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How To Write A China Arbitration Clause. Badly. Really Badly.

Posted in Basics of China Business Law, Legal News

Our China lawyers are detecting a trend. Years ago we talked of how most of the arbitration clauses we were seeing (not drafted by us) were bad. Now most of them are incredibly bad. And Chinese lawyers are laughing all the way to the bank.

Photo is from Daria. Click through for more of her work

We are more and more often seeing the following as the arbitration provision in contracts between US companies and their China manufacturers:

1. The agreement requires that the parties first try to resolve their differences on their own. It is silent on what this means. Even worse, it sometimes mandates that the parties must spend anywhere from 90 to 180 days doing this. Some even require that these discussions be in China.

2. The agreement requires that if the parties are unable to resolve their differences on their own, they then mediate. It is completely silent on what constitutes mediation and what the party seeking mediation should do to accomplish it. They do usually say that mediation must be in China.

3. If mediation fails, they then arbitrate before three arbitrators, with each party choosing one arbitrator and then those two arbitrators choosing the third. Again, completely silent on how to initiate arbitration or before what arbitral body, though they virtually also state that the arbitration will be in China and in Chinese.

An American company sent me one of these not that long ago and asked if the China lawyers at my law firm might be interested in taking on their case. My answer was essentially not in my lifetime. I figured that by the time we actually figured out what exactly we needed to do every step of the way and did it, we’d be about two years and many tens of thousands of dollars down the road. The amount of the American company’s claim simply could not support a case like this.

For more on China arbitrations, check out the following:

How To Sell Your Product To China. Which Of Us Is Most Local?

Posted in China Business, Legal News

My good friend Ben Shobert wrote an article a while back for Forbes entitled, A New Wrinkle For China’s Medical Device Market, with the following as its opening paragraph:

This week, China’s National Health and Planning Commission (NHPC) threw foreign medical device manufacturers a wrinkle: going forward, the Chinese government would pursue policies explicitly designed to favor domestic manufacturers over foreign manufacturers. The NHPC’s announcement was clear: “We want to strongly advocate health ministry organizations to use domestically-made medical devices, especially pushing top level class III hospitals to use domestically-made products.”

To which I say Duh-uh.  

Ben’s little finger knows more about China’s medical device market than I do (or just about anyone else for that matter), but I really do not view the above announcement as big news, and here’s why.

Our China lawyers have done quite a lot of work for medical device makers and other companies that supply product and services to Chinese hospitals and we have always told those companies the following:

China hospitals are under government pressure to buy local, but in the end, they generally do want the best product at the cheapest price. What this means is that if your product is truly the best and the cheapest product by a wide margin you will probably get the sale. But what this also means is that if your product is just marginally better than a Chinese competitor product and your product is a little bit more expensive you may not get the sale. What can you do to increase your chances of making the sale? Try to look more local.

What does it mean to “look local”? This means that the procedure for the sale to the Chinese hospital must look the same as a purchase from a Chinese manufacturer. The more the sale appears to be domestic, the better your chance of making the sale. This means that the purchase must be denominated in RMB and the purchase must be made from a Chinese company. If you force the hospital to pay in dollars for a direct purchase from a foreign manufacturer, you are not likely to succeed in selling your product or your services to a Chinese government owned hospital. This advice of ours holds true for any China industry with heavy Chinese government involvement.

In more detail, there are the following levels of “local” for making a sale in China, starting with the least local:

1. No China presence. No China distributor or sales agent. No China agent. Just your company based in Toledo, Ohio, making medical products and trying to sell those products to China. With this structure, you are not likely to ever make a sale to a Chinese owned hospital unless you have no legitimate Chinese domestic competitors.

2. Your company is in the United States, but it has a China distributor or sales agent that imports the product into China and then sells it to the Chinese hospital in RMB. This constitutes a domestic sale and it is generally the minimum required to have a chance of selling success as against Chinese domestic competitors.

3.You form a China joint venture and that company sells your U.S. made products to China’s hospitals.

4. You form a China WFOE and that company sells your U.S. made products to China’s hospitals.

5.  You form a China WFOE and that company uses a domestic Chinese distributor or sales agent to sell your product to China’s hospitals.

6. You form a China WFOE and that company actually makes your medical products and sells to China’s hospitals. Under this approach, you would create a Chinese brand identity for the product, registering a trademark for the Chinese name of the product. Since a WFOE is a Chinese legal person, the sale would constitute a sale by a Chinese company to a Chinese hospital, which meets the basic requirement for a domestic sale.

7. You form a China WFOE and that company actually makes your medical products and uses a Chinese distributor or sales agent to sell your product to China’s hospitals. It is almost certain that you will need to use an established Chinese distributor or sales agent, since these traditional traders control the market. If you set up this sort of arrangement, you should be certain to use an appropriate China product distribution agreement.

8. You form a China joint venture and that company actually makes your medical products and sells them to China’s hospitals.

9. You form a China joint venture and that company actually makes your medical products and uses a Chinese distributor or sales agent to sell your product to China’s hospitals.

10. You license the manufacturing of your product to a Chinese manufacturer. The Chinese manufacturer manufactures your product, makes the sales to China’s hospitals and pays you a royalty on each sale. The manufacturer sells the product through normal distribution channels. If you set up this sort of arrangement, you must be sure to use an appropriate China licensing agreement.

This last approach is the most “local.” It is also the result the Chinese government wants when it makes its “buy local” announcements. The idea is to pressure foreign medical device makers to transfer their technology to Chinese companies. Of course, medical device makers resist the pressure to make this kind of transfer. However, the Chinese government has shown that it is quite willing to use its purchasing power to encourage transfer of technology. Medical device makers seriously interested in entering the China market should try to become as local as possible. Those who are serious about entering the China market should even consider the licensed manufacture alternative, since in some circumstances this may be the only way to make significant sales in China.


China Business Proposals: Keep It Simple Stupid

Posted in China Business

American clients frequently come to me wanting to do a business deal in China. The client then shows me what they have sent to the Chinese side. This is usually a long document (typically at least fifteen pages and often double that), with lots of facts and arguments stating why the deal is a good one. The document is almost always impressive and clearly involved a lot of work. However, the document is also almost always a waste of time, and so will be the trip to China designed to negotiate the deal.

This cartoon is by areokay and can be found here:http://aerokay.deviantart.com/art/Proposal-212732039

After reading the document, I usually ask my client, “what exactly are you asking the Chinese side to do?” Their response is usually to tell me that they intentionally left that part out because they do not have a good sense of what the Chinese side will want to do. They then explain that this is why they set out so many facts and provided so many different options.  They then further explain that they cannot “just make a proposal because we do not really understand the motivation or concerns of the Chinese side and the last thing we want to do is offend them by making them think that we are trying to push them into a deal structure that will not work for them.

This approach to negotiation in China is almost always a disaster. Virtually no deal introduced this way will ever get off the ground in China because Chinese businesses typically want a simple, specific, concrete proposal to which they can respond. If the foreign side leaves the structure vague, the Chinese side will usually have nothing to say. In this situation, a deal that may be good for both sides never gets done because neither side can bring it to the point where the real bargain is negotiated. The Chinese side always wants to show its cards last. If you do not show your cards first, there will be no cards back from the Chinese side.

I recently worked with a client on a somewhat unusual investment project in China. The U.S. side had worked many years with a Chinese manufacturer and had developed a good relationship based on trust. The U.S. sent the Chinese side an investment proposal. The document was complete, describing the investment opportunity and the prospective return on investment. The U.S. side contacted me with a sense of frustration because the response from the Chinese side was not clear. The Chinese side had not said either yes or no. Instead the Chinese side had responded with frustration and irritation. I had to interpret the message. I told the client that the Chinese side’s message was: What do you guys want us to do?

I advised the client to assume that it understood what would be the best deal for both the Chinese side and the U.S. side and suggested that it draft up a one page proposal reflecting that. I then suggested that our client send this one one page deal proposal to the Chinese side and then visit the Chinese side a few days later. I stressed that this statement must be provided in writing in advance to give the Chinese side time to think about the deal and prepare its response.

The short story is that the U.S. side did what I recommended. They met with the Chinese side for three days. At the end, they put together a deal that is good for both sides.

From this negotiation, we can extract the following four basic rules for making just about any type of business proposal to a Chinese company:

1. Make a clear written proposal stating exactly what the Chinese side is expected to do. If a joint venture corporation will be formed in China, your proposal should state that, along with the joint venture’s ownership percentages. Do not worry about being wrong about what the Chinese side wants. If the underlying deal is a good one, the Chinese will be quite willing to tell you what is wrong with your proposal and to tell you what must be done to fix it. The Chinese side will not be offended that you took the first step; instead, they will be relieved. On the other hand, the Chinese side will never take the first step. If you don’t do it, it won’t happen.

2. Your clear written deal proposal should be one to two pages long. If you write more than that, the proposal will probably never get read. The Chinese often assume that a deal that is too complex to explain in one or two pages is a fraud, and they will have no interest in being scammed.

3. You should deliver your written deal proposal in advance of any meeting where the proposal will be discussed. Chinese business people do not want to be put in the position where they are required to think on their feet. They want sufficient time to digest any proposal and they need time to discuss the proposal with their bosses and their advisors. If you spring a proposal on them where they have not had a chance to prepare, you will likely be met with a stony silence at best, angry complaints at worst.

4. Your project timeframe should not extend beyond three to five years. Many foreign investors believe that Chinese businesspeople have a long-term view of the world and of business relations. This is typically true of Japanese and Korean businesspeople but this is not generally true of the Chinese, who generally have a three year business time line. Due to China’s rapid changes since 1980, Chinese businesspeople are quite reasonably convinced that business opportunities cannot be projected beyond three years. Your written deal proposal should reflect this.



China Music Copyrights

Posted in Events, Legal News, Recommended Reading

Late last year I attended the Dong Dong Music Convention in Beijing. Anybody interested in the music business in China should think about attending the Convention or at least the related Festival. Ed Peto of Outdustry invited me to a great panel he was moderating called What’s New in the Field of IPR in China. One of the panelists was Guo Biao of IFPI China. Just in case, IFPI is short for “International Federation of the Phonographic Industry.” 

There has been a lot of talk lately about proposed changes to China’s copyright law and the Dong Dong panel piqued my interest in the issues confronted here by the music industry. A few weeks later I sat down with Ed and Biao to discuss some of the points they raised during their panel.

Biao kindly provided the fourth draft of the new Copyright Law of China as drafted by the National Copyright Administration of China, known as the “NCAC.” When settled, the NCAC draft will go to the Legislative Affairs Office of the State Council, which will prepare its own draft for submission to the National People’s Congress. Along the way, the debate among stakeholders has been fierce. Chinese television broadcasters, in particular, do not want to see changes proposed by the music industry because those changes would require the payment of royalties. More about this in a later post.

In my next post I will look at some of the terminology used in the Copyright Law of China as it applies to music, especially the terminology attracting so much heat in the stakeholders’ debate. In the meantime, here is a good overview of copyright in China.

Demand Letters For China Disputes: They Just Work

Posted in Legal News

Demand letters have become so common in the United States that they rarely elicit either fear or action from their recipients. Some lawyers no longer bother with such letters, believing that you should always sue first and discuss settlement later.

China is different.  

Our China lawyers have a much higher rate of success in China demand letters than we as a law firm do just about anywhere else. We send these letters in Chinese, sometimes under our own law firm letterhead, and sometimes under the letterhead of one of our affiliated Chinese law firms — with their cooperation, of course. Like a demand letter in the United States, we usually conclude these letters by saying that if resolution is not reached within a certain number of days, we will commence a lawsuit or an arbitration.

It is not clear exactly why we tend to have such a high success rate with these letters — nor on one level do we really care. But for whatever reason, in China, where demand letters (they are actually called lawyer’s letters there) are less common and companies are not as joined at the hip to their lawyers as in the United States, these letters are viewed as more important, unusual, and serious.

Two Columbia Law School professors, Benjamin Liebman and Curtis Milhaupt, did a study, Reputational Sanctions in China’s Securities Market , where they posited that the avoidance of public humiliation is a big behavior inducer in China. Unlike in the United States where being sued is viewed pretty much strictly as legal matter, in China it is humiliating, as noted by the Economist Magazine in Shame fills a vacuum in China’s financial law enforcement:

Over the past 18 years, China has introduced rules against market manipulation, fraud, and insider dealing, but enforcement remains patchy. The China Securities Regulatory Commission seems competent, but overwhelmed. Sometimes it takes years to issue penalties after lengthy investigations — and along the way, cases lose relevance. In the meantime, the exchanges have quietly begun to acquire authority. The power that they wield appears flimsy — the most serious penalty they can levy is a rebuke to firms and individuals through public notices.

But it is remarkably effective in a country with a long history of punishment by humiliation. As a result of the culturally relevant and effective method of financial enforcement mechanism, Messrs. Liebman and Milhaupt write that between 2001 and 2006, the exchanges publicly criticized 205 companies and almost 1,700 people. They looked at the share prices of the targeted firms, both when they disclosed the conduct for which they were being criticized, and when the criticism was published. The admissions typically preceded the rebukes, and in the few weeks that followed, the firms’ share prices underperformed the Shanghai stock market by an average of up to 6%. After the criticism, there was a further lag of up to 3% on average.

After an entity goes on the government “black list” through public criticism and shaming, raising money through equity markets and banks became more costly, and sometimes impossible. Suppliers and customers also took a tougher line. Some people lost the right to be a director or senior manager, and suffered from pariah status in a country where there is little pity for failure. The criticisms were sometimes even a prelude to formal investigations by the regulatory authorities.

This study highlights the relevance of culture in how to handle a legal matter. In the United States, being sued, investigated, and/or prosecuted is pretty much a legal matter; while in China, it is more than that. When someone gets sued in China, one loses integrity in the public eye. For example, a few years ago, a Chinese friend of mine was sued by his boss down in Houston, and he was extremely distressed and felt humiliated by the lawsuit even though he understood that such lawsuits in the United States are quite common. Public shaming goes deeper into the psyche of the Chinese (in general terms) because of the fear of failure and because of “face.”

It is shockingly common for Chinese companies to respond to our demand letters by admitting its fault (which American companies virtually never do) and even by explaining in some detail why the problem occurred. Most importantly, these letters work to generate payments fairly frequently as Chinese companies very much want to avoid the reputational problems that come from being sued.

Unfortunately, we are finding — particularly recently as a result of China’s economic downturn — that even threats of imminent humiliation do not work on Chinese companies that no longer exist or simply lack the funds to pay. It also is important to mention that we do not bother writing demand letters when the legal claim against the Chinese company has little to no merit. Just as in the United States, a demand letter in that sort of situation will usually be a waste of time.

China Product Development Contracts: I Don’t Get No Respect

Posted in Basics of China Business Law, Legal News
When someone emails one of our China lawyers asking us what they need to protect themselves when manufacturing in China, we typically respond with something like the following:

Our clients that manufacture product in China typically use us for some or all of the following:

NNN/NDA Agreements. We do these NNN Agreements in Chinese (the official version) and in English (for you). These typically take us 4-5 business days to complete. You can learn more about our NNN Agreements here and here. These NNN Agreements aim to protect the confidentiality of your product and to prevent your Chinese manufacturer from competing with you or circumventing you. They make sense before you have chosen your Chinese manufacturer. The logistics of these are that we first send you via DocuSign.com a one page Flat Fee Agreement setting out the fee structure. Next we send you a questionnaire and then we draft the NNN in English for your approval. Once you approve, one of our China lawyers translates it into Chinese and we send that to you. You then send it to your Chinese counterpart and if they propose any changes (which happens about 50% of the time with them just approving it around 50% of the time) we revise it until completion.
OEM Agreements. Once you have chosen your Chinese manufacturer, you need an OEM Agreement (these are sometimes known as manufacturing agreements or product supply agreements). You can find out more about our OEM Agreements hereherehere, and here. These typically take us 10-14 days to complete. The process is pretty much the same as for the NNN Agreements. If you are already certain who you will be using as your Chinese manufacturer you can skip the NNN Agreement and go straight to the OEM Agreement as our OEM Agreements contain all of the substantive provisions of our NNN Agreements. 

China Trademarks. If you plan to put your company or brand name on your products or on their packaging you will also want to register your brand name and/or your product names and logos as trademark(s) in China. As we discuss here, this is true even if you will not be selling your product in China. 
There is one more contract that is occasionally needed and that is a Product Development Agreement. A Product Development Agreement makes sense for those foreign companies that do not have a finished product ready for manufacturing and will be working with a Chinese manufacturer to develop the new product. These agreements cover the cost and procedure for developing a product. Many companies fail to enter into this kind of agreement only to discover later that the Chinese side owns “their” product IP or the molds or the tooling at the end of the process.
In our experience, a Product Development Agreement is needed well under five percent of the time. This being the case, we do not mention it in our initial email setting out what is “typically” needed for having a product manufactured in China. I estimate that an NNN Agreement is needed around 50% of the time (the other 50% of the time there is nothing worth protecting or the secret has already been revealed and therefore the other benefits of an NNN Agreement will go into the OEM Agreement. I estimate that an OEM Agreement is needed 99.9% of the time and a trademark registration about 98% of the time.
Anyway, the problem that we as lawyers face is that when a Product Development Agreement is needed, it is almost always needed in addition to everything we mentioned in our email and our clients and potential clients by that point have reached what should probably be best described as document fatigue. I mean, who knew that something as simple as getting a widget made in China would require four separate legal line items. This makes our clients/potential clients reluctant to sign up for that “just one more document.” Think Monty Python’s thin mint.
We recently had this situation with a good client and the below is the email (modified slightly to remove any identifiers) one of our China lawyers wrote to this client on the pros and the cons of our doing a China Product Development Contract for this client (called ABC Company):
As discussed, the basic problem with having a Chinese (or Taiwanese) factory do product development without a development agreement is ownership of the IP should ABC Company not end up ordering products from the factory. We talked about what happens if the factory cannot make the product pursuant to your specifications. The variant of this that we see most often is when the factory likes the product and thinks it can do better selling it on its own, and once development is complete, it quotes the buyer (in this case, that’s you) a ridiculously high per-unit price. The buyer says forget it, at which point the factory thanks the buyer for reinvigorating its product line. We have seen this scenario play out dozens of times, and the buyer has absolutely no recourse: it has no agreement covering development, and it did not pay the factory a dime. I don’t think there’s a court in China that would hold the factory accountable.
That being said, I am not unsympathetic to your concerns. A separate development agreement would increase the cost of the process, and it would take additional time – time that you may not have, if your target launch date is mid-2015. I can’t say how your factories would respond, but sophisticated factories are (or should be) familiar with such an agreement.
Your point about your ongoing relationship with Chinese Manufacturer A and Chinese Manufacturer B providing some comfort is also well taken. The sort of behavior I describe above is more likely to happen with a factory that has no previous relationship with the buyer, and therefore more incentive to opt for a “sure thing” short-term gain. And it doesn’t happen every time. But we would be remiss as lawyers, and in particular as professionals with years of experience dealing with Chinese factories, if we didn’t flag the loss of your IP as a significant risk here. And the best way to protect against loss of your IP is to have a separate development agreement.
If you don’t want to do a separate development agreement, the next best option is an OEM agreement with two essential features. First, you will want a paragraph stating that the factory will be doing product development for Company ABC but that Company ABC will own all of the IP. This may not be enforceable, but it is better than nothing, and it will at least memorialize the parties’ understanding. Second, you will need language about mold ownership, and you absolutely must pay for the molds.
Do not let the factory create the molds for free. If you do not pay for the molds your arguments that you own the molds will hold little to no weight.
Given Company ABC’s time and cost constraints, and the primacy of product design (and hence molds) to the new product line, a single OEM agreement for each factory seems to be the most realistic course of action.
Don’t hesitate to contact me should you have any questions about the above.
 China Product Development Contracts: They Don’t Get No Respect.

Beijing Employment Rules: Tighter And Tighter

Posted in Legal News

In September 2014, the Beijing Human Resources and Social Security Bureau, Foreign Affairs Office of the Beijing Municipality and Beijing Education Commission jointly published the Circular on Further Strengthening the Employment of Foreigners in Beijing (关于进一步加强北京市外籍人员聘用工作的通知) (“the Circular”). In this post, I highlight a few key aspects of this Circular. 

According to the Circular, foreigners may be employed in Beijing only if they satisfy the following conditions:

  1. The candidate is in good health.
  2. The candidate does not have any criminal record.
  3. The candidate is between the ages of 18 and 60 (subject to the exception noted below).
  4. The candidate must possess a valid passport or other valid travel document in lieu of a passport.
  5. The candidate must have a specified employer.
  6. The candidate has a bachelor’s degree or higher and possess a minimum of two years work experience in the relevant area, with the exception of language teachers, who must have at least five years of work experience in the relevant field. However, for senior technicians urgently needed for tasks relating to key technology or research and development, a candidate without a bachelor’s degree can be employed upon providing a certificate proving the relevant skills or qualifications.
  7. The candidate must obtain a work permit and a residence permit for work purposes and cannot take on any job beyond the permitted scope of the work permit.

The circular also provides that the age and work experience requirements are not absolute and to the extent certain talents are “immediately needed” in Beijing, these requirements may be relaxed. The Circular does not define what would qualify as “immediately needed talents” and the Beijing Labor Bureau has not issued any written guidelines on this. We would expect that the more specialized or rare the skills, the more likely the admittance.


Additionally, the Beijing employer is required to enter into a written labor contract with the foreign employee, the term of which cannot exceed five years but may be renewed indefinitely. The Circular also reinforces the requirement that the employer contribute to social insurance for the non-Chinese employee. Employers that fail to pay the full amount of social insurance may be subjected to an administrative fine up to three times the outstanding amount. The Circular also mandates that employers maintain a copy of the following employment-related documents: the labor contract, a copy of the employee’s passport, a copy of the employee’s work certificate, a copy of the employee’s temporary residence registration form, proof of the employee’s lack of criminal history abroad (I note how much fun it is proving that someone does not have a criminal record!), the employee’s attendance records, the records of social insurance payments on behalf of the employee, and the employee’s wage payment history.

The employer must apply for cancellation of the employee’s work permit within 10 days after termination of the employee’s labor contract. If the employer wishes to renew its employee’s labor contract, it must do so by submitting an application with the relevant authorities at least sixty days before the expiration of the employee’s work permit, otherwise the non-Chinese employee’s work permit expires immediately upon expiration of the term of the labor contract.

Bottom line: Beijing is very serious about the applicable employment laws and rules and we strongly advice our clients that compliance will in the long term be cheaper than non-compliance.  If you are an employer in Beijing, you need to be mindful of the requirements imposed by this Circular in addition to the relevant national regulation and local rules,

China 2015: What’s Going To Happen?

Posted in Legal News

I know it is getting a bit late to be doing a year end/first of the year type blog post, but I just can’t help it. I just read Gordon Orr of McKinsey’s What Could Happen in China in 2015? and it is too good just to let slide by.

Orr mostly focuses on the economy and innovation and does a great job with both of those things. But this being a law blog (and me being a China lawyer), I was drawn to his section entitled, “Rule of law increases its impact in 2015.” I love this section because it both repeats what we have been writing about for the past few years and it very much dovetails with my recent Forbes article, Six China Business Law Trends and my even more recent Linkedin article, 2015: China Law Trends That Will Impact Your Business. Here is that section:

A comment you’ll hear less in 2015: I can do this—it’s China. Businesses will more fully recognize that anticorruption initiatives and rule of law with Chinese characteristics are long-term foundational elements of this leadership’s platform—they’re not optional, and they’re not going away. Companies will need to become clear about how recent statements—such as President Xi declaring that the objective of advancing the rule of law is conducive not only to updating state governance but also to deepening reform—apply to them.

We will see the government standardize more of its approaches to decision making on business and regulatory issues, using the precedent of cases heard. For example, reviews of acquisitions should be faster, with clearer conclusions. We will also see the government leveraging technology more to monitor, audit, and impose sanctions on bad behavior, from tax avoidance to overly aggressive entertainment of government officials. Where could anticorruption investigations bite in 2015?

  • in an Internet company where a senior executive gets investigated for begging forgiveness, rather than asking permission, once too often
  • in local government, where rapid asset sales made it possible for some sales to be made to favored individuals at below-market prices
  • in companies that have yet to fully get their sales forces under control

I wholeheartedly agree. If you are doing business in China, you should start acting accordingly.

China WFOEs: Don’t Let This Happen To You

Posted in Basics of China Business Law, Legal News

Every so often, someone with a WFOE about to be shut down by the Chinese government (broadly defined) contacts us. These contacts seem to accelerate during economic slowdowns and that has been the case of late. The following is a totally scripted composite of some of the emails we have received relating to a WFOE shut down:

We set up a WFOE and started a small widget manufacturing business inside a residential compound in Nanjing. The local authorities came by the other day to tell us that because it would be impossible to license our venue for any sort of business (our company legal address is necessarily elsewhere) they would be shutting us down. Apparently there is only a title deed for the entire complex, which was built around 4 years ago. The property management company is completely on our side, but they seem unable to do anything or don’t know what to do. We registered as a consulting company, not an XYZ business.  

We would really like to have this resolved asap, as we will otherwise need to lay off our staff. Is there anything you can do?

We usually very nicely write back suggesting that they retain local Chinese counsel because it just does not make sense for a small company to pay a large amount of money on what will almost certainly be a losing cause. But the following is what I really want to say:

You have a big, probably insurmountable problem, entirely of your own making. You no doubt used a cheap formation agent to form your WFOE and, unfortunately, you went along with what you either knew or should have known to be illegal. Your business is illegal and there is no way we can solve that.

Just to be clear, your business is illegal for the following reasons — and this is just what I am able to glean from your five sentence email:

  • You registered your business as a consulting company but you are operating as a widget manufacturing business. I’m guessing you did this because your entity formation company told you that doing so would be faster, easier and cheaper and would keep your required minimum registered capital low. But you knew all along that you were not a consulting company.
  • Your registered address is “necessarily elsewhere” because to get your WFOE you needed a separate and legitimate address that allows for manufacturing. Your widget business is in an apartment complex, which obviously does not allow manufacturing. You knew you provided the authorities with the wrong address and you knew exactly why you did so.
  • Your existing address can never qualify for a legitimate WFOE because you need your own separate space/address for a WFOE and where it is located (as you point out by saying there is only one title for the entire complex) constitutes just one business location. You knew this and this is why you did not list this address as the address when you registered.
  • Your lease is illegal and that is why your landlord cannot help you. It sounds like your landlord is not authorized to lease out a part of the property for a business. The area in which the building is located is almost certainly not zoned for business. It’s an apartment, isn’t it?

I really don’t know what else to tell you other than that you had better get a good local Chinese attorney and fast. Or maybe, better yet, you should just walk away.

In How To Form a China WFOE. Scope Really Really Matters, we talked of how the scope described in an initial WFOE application matters even after the WFOE is approved:

BUT — and this is why I am writing this post now — if you under or overreach on the description of your business scope, you might find yourselves in big trouble. My firm’s China lawyers are getting an increasing number of calls from American companies in trouble with the Chinese government for doing things in their business that were not mentioned in the business scope section of their initial WFOE.

In some cases, the companies have admitted to us that they were never “really comfortable” with the business scope mentioned in their applications, but that the company they had used to form their WFOE had “pushed” them into it as it would “make things much easier.” In some cases, the scope of the business changed after the application was submitted and the company had failed to secure approval in advance for the change. And in some cases, the company probably would never have been approved at all had it been upfront and honest in its application. In nearly all instances, the companies had managed to secure local approval but were now in trouble with Beijing, which constantly is auditing these applications. In one instance, the local government went back and changed its mind, probably after conducting an audit of its own.

I cannot go into any more detail on these matters, but I can give this advice: applying for a WFOE in China involves a heck of a lot more than just filling out a form and getting approval. It does matter for what you get approved and you (or whomever you are using for your WFOE application) need to know China’s foreign investment catalog inside and out before applying. You then must tailor your application to meet both the requirements of the foreign investment catalog AND the reality of what you will be doing in China. A failure to comply on both fronts will lead to, at best, a rejection of your application and, at worst, being shut down months or years later.

If you take away nothing from this post, please at least understand that your getting local government approval for your WFOE does not mean you are out of the woods. There is little to no benefit in getting approval for a non-conforming WFOE.

We typically see the following two fairly different WFOE scope problems:

1. The current scope of business applies to the basic type of business the WFOE is conducting, but the scope is too narrow. An example of this would be where the scope is for a service business, but now the company wants to do a service business that is not strictly within its original scope. In this case, making the scope broader can be done, but doing so is time consuming and complex.

2. The WFOE wants to go into an entirely different type of business. Take for example: service businesses, manufacturing businesses, trading companies,  and retail businesses. These are all entirely different forms of business in China. In this sort of case, the WFOE cannot simply change its scope of business; an entirely new WFOE must be formed that is then qualified to do the other type of business at a new location. Thus, shifting from service to manufacturing is not a simple matter of changing scope. It means starting over from the ground up with an entirely new business entity.

In other words, scope of business has two different functions in China. It is used to set out the basic business type and it is also used to set out what a WFOE is authorized to do within that business type.

Our China attorneys rarely confront a situation where the scope of the business is too narrow. What we mostly see is the situation where someone wants to do a business of a different type than that for which they were authorized. For example, it is common for manufacturers to want to operate as a general trading company or do basic retail. We also frequently have service companies that decide that they want to start manufacturing engaging in general trading or in retail. The issue in these cases is not that their scope of business is too narrow; it is that they want to go into an entirely different type of business for which they are not approved.

We see this a lot in software as well. The company starts its China WFOE planning to sell its software into China as a download from its U.S. server. No problem. Then after they have formed their WFOE, they decide that they want to sell their software as a service (SaaS) via the cloud or set up a retail operation in China. They think this is natural, but they are not authorized to do either and they cannot change their scope of business. They have to start over and determine how to do what they now want to do. Sometimes, what they want to do cannot be done by any WFOE in China. In other cases, the PRC staffing and registered capital requirements are so onerous that they either cannot comply or compliance is too expensive. In either case, the situation cannot be repaired by a change in business scope. They have to go back to the beginning.

Thus, even though formation agents often convince American companies to form an improper WFOE by saying that “this scope will make things easier,” what the formation agent really means is that “what you want to do is illegal or impossible so form your WFOE this way, operate illegally and hope for the best.” The point is that in these situations the matter cannot be “fixed” by manipulating the scope of business. Before forming a China WFOE, the foreign investor needs to determine how it will be doing business in China legally.

In Leasing Requirements For A China WFOE To Be, Part II, we talked about the importance of having a valid lease for your WFOE and made clear that without such a lease, you should not bother having a WFOE at all:

If you are not going to get the right space for a WFOE, you are probably better off not getting a WFOE at all. Registering a WFOE and then not complying with ALL of the requirements for having a legally operating WFOE is a classic example of trying to operate quasi-legally in China. For why this is a bad idea, check out “Quasi-Legal In China. Not The Place You Want To Be” and “Forming A Company in China. Do It Right Or Do It ALL Wrong, But Don’t Do A Rep Office.

But what if you right now have a WFOE that is “out of scope” or located in an improper location? What should you do beyond just sticking your head in the sand and hoping that the next knock on your door is not the government?

If your location is improper, hunt down a proper one and then seek permission from the appropriate authorities to have your address changed. This usually is not so difficult and it usually works.

The same general advice applies to broadening the scope of your WFOE’s business so long as your type of business does not change. The first thing you should do is secure shareholder approval to broaden the WFOE’s scope. Once you have that approval, you should revise the WFOE’s Articles of Association to reflect the new broadened scope. You then go to the State Administration of Industry and Commerce where your WFOE was originally registered with the applicable change in scope application form. This application requires the original and a copy of the WFOE’s business license, its company seal and legal representative seal, written proof of the shareholder decision to broaden the scope of the WFOE, and the WFOE’s newly revised Articles of Association. Once you have secured the scope change from SAIC, you should then update the WFOE’s tax registration to reflect that change. This too can be relatively complicated. Nonetheless, doing these things will always beat having a government official tell you under threat to do these things or having your business shut down because you failed to do so.

The Bottom Line: Form your WFOE correctly or don’t bother forming one at all. China’s economy is on the decline and it views foreign companies operating illegally as easy pickings. If your WFOE is not living up to its registration requirements/promises, you are at risk and you should act now to clean up. If you can.


CIETAC Arbitrations: U.S. Companies Can Win

Posted in Legal News

Charles Moure (my firm’s head of litigation) and I recently won a substantial award in a CIETAC arbitration in Shenzhen.

Our client was a foreign entity. The defendant was a well established local businessperson. Before we filed for the arbitration, a number of China lawyers told us that it made no sense to bring such an action since the case would be heard ten miles from the headquarters of the defendant. However, we found just the opposite. The arbitration procedure was professional and fair and the resulting decision fairly dealt with an extremely complicated set of facts. We did not win everything we sought, but we did receive a fair decision. What is also important is that we at all times felt that the arbitration panel fully desired to be fair to both sides in the action, with no regard to the nationality of the parties.  

Here are some takeaways from this arbitration action in China, and from those we have done previously:

1. Do not be fooled by the rules that suggest that the arbitration procedure is informal. The arbitrators will run the proceeding in a manner very similar to a trial in a Chinese court. If you do not understand Chinese trial procedure, you will be lost. In particular:

a.  Forget about using witnesses. Witness testimony is assumed to be false and the arbitrators generally ignore it. Any evidence that cannot be supported by a written document will be ignored.

b.  Forget about making a case out of a series of emails and related informal communications. If you cannot make your case based on more formal written documents, stay home.

c. This all means that your claim must be simple and it must be supported by a clear and unambiguous set of written documents. You cannot fill in with witness testimony and you cannot fill in with emails and correspondence.

d. It is typical of the Chinese side to attempt to confuse the matter by entering endless amounts of emails, phone records, unsubstantiated meeting minutes and the like. Do not worry about it as all of this will be ignored by the arbitrators. The only thing the arbitrators pay any attention to are documents that set out the terms of the transaction and that support the claim for damages. No documents, no case. It really is that simple.

d. You must prepare you evidence in accordance with standard Chinese trial procedure. That means formal presentation of each document and positive support for the authenticity of each document.

2. Though the official rules allow virtually any person to represent the foreign party, this flexibility is an illusion. The attorney representing the foreign side must be completely familiar with the case, with Chinese law, with Chinese court procedure, and with the Chinese language. Even though the rules allow for the legal representative to use an interpreter, in practice this simply does not work. The legal representative must be able to conduct the entire proceeding in Chinese. Language ability, however, is not sufficient. The legal representative must gain the respect of the arbitration panel. This requires an understanding of the Chinese legal system and of the constraints under which the arbitrators work. Many foreign lawyers treat the Chinese arbitrators and the Chinese system with contempt. This does not work.

3. The arbitration panel will be made up of three arbitrators. As the foreign party, you typically will have the opportunity to choose only one of the three. Do not waste your choice. Spend the money to appoint an arbitrator who will make a difference. That means that you must appoint a foreign arbitrator with a complete command of the Chinese language and a complete command of the Chinese system. Most important is that the other arbitrators must view the foreign arbitrator with respect. It must be clear that they will lose face if they issue a bad decision. The foreign arbitrator you choose cannot be a pushover. Fully expect that your most relentless questioner during the arbitration will be the foreign arbitrator. If you are going to wilt under the questioning, you should stay home.

One of our China lawyers is of the view that the determinative factor in most CIETAC arbitrations is the foreign arbitrator. This lawyer has two foreign arbitrators he chooses for every China arbitration and because he wants at least one of those arbitrators to be available for our own clients’ arbitrations he will never reveal their names to anyone other than other lawyers in our firm and to our own clients heading to arbitration.

4. Be prepared for hard questioning. The arbitrators will carefully study the documents you submit, your claims and how your documents do or do not fit in with your claims. They will find all the weaknesses in your case and they will question you without mercy concerning those weaknesses. If you cannot provide a clear and convincing explanation, you will lose. Many lawyers are used to passive judicial panels. Chinese arbitrators are the opposite: each arbitrator will aggressively chase down the holes in the case of each party. Be prepared and be sure that your client’s legal representative is ready to take the heat.