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Foreign Investment in China: Beware of Local Governments Bearing Gifts

Posted in Basics of China Business Law, China Business, Legal News

Recent news reports suggest that Foxconn is having trouble securing investment benefits promised them by the Zhengzhou government. The rumor is that Foxconn was lured to Zhengzhou with promises of over 5 billion RMB in tax benefits and related incentives. These incentives were granted in direct opposition to central government policy. Beijing found out and laid down the law and now the Zhengzhou government is backing down. Construction of a major factory is being delayed as the issues are being sorted out. Of course, Terry Gou, Chairman of Foxconn claims that this report is untrue, confirming that nothing is what it seems in China.

Beware of local government gifts

Beware of local government gifts

Whether true or not, the basic story is a standard in China, describing a practice that has been going on since the beginning of China’s opening up to foreign businesses in 1979. From the very start of opening up, the regions and the center have struggled over the issue of investment incentives. Local governments have always offered incentives to encourage foreign investment and jobs in their own backyard. The primary incentives typically consist of tax breaks and a reduction in land prices. The central government has consistently opposed these incentives. The center is the “owner” of both the taxes and the land. In Beijing’s view, local governments have no right to give away what rightly belongs to the center.

For this reason, the center has always issued clear rules, stating how much by way of tax reductions and land pricing incentives is permitted to be provided by local governments to encourage investments. The rules provide for a level playing field: no local government can legally offer any more than any other local government. Under this system, there is general encouragement to invest in China, but the decision on where within China to invest is based on the overall investment environment of a local region, rather than on the benefits provided. This also allows the center to on its own favor particular regions that it deems need extra help in securing foreign investment.

But what do local governments do when they are located in a region that is simply not terribly attractive to foreign investment? The standard response is to make yourself more attractive by improving local infrastructure, education levels and institutions. This sounds good, but it takes time and for many local governments this approach is simply impossible. For example, Zhengzhou is located in central China, with all the weaknesses that this location implies.

So what we have seen since the 1980s is that disadvantaged regions often seek to compete for foreign investment by offering incentives substantially in excess of that permitted by the central government. To be blunt, they have offered illegal incentives. Where this works, these illegal incentives can make a bad investment at least more attractive. However, the risk is considerable, as the report on Foxconn in Zhengzhou makes clear.

In my own experiences in China, I have seen the following investment incentive disasters:

— One client went to rural Sichuan in the 80s and worked for almost three years on a complex joint venture aimed at the trucking industry. When it finally came time for this client to sign the final investment documents, they were not met by the local party secretary who had been the leader in the project. Instead, they were greeted by a new party secretary and when our client asked about the set of documents they were there to sign the new party secretary told them that there were no documents. “The former secretary has been removed in disgrace. I have been assigned to replace him. His crime was to offer illegal incentives to foreign investors. I am here to clean up. Your project is one of the projects I am targeting. We are pleased to do the investment, but only on the basis of what is permitted by the central government. If that will not work for you, you will have to just go home.”The U.S. company went home, with three years wasted.

— In a different project in Sichuan at about the same time, a U.S. company made the investment. Under the central government rules, the project did not “pencil.” However, with the generous incentives offered by the local government, there was some chance of success. In year two of the investment, when it was too late to back out, a new party secretary arrived. The new secretary revoked the tax incentives and dictated that the joint venture would now be required to pay for the land and buildings at their current market value, not at the reduced price (essentially free) previously negotiated with his predecessor. These changes crushed the venture financially and it fairly soon had to shut down.

— On an aquaculture project in Shandong, the local government offered the standard illegal incentive of low to no taxes and free land and buildings. I advised this company not to go forward with the project since these incentives were clearly illegal. The client said: Steve, you just don’t understand China. In China, the law is not relevant. All that matters is who you know. We have the support of the local party secretary, Mr. X, and he has approved all of these benefits. There is no problem.” The company then headed off to a small coastal town in Shandong for the signing ceremony. On the day before the ceremony, representatives from our client company were eating breakfast in the party-owned and operated hotel, watching the national news playing on the TV. They looked up and saw Mr. X being led from his office in the custody of two policemen. He was arrested and imprisoned for corruption. That doomed the project.

— On a manufacturing investment project near Shanghai, I again advised the client not to go forward because the incentives offered were clearly illegal. The client fired me as his lawyer, giving me pretty much the same “You do not understand China” speech. The former client made the investment at significant cost. As the project proceeded, the company made a small profit, entirely due to the benefits provided by the incentives. However, after the Hu Jintao government took control of the center, the entire upper layer of officials in this region were replaced for having engaged in — your guessed it — corruption. All the special benefits were quickly revoked and this company rapidly spiraled down into bankruptcy.

What should a potential investor take from all this? The alleged situation faced by Foxconn in Zhengzhou is not an exception. This sort of thing is standard practice in China. But that does not make it legal or safe or wise. You are getting incentives, you should should evaluate your China investment in accordance with the central government’s investment rules. These rules (at least in Chinese) are easy to find and are quite clear. If your project makes financial sense under these rules, move forward. If the project does not make financial sense under these rules, you probably should stop.

The key rule is that you should never make your China investment decisions solely based on local investment incentives that violate central government rules. These incentives can be evaluated and accepted as a sweetener, making an already profitable project even more attractive. However, if your project hinges on such incentives, your risk will almost always be too high.

Beware of local governments bearing gifts. Look what happened to the Trojans. It could happen to you.

The China Bank Switch Scam: Still Very Much Alive.

Posted in Uncategorized

Long ago I formulated a self-imposed rule. Whenever I or one of my firm’s other China lawyers receive three emails on the same thing in a week, I write about it. Haven’t been so forced for a while, but it happened this week and the topic is that good old stand-by, the China Bank Switch Scam.

Two of the emails were from companies that had lost less than $50,000 and they were of the “we will never do business with China” school, so not all that much to be said about them. The third one though is far more substantial and I will be describing that one shortly.  China bank switch scam

But first, let me describe what this scam is not and then I will describe what it is. First off, it is not the entirely fake bank that is set up to bilk depositors. That happened in Nanjing earlier this year. This is also not the scam where a fake manufacturer takes money from a Western company and then never delivers any product because it has no product to deliver. That scam happens all the time, but mostly to unsophisticated Westerners who have failed to do even the most basic due diligence on their supplier. No, this is the most common, most pernicious and most difficult to detect China scam of which I am aware, and it just unrelentingly keeps happening. We have been writing about this scam off and on (mostly on) since 2012 in a failed effort to help stop it:

This scam usually involves your regular Chinese supplier asking you to make your next payment to a new bank account, though it sometimes can involve your very first payment to a new Chinese supplier. Then even after you make the payment, your supplier insists that you still owe it the full amount (oftentimes with added fees) because it has yet to receive your payment. When you explain that you paid, your supplier points out that the bank account to which you sent the funds is not theirs and you still owe the money. What happened? Your Chinese supplier got hacked, either by someone outside or within the company and you indeed have yet to pay them.

Here is the latest, with all identifiers changed so as to disguise identity:

We had about $250,000 worth of widgets arrive in the USA in late December.

We paid the remaining balance of about $144,000 to the manufacturer a few weeks before arrival.

The container is still at port in the USA because the Chinese manufacturer is claiming that it never received the remaining $144,000 balance. They refuse to give us the B/L.

After months of trying to track down the wire, we learned that the manufacturer’s email was hacked and the wire information was changed and the money has been stolen by someone in Hong Kong. We had been communicating with two of their employees (first Steven and then Jasmine) for years and we visit them frequently as well. But at some point their were hacked and someone posing as one of their employees started to write us. They claim that the fake person gave us the wrong bank account information.

They refuse to release the goods if we do not pay them $135,000 more (they are giving us a small discount off the balance). We also will need to pay anther $15,000 in costs for the container being stuck. They are saying that if we do not pay this right away, they will have the container returned to China.

We need this product and every piece in that container is stamped with our company logo so we are concerned about that too.

We can take legal action against them, but we have worked well with them for years and I do not want to see this continuing to drag on.

I have offered to make a small payment to them, promised that we will continue buying from them, and have agreed to cover all of the storage fines. But they are insisting on $135,000 plus the $15,000.

On my end, how do I know that their employee didn’t secretly steal the money? Or that they are just pocketing as a company? HSBC HongKong confirmed 100% that the money is received since January and as of now are refusing to return the money to our bank so we can redirect it. And why should I pay another $60,000 because “their email was hacked”?

What do you recommend?

In various responses, I wrote the following:

It will likely not make sense for you to take “legal action” in the United States against your Chinese manufacturer unless it has assets in the United States or in some country outside China that enforces U.S. court judgments. It is the rare Chinese manufacturer that has assets outside of China and China will not enforce your US judgment. If you sue in China, you will almost certainly lose because the court is more likely to fault you for paying someone in Hong Kong without confirming with your Mainland China manufacturer than to fault your manufacturer for allowing itself to get hacked.

Your Chinese manufacturer is not going to cover you for your full loss as it too no doubt faults you for having paid someone other than them. In our experience, the best way to handle these situations is to try to strike as good a deal as you possibly can and then at that point decide whether to pay or not. I also strongly suggest trying to get covered for this by your insurance company. You claim employee negligence caused you damages and you ask for insurance coverage for your loss.

As for your logo, for us to know how we can help, if at all, we first need to know where you have registered it as a trademark. Have you registered it as a trademark in China? Have you registered it as a trademark in the United States? Where else do you sell your widgets? Have you registered it as a trademark in those other countries? I strongly suggest that we discuss your current trademark registrations both for this pending matter and to help prevent future problems.

Again, I want to stress that we are seeing smart, worldly, sophisticated companies of all sizes get caught up in this scam. How can you prevent it from happening to you? Do the following (h/t to Renaud Anjoran for these):

  1. Get to know your suppliers who speak English (if you don’t speak Chinese) and get your supplier’s landline phone numbers as that cannot be hacked. Call if you have any concerns.
  2. Get your supplier’s bank account information in advance and ask them to refer to “bank account information document” on their invoices, rather than listing out full bank details every time.
  3. Ask your suppliers to fax you their invoice and make sure the sending fax number belongs to your supplier’s company.
  4. Do a first small wire to confirm the account.
  5. Have a special procedure for confirming the company name. Note also “that paying a Chinese company in mainland China is safer for you” than paying them overseas in Hong Kong, Taiwan or elsewhere.
  6. Have a special procedure for confirming bank account changes. “Follow the same procedure as point 5, but also call several people in the company. They will understand your attitude if you tell them you are worried about the “different bank account scam” — they are also a victim when it happens to their customers.

Be careful out there.

Made In China?

Posted in China Business, Legal News

 

What Does Made In China Mean

Before you read this post, take a moment to look at the back of your computer monitor or handheld device. Do you see a tag that states “Made in China?” My computer monitor does; my iPhone states it a little differently as Assembled in China. For products imported into and sold in the United States, this product information is not a customer courtesy – it is legally required.

Claims about products’ countries of origin are regulated by U.S. Customs and Border Protection (“CBP”). U.S. law generally requires that all foreign products imported into the United States have some sort of marking indicating the country of origin from which the product was sourced or in which it was manufactured.

Depending on the type of product imported into the United States, country of origin determinations can be easy. One such example is raw agricultural products. If a company harvests rice grown in China, the rice is a product of China. Its packaging would state Made in China.

However, for many products, determining the correct country of origin requires analyzing CBP regulations and prior CBP country of origin rulings. This may be the case for companies wishing to export from China products manufactured or assembled in China with components sourced from various countries. For such products, the first and principal issue to consider is whether one input gives the product its essential character and, if so, whether the essential input is “substantially transformed” when combined with other inputs.

The country in which a “substantial transformation” occurs is the product’s country of origin for CBP purposes. The substantial transformation test considers whether an input emerges from a manufacturing process with a new name, character or use.

Recent CBP Ruling – Prepopik from China

To gain a better understanding of how CBP determines products’ countries of origin, let’s review CBP’s decision last week about the country of origin for Prepopik manufactured in China. Prepopik is an oral solution used to cleanse the colon in preparation for colonoscopies. Prepopik is manufactured in China with ingredients sourced from different countries.

The U.S. importer of Prepopik argued that the only active pharmaceutical ingredient (“API”) in Prepopik was sodium picosulfate and that this API’s chemical and physical properties did not change during the manufacturing process in China. CBP determined otherwise. CBP found that the API sodium picosulfate’s combination with another ingredient, magnesium oxide, contributed to Prepopik’s essential purpose. In CBP’s view, the two ingredients were “substantially transformed” when combined in China and, consequently, that China was the country of origin for Prepopik.

The Importance of Correctly Determining Country of Origin

For companies in China exporting goods to the United States and their U.S. importers, country of origin determinations are important for several reasons. First, an imported product’s country of origin must be included on CBP Form 7501 Entry Summary and, in conjunction with a product’s U.S. Harmonized Tariff Schedule classification, determines a product’s U.S. import tariff rate. See Exporting From China By The Numbers: HTS(US). Second, under CBP regulations, a product should reflect its country of origin when imported into the United States. Deciding the country of origin early in a product’s conceptual development can prevent last-minute issues in designing and implementing country of origin labeling or embossing processes. Third, U.S. retailers may require that companies in China substantiate products’ country of origin claims reflected on product packaging.

Incorrect country of origin determinations can adversely impact an exporter’s and U.S. importer’s reputations with CBP. A U.S. importer that imports goods with incorrect countries of origin designations may face Customs penalties, increased chances of CBP audits, and delayed Customs clearance for the importer’s products.

A product’s country of origin should be decided in the early stages of the product’s conceptualization and business planning. Failing to determine a product’s country of origin, or reaching such a determination with no or unreasonable factual and legal support, can result in adverse direct and indirect company costs. Wise companies will plan for and be prepared to support an answer to the question raised in this blog post’s title: Made in China?

China Bank Technology Rules, Part 2: Go Local Or Go Home

Posted in China Business, Legal News

In my post last week, China Bank Technology Rules: Not the Same Old Thing, I said I would come back here with a solution to this bank software mess. How should U.S., European and Japanese bank software developers deal with this issue? The basic resolution will come in two steps. First, recognize that this is a software issue and not a trade issue. Second, software developers must face a stark choice. They either capitulate by going local or they stick to their fundamental rules and go home. The middle ground is rapidly being eliminated. China Technology Rules

First, consider the software issue. The question of software security has been confused by placing the discussion in the context of NSA/FBI spying and the fear of “back doors” being placed in foreign software. The foreign software developers have treated this as a factual issue. If they can prove that no such back doors exist then the dispute is over.

However, no such proof is possible under the standard model for the sale of software. Software is “licensed” as a compiled binary file. The license includes a prohibition against decompiling the software. Under this approach, the customer can never know what is in the software package. The package remains a permanent black box.

It is impossible for the foreign software developer to prove that this black box does not contain a back door custom designed to allow access by some third party. Even the vendor cannot be sure what has been inserted into the software by simply inspecting the binary file. From the Chinese bank perspective, the only proof can come when the Chinese bank obtains the source-code, analyzes it for back door code, and then compiles a clean version.

The entire discussion of spying and secret back doors is a distraction from the real issue, which is that foreign bank software has largely proved to be insecure as proven by the recent flurry of international hacking events.

The Chinese authorities are intimately aware of this because they are the ones doing the hacking. What the Chinese banking regulator is saying is very clear: we know foreign networking and banking software is easily hacked. This software is fundamentally insecure. Foreign banks can do what they want. However, for our own banking system we will require that Chinese banks use only networking and banking software that can can be confirmed by our own experts to be fully secure. If the software is not secure, and if the vendor is not willing/able to prove to us that this is true, then we will not allow our banks and other industries of national security significance to make use of such software and its associated hardware.

The position of the Chinese banking regulators is reasonable. Networking and banking software has proved to be fundamentally flawed and no software developer has shown that it has the solution. Software customers are simply provided with a series of kludgy patches after a major flaw has been discovered and often only after a major breach has occurred. U.S., European and Japanese customers generally accept this situation. The Chinese government does not and it is of the view that if the software developers cannot prove that their product is secure within tolerances set by the Chinese banking authorities, they should not be permitted to infect a critical pillar of China’s economy like the banking system.

Thus, as I have said, this dispute is not a trade dispute. This is a fundamental dispute about product quality with abundant support for the fundamental position of the Chinese regulators.

With this in mind, the obvious solution for China would be to move to open source software products like Apache, Firefox, or Linux Open Office, which have been remarkably resistant to hacking and related software failures. Encryption using PGP and its derivatives is very powerful. For both black hat and white hat hacking, the tools found on Kali Linux are state of the art.

Given that the Chinese authorities are asking for source code to be released, an observer might assume that the Chinese government is trying to push the major foreign commercial software developers towards an open source model. However, this is not the case. The Chinese authorities are just as hostile towards open source as are the foreign commercial software developers. The Chinese do not want to foster an open system. The Chinese want the opposite. The Chinese government wants a tightly closed system it and a small core of Chinese SOEs control. For this reason, the open source solution is not what the Chinese are seeking.

So how can foreign software/hardware vendors deal with the situation in China. The position in the past has been to strongly resist capitulating to the China control model. However, the bank technology regulations will likely show that such resistance is futile. Foreign software/hardware vendors are going to be confronted with a stark choice: Go local or go home.

The go home approach has been taken by Google in the past and more recently by Yahoo. President Obama in his recent comments on the issue has suggested that foreign software/hardware vendors will follow Google’s lead and take their balls and leave China’s court. The idea is that Chinese banks will suffer so severely from the lack of viable product that the Chinese will capitulate and back down. However, this plan is based on the fundamental mistake that the dispute is a trade dispute rather than a factually based, legitimate dispute over software quality and network security.

I therefore believe that the better solution for the future will likely be for these companies to “go local.” There are two main business models for this. Foreign developers will either license their software/hardware to Chinese entities or they will form Chinese WFOEs. In either case, the software/hardware will be provided to Chinese customers (banks at the outset) by Chinese entities. No foreign business entity will be involved in the transaction.

The Chinese entity will be under the control of the Chinese government regulatory authorities. This control will at a minimum involve the following:

  • Software source code will be provided to the customer and to the Chinese regulator for inspection and analysis. Protection of the software will need to be done through standard trade secrecy and licensing agreements rather than through the current black box approach. Compilation will be done in a controlled manner, ensuring that the inspected source code is the sole source for compilation. Suitable back doors for access by the Chinese government regulators will be installed and open access will be maintained.
  • Encryption will not use foreign systems but will instead be developed in cooperation with and under the control of the Chinese regulatory authorities. Such encryption will provide back door access to the Chinese regulators and enforcement agencies (police, military, security agencies).
  • Software and hardware vendors will he held liable for the security of their products. If a breach occurs, the vendor will be required to resolve the problem and be held liable for the damages that occur. The costs of defective software will not be loaded off on the customer and the burden of repair will not be given to private network security companies.

Provided that the foreign vendors proceed as above, the Chinese regulators will allow them to make a profit from their products. It is simply false that the Chinese are seeking to create a software industry that will displace the foreign software vendors. The Chinese authorities are well aware that China does not have the expertise to accomplish this goal in the short or even middle term. For this reason, Chinese regulators are willing to allow foreign vendors to make a profit from selling and licensing their products in China. The Chinese government is seeking control, not profit.

The business model the Chinese are seeking violates the fundamental business principles that have allowed for the development of the commercial software industry in the U.S., Europe and Japan. Many software and hardware developers see the set of rules that would be violated by this Chinese approach in almost religious terms. It would therefore violate a fundamental moral code to capitulate to the Chinese model.

However, if foreign vendors plan to operate in the Chinese market in the future, they will be required to capitulate. If they do not capitulate, they will be forced to simply go home. This is the choice, and it must be faced. Ducking the issue by sending in the trade negotiators will likely do nothing to resolve the issue. There is perhaps a creative solution. But it will only be found when the industry faces the real concerns of the Chinese banks and other industries around the world that are not drinking the same kool-aid.

How To Form A China WFOE: The Initial Information Required

Posted in Basics of China Business Law, Legal News

Forming a China WFOE is like traversing a maze.

Just cc’ed on an email from one of our China lawyers to a new client for whom we have been retained to form a China Wholly Foreign Owned Entity, or WFOE. One of the things that so often surprises American companies is how difficult it is to form a WFOE in China. This email goes a long way to explaining what is involved with forming a WFOE and why it tends to be so complicated and time consuming.

Thank you for engaging us to assist with the formation of your China WFOE. I will be overseeing this project with the assistance of Grace Yang. I have set forth below the preliminary information and documents that we will need. Depending on the exact nature of your activities in China and the requirements of the local government, we may need additional information at a later date, but this will be a good start.

1.Please state the identity and contact information of the proposed WFOE shareholder(s). At minimum, we will need each shareholder’s legal name, legal address, the state and country of formation, and the state and country of the principal place of business. Once we determine the ownership structure of the WFOE and the identity of the WFOE’s shareholder(s), I will ask you for a number of corporate documents.

2.Some of our clients elect to form a Hong Kong company as an intermediary company, so that the sole shareholder of the WFOE is the HK company, and the sole shareholder of the HK company is the US company. At one time forming a HK company made it significantly easier to move through the initial stages of the WFOE formation process, but these days it’s pretty much a wash. Also, although forming a HK company is relatively easy and cheap, it’s another corporate entity and as such will require ongoing maintenance: annual reports, taxes, renewals, and so forth. Forming a HK company  also requires opening a Hong Kong bank account, which often requires that a director of the HK company go to Hong Kong in person.

The main reason to form a Hong Kong company these days is for tax reasons, particularly if you anticipate that the China WFOE will become a profit center and remit substantial sums back to its parent company. Based on our conversations to date, I don’t think this is what you have in mind for your China WFOE. Still, I would advise that you (and I) speak to your accountants on whether your tax situation will make it  a good idea to form a Hong Kong company.

3. Have you determined a location for the WFOE? If you have already have a proposed office address, please provide it, along with the name and contact information of the landlord. If you haven’t yet determined the exact address, then provide the city and district (e.g., Huzhou, Wuxing District).

4. If you have a lease or proposed lease for the office space, please provide that document. Note that the lease should be valid for at least one year beyond the eventual approval date for the WFOE. As the WFOE may not be approved until several months hence, it is best for the initial term of the lease to be at least a year and a half, with 2 years being even better. The lease should also be in a proper format, and typically will need to be registered with the local real estate authority. We will work with you on this.

5. We will also need proof that the landlord owns the property and has the authority to enter into the lease. This is usually proved by provision of a land rights certificate and documentary proof of existence from the landlord (i.e., a national ID for an individual, and a business license for a company).

6.You will also want to make sure that your proposed use is acceptable for the premises and that the premises are suitable for use by a foreign-owned entity. It used to be possible to check these things with the local SAIC, but this information is no longer publicly available. Accordingly, we will need to make sure the lease includes provisions protecting your interests in this regard – that is, a guarantee from the landlord that the premises are suitable for use by a WFOE and for your proposed use, and a requirement that the landlord cooperate with any requests for documents, receipts, or certifications. We have model language (in Chinese) that we use for this.

7. As part of the WFOE formation process, we will review the lease to make sure it is suitable for use by a WFOE, contains adequate protections for you during the formation process, and is properly executed. Though we would also be happy to conduct a substantive review of the entire lease, or negotiate with the landlord on your behalf, this would be outside the scope of our engagement and we would charge on an hourly basis for such work.

8. Please provide four proposed company names in Chinese, in order of preference. The shorter the better; if possible, use no more than four characters. For now, we only need the basic name (e.g, “Nike,” not “Nike, Inc.”) We will then work with the local authorities to determine what should be the full legal name, which will likely include the scope of business and the location. Note that the Chinese authorities are primarily concerned with your WFOE’s Chinese name. The WFOE’s English name will be unofficial and is, for the most part, up to you.

9. Please prepare a one-page summary of your WFOE’s activities. This is not a mission statement but rather a narrative that should include the following:

(i) A general description of the business conducted (i.e., the services and/or products provided)

(ii) How the services and/or products provided will change over the 5-year period following formation;

(iii) How it will be staffed (e.g., the number of employees upon formation, how that number will change over the next 5 years, and the citizenship of each employee);

(iv) Job descriptions for each employee and an explanation of how the employees will be managed;

(v) A general description of the customer base;

(vi) The cashflow model for the WFOE. That is, from which entities will the WFOE’s income come from? How will this income be generated? Will the WFOE’s income stay in China or be paid to an entity in another country? To which entities will the WFOE’s expenses be paid? For what purpose will these expenses be paid? What are the estimated amounts of such inflows and outflows? In what currency will payments to/from the WFOE be made?

(vii) A detailed first-year cost projection.

(viii) A one-year and five-year pro forma income statement and balance sheet.

(ix) A statement of the amount of “total investment” and the amount of “registered capital,” if not contained in one of the above financial statements. Registered capital is money that the parent company must contribute to the WFOE after formation. By contrast, total investment is the amount of registered capital plus the amount of (optional) debt financing that the WFOE can take on. There is no requirement that the WFOE raise any funds through debt financing; however, having a total investment amount higher than the amount of registered capital gives WFOEs flexibility with debt financing that, from a regulatory standpoint, they would not ordinarily have. Typically, any such debt financing is simply a loan from the parent company. (Note that if a WFOE needs an influx of cash from its parent company, a loan is usually preferable to a payment, as the latter will be treated as income to the WFOE and taxed accordingly. The relevant Chinese regulations state that for lower-capitalized WFOEs (i.e., those with total investments of less than US $3 million) the amount of registered capital must be at least 70% of the amount of the total investment.

10. Please describe the WFOE’s management structure. Will it have (1) a board of directors or (2) a single director (called the managing director or executive director)? Once you decide that, we will need to know the identities of the following WFOE personages:

(i) Managing/Executive Director (or all the Directors, if you have a board): This person is in charge of overall management of the company, but not day-to-day management.

(ii) General Manager: This person is in charge of day-to-day management of the company—making bank deposits and withdrawals, paying taxes, arranging utilities, hiring and firing, and so forth. As a matter of law, the general manager and the managing director can be the same person and do not need to reside in China. As a practical matter, for any company actively operating in China, the general manager should be resident in China.

(iii) Supervisor: This person has nothing to do with the day-to-day operations of the WFOE. The supervisor merely represents the interests of the shareholders, and oversees the actions of the managing director (or board of directors, if you have a board). In a one-shareholder WFOE, as here, the supervisor does next to nothing, but Chinese law still requires that one be appointed.

(iv) Legal Representative: This person has overall responsibility for the management of the Chinese company, and is vested with the authority to act in the name of the company. The “legal representative” is a position unique to China corporations; the closest analog in American corporate structure is the chairman of the board. By definition, the legal representative has authority to sign contracts on behalf of the company. The legal representative is not a standalone position; he or she is virtually always either the chairman of the board (for a three-person board) or the managing/executive director (for a one-person board).

11. Note that though the same person can simultaneously serve as the managing director, legal representative, and general manager, that person cannot be the supervisor. The supervisor must be a separate person.

12. Please provide color copies of the passports of the above people and a current resume of the WFOE’s legal representative.

The first step in WFOE formation is to apply for registration of the WFOE company name. But before we can do that, we must first finalize both your company’s scope of business and the exact location of the office, because the address of the office determines where we must submit the WFOE application. Additionally, the specific procedures for WFOE formation vary depending on the city and district in which your office will be located, and on the scope of business. In other words, the first step itself requires a considerable amount of preparation.

Once we determine which entity will be the shareholder of your China WFOE, I will send you another email with some additional questions. We will keep you informed of the status of your WFOE throughout the process, and you should feel free to contact me or Grace at any time with questions. That being said, the WFOE formation process is long and inefficient, and can be frustrating for foreign investors. It’s a marathon, not a sprint.

I look forward to working with you on this project. Don’t hesitate to contact me should you have any questions.

For more on what it takes to form a WFOE in China, check out China WFOE Formation and Minimum Capital RequirementsChina WFOE Lease Reviews and How To Form a China WFOE. Scope Really Really Matters, Part II.

 

China Contracts, But With Whom?

Posted in Basics of China Business Law, China Business
China Contracts

Don’t get burned by contracting with the wrong party

One of the most important things to determine before entering into a contract with a Chinese company is to make sure that you are contracting with the right company The right company is usually the company with sufficient financial resources to cover you if and when things go bad. On one level this sounds incredibly obvious, but I can tell you that foreign companies get this wrong all the time.

This seemingly simple principle is often overlooked because many U.S. buyers of products manufactured in China contract with third-party sourcing companies unaffiliated with the Chinese company that actually owns the factory making the product. So when a product defect is uncovered, the U.S. buyer will only have legal recourse against the sourcing company with whom it contracted and not the actual Chinese manufacturer.

Oftentimes the foreign company will contract with the Chinese manufacturer’s holding company in Hong Kong, Taiwan or Singapore. Like the typical sourcing company, these sorts of holding companies rarely have assets much beyond a few computers and a market-rate office lease.

Before contracting with anyone, you should do your due diligence and make sure the party you are paying is not a shell entity or a sourcing company with little or no assets. When the contracting party is the U.S. sales subsidiary of a Chinese contract manufacturer, you should consider having the Chinese contract manufacturer co-sign the agreement or guarantee its performance.

The following are just some of the instances where American companies have gotten into big trouble by not abiding by the rules above:

  • American company pays Chinese company nearly a million dollars to produce a toy line for it. Chinese company never produces a single toy. American company hires our firm to explore options for pursuing the Chinese toy manufacturer. We look at the Chinese language official version of the contract and the signing party is a completely different entity than the Chinese toy manufacturer with which our client believed it had contracted. A few hours of research reveals that the company with which it contracted was a one person “sourcing consultant” who operated out of a $300 a month single person office. Not good.
  • Many years ago, an American company called us after just having learned that its two million dollar order of Christmas tree lights would not be delivered to the United States until December. We called the factory and they told us they had no idea who our client even was. It turned out that our client had unknowingly been using a sourcing agent (we figured it out by looking at some Chinese language documents) and so it had absolutely no contractual relationship with the factory. So at that point, all it could do was to beg its agent to do whatever he could to get the factory to speed up the order. There was no point in suing the agent because he was one guy in a small office with an old computer (we investigated).
  • American company gets bad product from its Chinese clothing manufacturer and so refuses to pay the remaining $500,000 or so for the shipment. American company then gets sued in China and retains us to assist. Turns out that the lawsuit in China has been brought by a Chinese sourcing agent whose contract with our client makes clear that he gets paid for brokering each transaction, whether or not the transaction goes well or not. In other words, there would have been a very good chance that this sourcing person would have prevailed against our client because he had fulfilled all requirements of his deal with our client, and the fact that some third party manufacturer had provided bad product was irrelevant. Our client ended up settling.

We could go on and on.

The key to avoid these sorts of problems is to know your counter-party. The way to do that is to get the Chinese name of the party with which you will be contracting and then do your due diligence on that company. Generally (though not 100% of the time), the best party with which to contract will be the company that owns the factory that will be making your product or providing you with the contracted-for service.

Just get it right.

China Factory Problems: Always YOUR Fault?

Posted in Basics of China Business Law, China Business

China Product Outsourcing Problems

The title is somewhat of a stab at humor. It stems from my blaming most (but certainly not all) China factory problems on the foreign buyer. We have written countless times of what is required to secure good product from Chinese factories:

We have also written how our China lawyers constantly get calls or emails from American and European companies that have received bad product from their Chinese factory suppliers and how there is nothing we can do for them. We wrote about this just last week in How To Get Bad Product From China With No Legal Recourse. To a certain extent, we like being able to blame the victim in these situations because that way we as lawyers can comfortably sit back and tell ourselves that had they only contacted us BEFORE they started having problems, we could have prevented all of their problems.

But what about where the Chinese company just up and suddenly shuts down. How can the American or European buyer be blamed for that? Well guess what, they can and in Doing Business In China Safely. The Due Diligence Basics, I explain the following situations where blaming the victim is really pretty easy:

  • The guy who “invested” $500,000 into a China business because the owner of the Chinese business was allegedly the son of a five-star general. One of my law partners suggested to this investor that he instead use the money to fly himself and my law partner to Vegas (this was before Macao got so big) and put the money on red.  As my partner put it, the chances of the client recovering his money there were much greater and it would be a lot more enjoyable. This guy went ahead and invested the $500,000 and lost every bit of it. He then wanted us to sue the “son of the general” on a contingency fee basis, but we would not have taken on that case for a 150% contingency.
  • The guy who bought a million-dollar condo in Shanghai under his girlfriend’s name because he believed that foreigners were not allowed to own real property in China. His girlfriend then left him and claimed he had given her the condo as a gift. The guy wanted us to sue the girlfriend but we demurred, saying that we just did not like a case where our client would need to stand in front of a Chinese judge and explain that he had put the condo in his girlfriend’s name so as to avoid (what he believed was) Chinese law.  And here’s the kicker. When he bought this condo for his girlfriend, he could have purchased it in his own name, no problem! His girlfriend had lied to him about Chinese real property ownership laws
  • The countless people who call my firm after having sent tens of thousands of dollars (sometimes hundreds of thousands of dollars) to someone in China for a product that never arrives. Eventually the person and “company” to whom they sent the money disappears. We have never taken one of these cases because we deem them pretty much hopeless.
  • The US company that used its joint venture partner’s local Chinese lawyer (what was this company thinking?). The Chinese lawyer drafted up agreements that involved the American company giving its critical technology to the joint venture permanently, without getting any real influence or control in the venture.  This is an amalgamation of probably half a dozen poorly formed joint ventures in which we have been called in. You can find out more regarding this sort of Chinese joint venture deal in When in China Trust Everyone.

I then listed out the following seven things that American and European companies should do before doing business with China:

In Seven Rules Of China Due Diligence we set out the following seven rules to analyze a Chinese company with which you are doing business, taking the first six from an article by Muddy Waters entitled, The Six Rules of China Due Diligence:

  • Approach the company as a potential customer does. “You want to see what the China side customers see. Fraudulent companies have far less confidence that they can fool a Chinese company in their industry than they do about fooling a starched shirt analyst. Moreover, they’re usually less willing to take legal risks in their home market (China) than they are in the United States.” In other words, look to see how the Chinese company with whom you are interested is treated by other Chinese companies.
  • Take all company-provided introductions with a grain of salt. “When companies set up meetings or conversations between you and their suppliers or customers, take them with a grain of salt….In a country where a lot of managers earn less than $500 per month, it’s not hard for an unscrupulous company to buy someone’s loyalty for the duration of a meeting or phone call. You should instead rely on your own networks to help you understand the company and industry. If you don’t have those networks, you unfortunately shouldn’t be making investment decisions in China by yourself.” I completely agree.
  • Try to construct your own fraud scenario. “At some point in evaluating every investment, you should stop and ask yourself how you could have staged everything you’ve been shown or done with the company. It is good for American investors to practice this mentality because it makes us less credulous. More importantly, this kind of thinking makes clear how surprisingly simple measures (e.g., switching factory signs before you arrive, painting old machinery) can be so effective in fooling the credulous investor.” I absolutely love this advice and I urge everyone to follow it.
  • Forget about the paper. Focus on the operations. “In today’s world where you can buy a competent color printer for less than $200, it’s hard to understand why investors place so much faith in bank statements, invoices, and contracts. China’s deal making world abounds with stories of forged bank statements and other documents leading to disastrous deals. Unfortunately, most auditors apply the US audit playbook in China – reviewing and taking documents at face value….Instead, you have to look at the operation itself. How much does the output seem to be, how much material is moving into and out of the factory, does the office seem to be a hive of activity, how many employees can you count, what is the square footage of the facilities? These are all basic questions one should concern themselves with during site visits. And it pays to visit two to three (or more) times — a good fraudster can put on a show, but they’re unlikely to be able to do it the same way each time. Watch for the subtle differences. Ultimately if you cannot find a good way to measure the company’s sales or productivity (as in the case of a service company), you should think carefully about proceeding with the investment.” I completely agree with the advice to put the Chinese company’s operations under a microscope, but I completely disagree with the advice to ignore the paper, as I discuss more fully below. I advocate putting the paper under a microscope as well.
  • Speak with competitors. “Competitors with real businesses can usually tell you one of two things about a fraudulent competitor — either that it’s obscure (sometimes the “competitor” is hearing about the company for the first time); or, that they know it’s a fraud. Many competitors will be reluctant to speak openly at first about a fraudulent competitor if they know you’re a potential investor in the fraudulent company. However, if you’re a potential customer who is shopping around for a vendor, it can be a different story.” This is excellent advice, but one should also take the views of competitors with at least a bit of salt.
  • Do not delegate. “A lot of experienced China investors have stories about subordinates who colluded with a target company to attempt (and sometimes succeed) to defraud the investor. Be attuned to the dichotomy between the investment funds at stake and the income/wealth of the people on whom you rely for judgment.” Very true. At least half the time when my firm has been brought into a fraud situation, we have to ask ourselves whether the “trusted subordinate” was incredibly stupid or in on the fraud.

The seventh rule (my addition) is to put the documents you receive under a microscope because the fraudulent company will nearly always make some mistake in its documents. In my career, I have caught the following, all of which threw up massive red flags:

  • Company claimed to have a multi-million dollar account at a non-existent bank;
  • Company documents showed a subsidiary in the Marshall Islands, yet always spelled the country as Marshal Island. It had no such subsidiary;
  • Company claimed to have a branch office in a particular city, yet its documents on that branch office (including supposed government documents) put that city in the wrong province;
  • Company claimed to be bringing in twice as much product as physically possible on a particular ship;
  • Company claimed to have been shipping out product on a particular ship that did not exist during the first few years when the product was allegedly being shipped;
  • Company claimed to have won an IP lawsuit in a country’s Supreme Court (they produced the Supreme Court’s decision and everything), but there had never been such a case.

Okay, but what about the situation where the American or European company has done everything set forth above and its Chinese factory just suddenly and without any warning shuts down and its owners disappear into the night? Doing the above will not help at all with that situation, right? Wrong. In fact a couple of times that has happened to clients of ours and both times because they had a really good contracts they were able to go their China factories and take away the already produced product for which they had paid, while other product was being held by the Government to be used to pay employees. Okay, so far so good.

But I have to admit that even in the above two situations our clients were not made whole because in both instances the Chinese factory had only produced about half of the product for which our clients had paid and so our clients ended up losing some money on the other half and, more importantly, they were left short-handed in terms of product inventory — and in both instances, at the exact wrong time. Could even this have been prevented?

When asked this sort of question (and I have been asked this question a couple of times at speaking engagements) I usually give a fairly pat answer along the lines of how about all that companies can do is to consistently monitor their Chinese factories for any signs of problems. That sort of answer is fine at a seminar, but what does it mean in real life? I think I now have a good answer, thanks to the post, 3 Telltale Signs of a Bankrupt Factory at the Intouch Manufacturing Services Blog.

This post starts out saying that for all sorts of reasons “more and more factories in China are shutting their doors.” I agree. It then explains why Chinese factories always seem to be open one day and then shut down the next, virtually always without any sort of notice. Most importantly, it then lays out the following three key indicators that your China factory is in deep trouble:

  1. Unused floor space/clear overcapacity.
  2. Increasingly poor product lead-times.
  3. Staff Strikes, Walkouts, and Layoffs

All three make sense to us and I urge you to read the whole article. I will also add one more thing against which you should always be on the lookout: changing laws and changing market forces. We had one client who came to us because it had heard a rumor that its not so small China factory was going to get shut down because it had been operating illegally in its location. We researched the matter, determined that it was true and our client ceased its purchasing. Maybe 4-5 months later, the factory was closed. Another time one of our clients had heard that its Chinese factory had been or was going to be bought as it was in the line of a planned highway. Very quick research revealed that this was the case and gave our client plenty of time to find a new supplier.

Bottom Line: Outsourcing your product to China will never be without risks, but the more proactive you are in seeking to reduce those risks, the better your odds will be of preventing problems.

Does anyone disagree with this?

China Bank Technology Rules: Not the Same Old Thing

Posted in China Business, Legal News

China Bank Technology Hacking

The latest hot issue in China/U.S. trade relations is the highly restrictive bank technology rules recently announced by PRC banking regulators. As reported in the foreign press, these rules will require all Chinese banks prove that their computer technology and software is “secure and controllable.” The following are the most controversial provisions:

  • The source code for all software shall be provided to government regulators.
  • Encryption will be done in accordance with Chinese encryption standards, meaning that the Chinese authorities will be able to break all encryption schemes.
  • Providers of both software and hardware must do some portion of their R&D in China.
  • Banks must provide an initial compliance plan by April 1, with full compliance to take place by the end of 2019.

As would be expected, these rules have been greeted by strong opposition from U.S., European and Japanese software and hardware manufacturers. The U.S. trade representative has taken up the issue in formal talks with Chinese regulators and President Obama indicates that he discussed the matter personally in recent talks with Xi Jinping.

For anyone even remotely aware of the technical issues involved, it is difficult to understand what these rules are intended to accomplish. Consider the following:

  • What real good does the Chinese government getting the source code do if the issue is ensuring no “back door” or other security leaks are included in the software? If the Chinese banks purchase compiled software, there is no way to ensure that the compiled software has any particular relation to the source code. Certainly, the Chinese government is not planning to compile software for the benefit of its banks. Thus, the only explanation for requiring the turnover of source code is to give the Chinese authorities the opportunity to take the code and provide it to Chinese software companies owned or controlled by the Chinese government. Foreign software developers quite naturally object.
  • Chinese banks are required to interface their technical systems with banks outside China. These banks operate their complex systems using a standardized suite of software and hardware products. If China drives out the foreign providers of these products, who in China has the product available to replace the standardized products? China may have available networking hardware and computers that may meet the raw technical specifications, however, no Chinese company provides software even remotely close to meeting the requirements for compatibility. Moreover, in this area, hardware and software are tightly linked. The fact that the hardware exists means almost nothing regarding whether the hardware will work properly with the required software.

Since this kind of thing has happened many times in the past, many worn out old China hands like me respond by saying: “this is just the same old thing.” An impossible proposal designed by officials who do not understand the technology and did this to extract some sort of trade concession. The proposed rules will not work and are not intended to work. As soon as the trade concession is granted, the rules will quietly die.

Unfortunately, I am not so sure that is the case here and this issue must be considered more carefully for two reasons. First, the impact of this kind of regulation risks having an impact on a significant portion of the Chinese economy. Second, the concerns of the Chinese regulators are actually quite reasonable. When rules that have a reasonable basis have the potential for significant impact, the situation must be treated seriously and it is not appropriate to just laugh off the rules as the “same old thing”.

Consider first the seriousness of the rules. In discussing these regulations with others here in China, I am being told that this type of regulation is not a significant trade issue because it impacts only one business sector and it applies only to state owned enterprises. But this argument fails for several reasons. First, the banking sector plays a major role in the Chinese economy, especially in the area of software and hardware. Second, all Chinese banks are owned by the government, so state owned enterprises constitute the entire sector. Third, and most threatening, if this set of rules gets applied in the banking sector, it is almost certain that similar rules will be applied in other SOE dominated sectors such as insurance, shipping, petroleum and telecommunication. Thus, virtually all of the relevant sectors of the Chinese economy would ultimately be restricted in similar ways. Not to mention that a country’s banking system — as much as any other industry — has tentacles that reach into an entire economy.

Consider then the fact that the rules reflect a reasonable concern with security on the part of the Chinese government. For many years, the Chinese government has seen international computer networking in a negative light. Chinese regulators have consistently portrayed these systems as a weapon aimed at the heart of China. The Great Firewall can perhaps protect China from invasion through the Internet, but what about invasion through weapons hidden inside foreign software and hardware?

Until recently, it was possible for Western companies and governments to laugh off these concerns as just a cover story for economic motives. The argument has been that the Chinese authorities are not really concerned about security; they are really just trying to force Chinese entities to purchase (inferior) product from Chinese companies.

However, this dismissive portrayal of the concerns no longer holds water. In the past year it has become clear that U.S. software and hardware companies have cooperated with the U.S. government, the NSA and the FBI to make use of vulnerabilities in software and hardware to obtain otherwise confidential information. The NSA has also been accused of secretly placing surveillance software on sim cards and other networked devices. Going beyond intentional spying, vulnerabilities in software and hardware that allow for hacking banks and other significant businesses has become daily news. For these reasons, Chinese regulator concerns with the security of foreign software and hardware can no longer be laughed off as paranoia.

So far as I can see, foreign companies have yet to directly confront the issues. Instead, U.S., E.U. and Japanese software/hardware companies are treating this entirely as a trade issue. Trade representatives are now negotiating the matter, with their industry trade associations watching carefully in the background. I am dubious that this sort of approach will succeed

How do I propose proceeding in this area? I will let you know in my next post.

The Music Business in China: Copyright And Regulatory Issues. Beijing, March 26

Posted in China Film Industry, Events

China's Music Industry

Mathew Alderson, head of our Beijing-based China Entertainment Group will be leading an AmCham Conference on China’s Music Business. This event, The Music Business in China: Copyright and Regulatory Issues, will take place on March 26 from noon until 2:00 p.m. at the following venue:

AmCham China Conference Center
The Office Park AB, 6th Floor
No. 10 Jintongxi Road Beijing
中国北京市金桐西路10号
远洋光华国际AB座6层

Mathew Chairs AmCham’s Media and Entertainment Forum and he will be moderating the event, at which recent developments in China music copyright and trends in tours and live shows will be discussed. “Issues faced by international labels and artists will be considered along with those confronted by the domestic industry.” In addition to Mathew, there will be a panel of industry consisting of the following:

  • Guo Biao, who has been China’s Chief Representative of International Federation of the Phonographic Industry (IFPI) since 2006 and before that was the Deputy Director of the International Division of the National Copyright Administration of China and Secretary to the Vice Minister of the NCAC. Guo Biao is a council member of the China IP Law Society and a council member of the China Copyright Society.
  • Ed Peto, owner of Outdustry Group, “a unique family of businesses specializing in China market entry for western music companies, services and talent, producer management, rights management, digital marketing, market intelligence and sync licensing.”
  • Nathaniel Davis, head of Split Works a China-based concert promotion agency with offices in Shanghai and Beijing. Davis has been booking concerts in China since 2001 and  he booked his first Grammy Award-winning artist, k.d. lang, in 2002 in Shanghai. and also produced and tour managed China gigs for acts such as Norah Jones and Alicia Keys.

For more information on this event, please contact: Dana Lv, Tel: 010-8519 0864, Email: dlv@amchamchina.org.

How To Get Bad Product From China With No Legal Recourse

Posted in Basics of China Business Law, Legal News

Yesterday’s post, How to Give Away your IP in China, drew such favorable reactions that I figured I’d reprise the theme today and explain how to ensure bad product from China without being able to get compensated. But rather than write a new post on it, I will just cite a recent email (taken from a template) I use to explain to people why we will not pursue their claims against their Chinese manufacturer. This email essentially recites all of the things that the recipient did to ensure that the product it would get from China would be substandard and why once it got that product, there was little or nothing it could do to secure compensation for the quality problems.  Defective Products from China

Sorry, but we would not be interested in taking this on a contingency fee basis and I cannot in good conscience ask you to pay us to pursue it.

Our lack of interest in your case stems from the following:

1. Your contract (even assuming that this qualifies as a contract under Chinese law) is in English. Many courts in China will not hear a case with an English language contract. This is even more likely to be the case in a place like _____.  For more on the importance of your contract being in Chinese, check out China OEM Agreements. Why Ours Are in Chinese. Flat Out and How to Draft a Contract for China.

2. It looks like you did not pay the company with whom you have the contract. You instead paid some other company. This is a classic China ploy. If you sue the company with whom you have the contract, it will say that you never paid them because you didn’t. Not sure if it will win on this, but it is yet another hoop you will have to jump through.

3. The “contract” says that you will inspect the product before it ships. The Chinese manufacturer will contend that you either did inspect and were fine with it or you chose not to inspect. Either way, it should make for a pretty good defense because for whichever reason you allowed the product to be shipped to you without voicing any complaint. If you are not going to inspect product before it gets sent to you, you should not have this sort of provision.

4. China does not generally recognize samples as the standard that must be met. If you want your product to be of a particular quality, you had better lay out every single specification that will get it to that quality. As I alway say in my speeches, putting in a term like “good quality” in a contract with a China manufacturer is a waste of time because in China they have incredibly low quality levels that are just fine for Chinese commerce and for Chinese courts. It is not at all clear to me that your manufacturer failed to give you exactly what you ordered. You say that it is of bad quality, sure, but that is under US standards, not under any standards that I see in the contract and that is what is going to matter to a Chinese court. For more on why this matters and for how you should handle this the next time you have product manufactured in China, check out How To Get Good Product From China; Specificity is THE Key To Your OEM Agreement.

You might want to try to interest a Chinese lawyer in taking this case, but I have my doubts whether even that would be worth your time and money as you will almost certainly have to pay at least the out of pocket costs for pursuing this litigation. Suing in the United States would be a complete waste of time and money unless this Chinese manufacturer has assets in the United States, and incredibly few do. China courts do not enforce U.S. judgments so even if you win over here, it will be of no value in collecting money from your Chinese manufacturer in China. For more on this, check out Why Suing Chinese Companies In The US Is Usually A Waste Of Time.

If you are going to continue buying product from China, you should have a contract that will work. I suggest that you read the links within this email (now this post). What you want is a contract that the Chinese manufacturer believes will allow you to win in a Chinese Court if it provides you bad product, and win fast and win certain specified damages and be able to seize the manufacturer’s assets upon filing the lawsuit (before you even win). With that sort of contract, your chances of ever getting bad product go way way down and should you get bad product, your chances of winning at trial and getting your money go way way up.