we have noted where the statements that have become glaringly out of date.

I. INTRODUCTION

On October 27, 2005, the People's Republic of China adopted a new Company Law. This law became effective on January 1, 2006.' The New Company Law replaces the Old Company Law, which had been adopted in 1993. The New Company Law is a complete revision of the old law. Almost nothing of the old law survived the revision. Drafters estimate approximately ninety percent of the provisions of the new law are unique.

The New Company Law governs two types of corporations: limited liability companies (youxian gongsi) and joint stock companies. The changes to limited liability companies are especially important to foreign investors in China because the statutes governing foreign direct investment in China require foreign investors to operate through a Chinese limited liability company.

For existing foreign invested limited liability companies, the rules on operation of such companies have substantially changed. Potential new investors must realize the old rules no longer apply and consider the new regime. Because foreign investors are currently prohibited from investing directly in China through joint stock companies, the discussion below will be limited to the New Company Law's changes regarding limited liability companies.

II. IMPORTANT CHANGES INTRODUCED BY THE NEW COMPANY LAW

A. Management and Articles of Association

Under the Old Company Law, the articles of association for a limited liability corporation was not a living document. Article 22 of the Old Company Law provided a list of items to be included in the articles. As a matter of practice, companies were required to include those provisions and no others. As a result, articles of association were virtually the same for every company regardless of its size or nature. There was no freedom to revise or adapt the articles to meet the specific needs of a particular company. Under the Old Company Law, the roles of shareholders, directors, and officers were taken as mandatory provisions to be followed by all companies. As a result, the articles of association became little more than a "Fill in the blanks" form document adopted by every company without regard to the actual management needs of that company.

The New Company Law abandons the rigidity of the old law and encourages shareholders of limited liability companies to take a flexible approach to company management. The articles of association now are intended to be adaptable to meet the specific needs of each company. The New Company Law provides for management of the company by the shareholders, directors, officers and supervisors and provides default provisions concerning the duties and scope of authority for each. However, with respect to many important provisions related to management of the company, the New Company Law specifically provides that the shareholders are free in the articles of association to adopt specific provisions to meet the needs of the company. There are virtually no provisions related to management that cannot be altered or expanded in a manner determined by the shareholders in the articles of association.

The New Company Law also encourages shareholders to include provisions in the articles of association related to the financial management of the company. For example, the Old Company Law required profits earned by the company to be distributed among shareholders strictly in accordance with the shareholders' ownership interest in the company. Under the New Company Law, shareholders are entitled in the articles of association to provide for distribution of profits in any manner agreed to by the shareholders, even if that distribution differs from the ownership percentage of the respective shareholders. This provides significant flexibility in financing of limited liability companies that was entirely absent under the Old Company Law.

Under the former company law system, officers and directors often used their companies to secure financing of other businesses with which the officers and directors were involved. To restrict such behavior, the New Company Law provides that the shareholders may impose limitations on the authority of the directors and senior management. If officers or directors exceed the authority given them, their actions are void and the shareholders may file suit to compel compliance and for damages.

B. Reduced and Simplified Minimum Capital Requirements

Chinese company law emphasizes registered capital requirements as a means to protect creditors. Since credit reporting is still primitive in China, the New Company Law emphasizes registered capital reporting and full capitalization of all new companies. It simplifies and significantly reduces minimum capital requirements in an effort to make the corporate form available to more individual investors and to more investors from China's less developed regions. The Old Company Law imposed minimum capital requirements of 500,000 RMB for manufacturing and wholesale trade businesses, 300,000 RMB for sales businesses and 100,000 RMB for service businesses. Though these limits did not significantly restrict state owned enterprises or individual investors in China's wealthier coastal regions, they imposed significant barriers for individual investors and for businesses in the less developed regions.

The New Company Law eliminates both the high minimum registered capital requirement and the system of capitalization based on the type of business. Under the new system, the minimum capital requirement for limited liability companies with two or more shareholders is reduced to 30,000 RMB. For single shareholder limited liability companies, the minimum capital requirement is set at 100,000 RMB. The minimum capital requirement is the same for all types of business activities. The intent of this change is to channel as much economic activity as possible into companies formed and registered under the New Company Law. The hope is that the protection of limited liability will encourage economic activity, particularly in currently underdeveloped regions of China.

C. Single Shareholder Limited Liability Companies

The New Company Law now allows natural persons or legal persons to form single shareholder limited liability companies. Under the Old Company Law, a limited liability company was required to have two or more shareholders. In contrast, the new statute provides for a simplified management structure appropriate to single shareholder entities. However, in order to prevent abuse of the corporate structure in single shareholder companies, the New Company Law provides for a number of restrictions:

* the registered capital requirement is increased to 100,000 RMB;

* the entire registered capital amount must be paid in a single installment;

* a single investor may form only one single shareholder company; and

* if the shareholder fails to maintain adequate distance between the finances of the company and the shareholder's personal finances, the shareholder will lose the protection of limited liability and will have joint financial liability for company debts.

These single shareholder provisions illustrate the manner in which the New Company Law attempts to balance the benefits of limited liability status to potential investors while still providing protection to creditors.

D. Public and Shareholder Access to Company Information

The Old Company Law was silent regarding public access to information about companies, and in practice, access was extremely limited. Without the assistance of an attorney or other legal professional, it was generally not possible to access a company's basic registration information.

The New Company Law takes an entirely different and much more public approach. The New Company Law provides that the public has the right to access basic company registration information and further provides that the registration authority must provide consulting assistance in accessing that information. The public will now have access to the following information on limited liability companies:

* name

* registered address

* legal representative

* registered capital

* business classification

* scope of business

* termination date

* identity of shareholders

Under the Chinese system, all of this information is considered essential for creditor protection. The New Company Law takes the reasonable position that creditor protection requires this basic information to be freely available to the public. Since the identity of shareholders is freely available, it is now impossible to use a Chinese limited liability company to conceal the identity of the true party in interest.

The New Company law also significantly expands shareholder access to company information. Under the former system, shareholders had no practical way to obtain information about company operations. This allowed the directors and officers to operate the company for their own benefit and without any effective supervision by the shareholders. Under the new law, the company must maintain the following basic records and make those records available to the shareholder at the shareholder's request:

* articles of association

* minutes of meetings of the board of directors

* minutes of meetings of the board of supervisors

* tax returns and financial reports

The statute also provides for shareholder access to the company's full financial records. In this case, though, the company has the right to deny access if it believes such access will damage it. This could occur, for example, where a shareholder is also a competitor of the company. If the company willfully withholds information from the shareholder, the shareholder may file suit to force the company to release information.

E. Abuse of Shareholder Rights and Piercing the Corporate Veil

The New Company Law introduces the new concept of the abuse of shareholder rights. This concept is intended to protect both the company and third party creditors. The new law provides that shareholders must exercise their rights in accordance with the law, the regulations, and the company articles of association. The shareholder must not abuse the independent legal person status of the company or his own limited liability rights in a manner that harms the interests of the company or its other shareholders or creditors.

Where such abuse damages the company or other shareholders, the offending shareholder is liable for such loss. Where such abuse is used by the shareholder to escape liability for his own debts in a manner that seriously damages the interests of a creditor of the company, the shareholder is jointly liable for such debts. A similar provision is contained in the single shareholder company section. It provides that the shareholder of a single shareholder company who cannot prove that the finances of the company are independent of his or her own finances will have joint liability for the debts of the company. This "piercing the corporate veil" concept is entirely new to China and though it may be useful to prevent obvious abuses, it could also be used to undermine the concept of limitation of liability, which is the foundation of the corporation law concept.

F. Limitations on Third Party Loans and Guarantees

Unrestricted debt guarantees to unrelated companies were a major problem under the former company law system. Large companies that appear to be financially solvent are often actually insolvent because they used their profits to acquire unrelated companies or to guarantee the debts of companies related only through the private financial interests of directors, officers, or controlling shareholders. To the detriment of legitimate creditors, the extent of such loans, guarantees, and other security arrangements are oftentimes not exposed until bankruptcy or insolvency proceedings are commenced.

Articles 15 and 16 of the New Company Law seek to remedy this. Article 15 permits a company to invest in another company, but prohibits it from doing so in a manner such that it becomes jointly liable for the debts of the other company. Article 16 provides additional rules concerning the providing of investment or debt guarantees to third party companies:

* the investment or guarantee must be approved by either the board of directors or by the shareholders, as provided in the articles of association;

* where the articles of association limit the amount of investment or guarantee, such limit may not be exceeded; and

* the shareholders must approve a guarantee provided to a shareholder or to the person actually controlling the company, In such cases, the benefiting shareholder may not participate in the decision and approval must be by a majority of the remaining shareholders.

Under this approach, the senior management of the company and individual directors have no authority to make investments or to provide guarantees. This is a significant departure from former practice. This is also an example of the new approach to the articles of association, where shareholders are encouraged to limit potential abuses by specifically limiting the authority of directors and officers.

G. Legal Remedies for Improper Acts of Directors and Senior Management

As noted above, a major problem affecting companies in China has been that individual directors and senior management operate the company to benefit themselves while disregarding shareholders' interests. The New Company Law seeks to address this matter directly. First, Article 149 expressly prohibits directors and senior management from engaging in the following acts:

(1) Misappropriating company funds; (2) Depositing company funds into an individual account; (3) Loaning company funds or providing a company guaranty without shareholder approval; (4) Signing a contract or trading with another company in violation of the articles of association, unless the shareholders expressly consent; (5) Without shareholder consent, seeking business opportunities for oneself or for any other person by taking advantage of one's authority, or operating for oneself or for any other person any business similar to that of the company for which one works, without shareholder consent; (6) Taking commissions on a company transaction ; (7) Disclosing company secrets without permission; (8) Other acts inconsistent with the obligation of fidelity to the company.

This detailed list of prohibitions is a good summary of the kinds of problems that occurred under the old system.

The Old Company Law did not provide any clear method for shareholders to protect their rights when directors and managers behaved improperly. It was silent on the power of the shareholders to take action in the court system if such activities occurred. As a result, some courts refused to hear shareholder complaints on the ground that the Old Company Law did not authorize them to interfere in a company's internal affairs.

The New Company Law provides a clear set of procedures for shareholder action and specific authority to appeal to the courts to resolve such matters. Article 152 provides that when a director or senior manager violates the provisions of Article 149, noted above, the shareholder(s) holding one percent or more of the total shares of the company may require the company to file suit in the people's court. If the company refuses to file suit, the shareholder may file suit on behalf of the company. In addition, if the interests of the shareholders are directly affected, then the shareholders may file suit on their own behalf. Article 153 further provides that if any director or senior manager damages a shareholder's interest by violating any law, administrative regulation, or the company's articles of association, the affected shareholders may file suit for compensation.

Under the New Company Law, the court system is intended to be the final authority for protection of shareholder rights and for ensuring that companies comply both with government regulations and with the provisions of their articles of association. These provisions in the New Company Law further underline the importance of the articles of association in governing the company and in protecting shareholder rights.

III. THE NEW COMPANY LAW'S IMPACT ON FOREIGN INVESTORS

Direct foreign investment in China may be carried out in three forms: a wholly foreign owned entity, an equity joint venture, or a contractual joint venture. [UPDATE NOTE: come 2010, it appears we will be adding limited partnerships to this list] These forms of foreign invested enterprise are typically organized in China as limited liability companies. The statutes and associated regulations provide for specific and unique provisions concerning each of these three forms of foreign investment in China. Where the unique provisions do not apply, the provisions of the New Company Law will control. The foreign invested enterprise statutes and regulations are concerned with approvals and investment percentages, but not with day to day management issues. Accordingly, the fundamental changes introduced by the New Company Law will significantly impact both existing and future foreign invested enterprises in China.

The three foreign invested enterprises laws provide for special treatment of investors in a limited liability company based on the status of the investor. In this case, the status is foreign nationality. Similar status based distinctions formerly existed for domestic enterprises. For example, wholly state owned enterprises and town and village enterprises were governed by their own unique statutes and regulations. A primary goal of the New Company Law is to eliminate such status-based distinctions for domestic enterprises. As a result, all Chinese companies are in principle formed under the provisions of the Company Law, regardless of the status of the investor.

This change in principle is not the case for foreign investment, primarily because China still provides significant tax benefits and other incentives to foreign invested enterprises. It is essential to be able to characterize a limited liability company as a foreign invested enterprise to maintain these special benefits. [UPDATE NOTE: Most of the tax law distinctions and special benefits for foreign companies no longer exist.]

For example, an extremely favorable tax regime provides foreign invested companies with benefits not available to domestic enterprises. This foreign invested enterprises tax regime provides for numerous tax reductions, including the following:

* a reduced fifteen percent tax rate instead of the normal thirty-three percent rate

* exemption from all income tax for certain periods

* rebates of taxes paid upon reinvestment of profits

* exemption from import duty on imports of equipment

In addition, local authorities are authorized to provide additional tax and related incentives to foreign invested enterprises.

This special regime for foreign investors has survived adoption of the New Company Law. These tax and related benefits give foreign invested enterprises a significant business advantage over purely domestic Chinese competitors in the Chinese market, which makes investment in China more attractive for foreign investors. [UPDATE NOTE: Most of these special benefits for foreigners no longer exist]

IV. CONCLUSION

The New Company Law intends to make a revolutionary change in the practice of formation and management of corporations in China. However, a mere change in the law is not sufficient to bring about such change. The change will come only if the principles and procedures embodied in the new law are actually adopted and used by entrepreneurs, attorneys and the courts. There is much that suggests that the process of change will be slow and difficult.

Some elements of the New Company Law will have an immediate impact. These are elements that can be applied automatically by local government officials and that do not require the participation of legal professionals or the courts. There are three such provisions that should have such immediate impact: the reduction in the amount of registered capital, the provision allowing single shareholder limited liability companies, and the provisions that allow for a simplified management structure for limited liability companies with a limited number of shareholders.

It is realistic to presume that these provisions will be implemented within the existing Chinese system. Each of these provisions can be implemented without the commitment of resources and in a way that is entirely automatic. For the reduction in registered capital and single shareholder companies, this is obvious. The changes are uniform and are applicable throughout the system without the need for local officials to make discretionary evaluations. Management structure is similar. Local authorities can devise a check box form that allows the party forming the company to choose one of two options: either a full board or a single director. Once the choice is made, the local authorities can then proceed in a rigid and formalized manner that does not require discretion or judgment.

The other, more dramatic changes introduced by the New Company Law will encounter implementation problems. As with most Chinese laws, the New Company Law was drafted by a group of sophisticated legal professionals at the top levels of government but with little input from the public or lower levels of the bureaucratic structure. These changes require demand from the public, legal professionals for implementation, government officials for registration, and a court system for enforcement. Given the weak judiciary system and a bureaucracy unaccustomed to handling complex corporate law questions, the New Company Law likely will have little impact on closely held limited liability companies in China. Absent public or institutional demand for such sweeping legislation, the only way the legislation may have any impact is through a combination of massive, government-imposed education and vigorous government enforcement. Since neither of these may happen in China, the New Company law likely may fail to have the significant impact the drafters hoped for. [UPDATE NOTE: Steve's predictions have generally come true. The new law has improved corporate governance in China, slowly but surely.]

V. BIBLIOGRAPHY

1. Company Law of the People's Republic of China (promulgated by the Standing Comm. Nat'1 People's Cong., Oct. 27, 2005, effective Jan. 1, 2006) LAWINFOCHINA (last visited Nov. 5, 2006) (P.R.C.) [hereinafter New Company Law].

2. Company Law of the People's Republic of China (promulgated by the Standing Comm. Nat'l People's Cong., Dec. 29, 1993, amended Dec. 25, 1999 and August 28, 2004), translated at www.lawinfochina.com/dispecontent.asp7db= l&id=3656 (last visited Nov. 5, 2006) (P.R.C.) [hereinafter Old Company Law].

3. See the discussion on foreign invested companies, infra Section III.

4. See New Company Law art. 37-57 (giving the provisions for management of limited liability companies).

5. See, e.g., id. art. 42-47, 49-51, 54, 56.

6. Old Company Law art. 33.

7. New Company Law art. 35.

8. See id. art. 38,46, 50.

9. See generally id. art. 26-32.

10. Old Company Law art. 23.

11. New Company Law art. 26.

12. Id. art. 59.

13. Id. art. 58-64.

14. Old Company Law art. 20.

15. New Company Law art. 59.

16. Id.

17. Id.

18. Id. art. 64.

19. Id. art. 6, 7.

20. Id. art.7, 25.

21. Id. art. 23(3).

22. Id. art. 165,166.

23. Id. art. 34, para. 2.

24. Id. art. 20.

25. Id art. 64.

26. Id. art. 16.

27. Id. art. 149.

28. See generally Law of the People's Republic of China on Enterprises Operated Exclusively with Foreign Capital (promulgated by the Standing Comm. Nat'l People's Cong., Apr. 12, 1986, effective Oct. 31, 2000) LAWINFOCHINA (last visited Nov. 7,2006) (P.R.C.).

29. See generally Law of the People's Republic of China on Chinese-Foreign Equity Joint Ventures (promulgated by the Nat'1 People's Cong., Mar. 15, 2001, effective Mar. 15, 2001) LAWINFOCHINA (last visited Nov. 7, 2006) (P.R.C.).

30. See generally Law of the People's Republic of China on Chinese-Foreign Contractual Joint Ventures (promulgated by the Nat'l People's Cong., Oct. 31, 2000, amended Oct. 31, 2000) LAWINFOCHINA (last visited Nov. 7, 2006) (P.R.C.).

31. New Company Law art. 218.

32. See generally Income Tax Law of the People's Republic of China for Enterprises With Foreign Investment and Foreign Enterprises (promulgated by the Nat'l People's Cong., Apr. 9, 1991, effective Jul. 1, 1991) LAWINFOCHINA (last visited Nov. 7, 2006) (P.R.C.).

33. Id. art. 7, 8, 10.

34. New Company Law, art. 26, 59.

35. Id. art. 58-64.

36. Id. art. 61, 62.

37. The transparency of the legislative process in China has been studied and criticized by many legal scholars. For a brief treatment of this issue and the Chinese law-making system generally, see generally, Congressional-Executive Commission on China, Legislative Transparency of China's NPC, http://www.cecc.gov/pages/virtualficad/govnegistransp.php.

Yesterday, in a post entitled, "How to Start a Business in China -- WFOE," we discussed the basic requirements for forming a wholly foreign owned entity (WFOE or WOFE) in China. One of the questions we are most frequently asked about how to form a WFOE in China is is how much the Chinese government requires in minimum capital.  This post follows up on yesterday's post by addressing the minimum capital requirements issue.

Every company in China must have a stated registered capital. This amount is provided in the Articles of Association of the company and is also noted on the company register. Beginning in 2006, this company register is available to the general public. The registered capital includes all of the components of the initial investment in the company, including its start up cash, contributed property, and transferred intellectual property. Where the registered capital is small, the entire amount must be contributed immediately upon formation of the company. If the amount is large, it may be contributed in installments. There are a number of schedules for the percentage and timing of large amounts of registered capital. It is a crime to state a registered capital amount and then fail to contribute. The purpose of registered capital is to provide some notice to creditors of the capital adequacy of the company. Because of this, Chinese regulators take very seriously the rules regarding registered capital.

Registered capital is an initial investment that is intended to be immediately used in operating the company. It need not just sit in a bank and never be touched. It can be used to pay salaries and rent, to purchase product, or for any other normal start up operating expense. Registered capital may include contributed real and personal property used in operating the business. Many foreign investors think registered capital is some sort of security deposit that they can never utilize. This is not true. On the other hand, some foreign enterprises believe they can simply withdraw their registered capital after the Chinese company begins normal business operations. This also is not true. Once the capital is contributed to the Chinese company, it can never be withdrawn for anything other than paying company expenses.

The only way to get funds from the Chinese company out of China is by repatriating profits or by liquidating the Chinese company. Both of these methods will work, but they both require paying Chinese taxes and meeting other requirements under Chinese law. Investors should also note that the RMB is not a freely convertible currency. For companies that will earn RMB income, the issue of conversion to U.S. dollars or other foreign currency should be carefully considered and a failure to abide by Chinese law all the way along the process will likely lead to an inability to get money out of China at some point down the road.

Under the new Chinese Company Law, the minimum capital requirement for multiple shareholder companies has been reduced to 30,000 RMB (less than $5,000 USD). For single shareholder companies, the amount is 100,000 RMB (around $13,000 USD). However, these numbers have no real meaning for the formation of a WFOE in China.

The real question is what the Chinese authorities will consider as adequate capitalization for the specific project. Of course, that answer varies by type of business and location. For example, it is very expensive to operate a business in Shanghai. On the other hand, it can be very inexpensive to operate the same business in a rural area of China. It is expensive to operate a capital intensive business like manufacturing, but relatively inexpensive to operate a knowledge based consulting business.

The Chinese regulators usually consider all of these issues. To complicate matters, each local regulator has its own basic standards on what constitutes adequate capital for certain types of business activities. These numbers are not published, but when asked they will almost always be provided. They can only be determined through direct contact with the regulator and only after providing a clear explanation of the project. The local regulator virtually never considers the statutory minimum in making a determination regarding adequacy of capital. Rather, the local regulator will determine what it believes is an adequate amount of capital based on all the circumstances. Once the investor has a clear idea of the outlines of a project, it is usually a good idea to engage an attorney to contact the local regulator to see what their response will be to the proposed amount of investment. This initial screening can save a lot of time if the investor's idea of the proper amount of capitalization is dramatically different from that of the local regulator.

In determining what constitutes adequate capital, one needs to consider the peculiar situation in China that building rents are virtually always paid in advance, that payment for products for sale are virtually always paid in advance, and that a reasonable advance reserve for salaries is also required. Thus, the initial start up costs are much higher than in a location like the United States, where credit and time payments are more common. In addition, the foreign investor needs to take into account the risk aversion of the Chinese regulator. The Chinese regulator will not approve a project that looks risky or under-funded. The regulator has no incentive to do this, especially for a 100% foreign owned entity.

The government sometimes permits the minimum capital to be paid in installments over up to two years, though the first installment must be at least 15% of the total amount required and it also must be at least the statutory minimum for total capital. The capital contribution can be made in money, equipment, intellectual property, or other transferable property, but the monetary contribution must be at least 30% of the total capital amount. The government will appraise the value of any non-monetary contribution and our experience has been that it will come in fairly low in its valuation.

We frequently see two big mistakes being made by foreign investors when it comes to their putting in the required minimum capital. Foreign investors hear that assets can be used as a contribution towards the minimum capital requirement, so they go ahead and ship certain assets over to China, with the expectation of then using those assets towards minimum capital. The problem with this approach is that unless the proper authorities have been notified and granted their approval in advance of the shipping, the assets you just shipped to China will not be applied towards minimum capital, and you will have a huge problem on your hands.

The other common mistake we see is the foreign investor putting a value on its assets (including its intellectual property) and assuming the Chinese regulators will put the same value on those assets in determining the contribution towards minimum capital. The Chinese regulators will require their own appraisal (at your expense) l of anything other than monetary contributions towards the minimum capital requirement, and those appraisals tend to come in low, particularly for IP.

Global mega-firm DLA Piper has online an 18 page booklet that does a truly superb job of explaining China's anti-monopoly laws and how they will impact your business. [h/t Experience Not Logic, who appropriately called his post, "There's No Competing With This AML Guide"]. Click here for the DLA primer.