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What Your Chinese Operations Needs To Know About Iran Sanctions

Posted in China Business, Legal News

Recent news about a framework agreement between Iran, the United States, China, France, Germany, Great Britain, and Russia raises important geopolitical issues – and also important business considerations. The agreement basically rests on two important representations. Iran would allow monitoring of its nuclear programs and the United States and Europe would agree to eliminate restrictive sanctions on commercial dealings with Iran. Such an agreement would dramatically change the way companies conduct business globally.  China Operations

For companies with even the slightest interest in expanding sales to Iran, even the current framework discussions and possible elimination of U.S. and E.U. sanctions is likely spurring careful analysis about how such Iranian sales would be structured. This caution is due to the restrictive nature and severe penalties of current U.S. sanctions on dealings with Iran.

For U.S. companies with Chinese operations, U.S. law generally prohibits the U.S. companies and their Chinese subsidiaries from engaging in commercial and financial transactions with Iran and its citizens. A U.S. company’s Chinese wholly foreign-owned entity (“WFOE”), and a Chinese Joint Venture subsidiary in which the U.S. company owns at least half of the controlling interests, cannot sell or export products manufactured in China to Iran. Doing so violates U.S. sanctions laws on transactions with Iran.

U.S. companies and and their Chinese subsidiaries also generally cannot sell or ship products to a distributor if they know or have reason to know the distributor will transship or sell the products to Iran. In other words, U.S. companies and their Chinese subsidiaries cannot structure “blind-eye” sales transactions to Iran through third parties and claim they were unaware of their products’ delivery destination.

The reason to know standard can be established through circumstantial evidence. For example, a Chinese subsidiary and its U.S. owner may have reason to know that a sale to a distributor is destined for Iran if the distributor’s customer base is exclusively or overwhelmingly Iranian companies. In such an example, the U.S. owner and its Chinese subsidiary would be well advised to undertake and document due diligence to confirm the ultimate destination of such sales in order to comply with U.S. sanctions on Iran.

Current negotiations on the framework agreement do not preclude U.S. enforcement of its Iranian sanctions. In fact, the contrary may be true as the United States most likely wants to demonstrate not only its resolve to effecting change through sanctions if an agreement is not concluded, but also how Iran can benefit if such sanctions are eliminated.

Last October, while the negotiations were underway, the U.S. Office of Foreign Assets Control (“OFAC”) entered into a settlement agreement with Indam International, Inc. located in Houston, Texas. Indam paid about $45,000 to settle potential civil liability stemming from alleged violations of U.S. Iranian sanctions based on shipments to the United Arab Emirates that Indam had “reason to know” were intended for transshipment to Iran. OFAC stated that the $45,000 settlement amount was based on the following aggravating factors:

  • Indam’s failure to conduct due diligence of its products’ end users.
  • Indam’s understanding that exports for use by Iran violated U.S. sanctions based on a previous incident.
  • Awareness by Indam’s management that the shipments were ultimately destined for Iran.
  • The benefit Indam’s shipment would have conferred on Iran’s petroleum industry, which would have harmed U.S. sanctions’ objectives.
  • Indam’s failure to implement appropriate corporate policies and procedures to avoid transactions that violate U.S. sanctions.

The Iran framework agreement is currently just that – a framework. It faces intense scrutiny in the signatories’ home countries and further detailed negotiations between the parties before it can be finalized. Consequently, companies contemplating possible commercial engagement with Iran must carefully understand their current obligations and risks under Iranian sanctions implemented by the U.S., E.U., and other countries. As the U.S. OFAC’s settlement agreement with Indam suggests, U.S. companies and their Chinese subsidiaries have a reason to know about trade sanctions and a reason to ensure compliance with such sanctions.

Doing Business In China: Lessons From The Music Industry

Posted in Basics of China Business Law

Loyal China Law Blog reader Declan Nolan, of Shanghai SIP Engineering Consulting, sent me a really excellent Smart Shanghai article the other day on Archie Hamilton. Hamilton is the Managing Director of Splitworks, a China-based concert promotion agency, and the interviewee in the article. Hamilton has been in the China music business for ten years and in his interview he shares countless pearls of wisdom applicable for anyone doing business in China or planning to do so.

How do I know the article is excellent and Hamilton’s words constitute pearls of wisdom? Because our China lawyers have either seen or dealt with pretty much everything he describes, and in most instances, many many times.  China's Music Industry

Hamilton starts the interview talking about the cancellation of Lenny Kravitz’s show:

It just bugs the shit out of me, because all these agents and managers, they’re always like, “Fuck we just got burned again!” and “It’s a shit market…” And you’re like, “You know there are good promoters in China, because you’ve worked with all of them, so why don’t you give the fucking shows to the good promoters?” And they’re like “ahhhh yeah but the money was so good…” And generally when something sounds too good to be true, it is.

Exactly. I cannot tell you how many times we have seen a company choose someone in China because “the money was so good” but in doing so set themselves up for problem after problem. We see it with the partners these companies choose and the unnecessary risks they take. Even closer to home, we see it with the law firms they choose, and all to save (or make) just a little bit more. An example from this week is telling. An American company contacted my firm about a year ago for help with what I knew would be a complicated and risky China joint venture. This company ended up choosing not to hire us because we were “considerably more” than the -no-name Chinese law firm that had been referred to him by his China handler. Now he was e-mailing because the government had turned down the Joint Venture for the exact reason I had told him it could not work. He was frustrated because he had wasted massive time (and even money) and was seeking our assistance on what to do. Amazingly enough, when I quoted him the initial retainer we would require to get started, he balked because a Chinese law firm that someone he knew had referred him to would be “considerably cheaper.” I did not even bother to tell him what his always seeking to save had already cost him, I merely told him that we would not be budging on our retainer amount or our fees and also stated that I did not see our two firms as a “good fit.” It would be un-lawyerly of me to use the same sort of language as Hamilton, but seriously?

Hamilton then notes how he is seeing fewer expats coming to China, which absolutely jibes with what our China-based lawyers are seeing. Hamilton also sees the second tier cities becoming “even more interesting” than Shanghai and Beijing, and due to rising costs, we are seeing the same thing for our clients.

Hamilton’s views on China’s anti-corruption crackdown jibes with ours as well in that he sees it as real and as having an impact. He also very rightly notes that “the rules are laid out very clearly, if you take the time to listen.” Here’s how he sees it:

Yeah there’s a big crackdown on red envelopes, but there’s also a lot more competition. A lot of people are going, “Well if I write about cool stuff, then people will read it, and we’ll get more ad revenue.” So we’re finding a lot more than the Chinese media we talk to are a bit more open to talking about stuff without being paid for it, and that’s a huge change.

For me, there’s always been a way to do it. All our shit’s above board. The rules are laid out very clearly, if you take the time to listen.

Reminds me of what I said in a 2011 post, China Law: Don’t Blame It On The Gray

For years I have been fighting against those who claim Chinese laws are gray. China’s business laws are generally as well written or as clear as any other country’s. My contention has always been that those who claim China’s laws are grey are usually just saying that to excuse their own failure to abide by them.

Hamilton does a great job explaining how and why China is increasingly enforcing its laws:

It demonstrates to me that there is a level of pragmatism within the authority, like “We understand this has to happen. We understand this is an important part of development. We’ve let it happen up to now in the grey, but actually it’s too big and it’s too out of control from a safety/crowd-control perspective, and we need to start regulating this stuff, because every other country in the world does.” It’s gonna force change, and make things a little bit more expensive, but regulation always does…

What are your thoughts?

 

China Closes 66 Golf Courses And Why That Really Matters

Posted in China Business, Legal News

Since becoming China’s President about two years ago, Xi Jinping has consistently stressed rule by law. Even if you do not know exactly what that means (and I am not sure that anyone does), it is damn clear that he means it. And when I say that he means it, I mean that he not only means it but he really believes it is of critical importance for China.

We can talk about why he believes this. Is it to maintain order? Is it out of fairness? Is it for philosophical or moral reasons? Is he just using it to crush his enemy? But that does not really matter. What matters, and I will say it again because this is important, is that he really means it.China Law Enforcement

I could write page after page giving you countless examples of why I know this to be true, and still not go beyond the last six months or so. But I won’t. I will instead provide four specific and telling examples from just the past month and start with one very general one.

The general one is that despite China’s slowing economy, the China lawyers at my firm have never been busier than in the last year and I mean by a wide margin. And I am convinced that much of that business stems from the realization by foreign companies doing business in China that they need to figure out which of China’s laws apply to them and follow them. It is that simple. And that is what many of them are telling us. One client just the other day told me that he has been in China for 20 years and he “has never seen anything like this,” referring to the scrutiny his business is getting from Chinese regulators and to what he knows to be happening to his domestic and foreign competitors in the same industry.

Now for the five specific examples, all of which happened in the last week:

1. News reports suggesting that Foxconn is having trouble securing investment benefits promised 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. In other words, Beijing is enforcing a long-standing but often violated law, and doing so against one of the two or three largest foreign investors. For more on this, check out Foreign Investment in China: Beware of Local Governments Bearing Gifts.

2. China this past week shut down 66 illegal golf courses. Everyone (even me, who proudly terminated his budding — okay so that’s a lie — golf career in a pique of frustration at least a decade ago) knew that China had tons of illegal golf courses and that nothing was being done about that. The “nothing being done” part is no longer true. Reuters described these closures “the first real sign of enforcement of a 2004 ban.”

3. Two reports from friends/consultants in China with whom our China lawyers have done substantial work. I am combining these two reports into one, both because they are so similar and so as to disguise any identities. These consultants reached out to my firm on behalf of two of their clients who were just shut down this week in big cities for half of their “employees” being off the grid. Both of these companies had less than 10 off-the-grid workers and here’s the kicker — one of these companies is a Chinese domestic company. In both instances, the consultant had no idea why the closings were happening now. Have you heard of similar?

4. Foreign company doing business in a small Chinese city as a WFOE is told by city officials that it needs to form a new WFOE because the scope of its existing one does not cover its operations. The funny thing is that this WFOE had been formed only a few years earlier with the help and at the direction of this same city. When asked what had changed, the city said that “Beijing is looking at this sort of thing.” We have been warning of this for years but this is the first time I have heard of a city issuing this sort of order so much out of the blue. Are you aware of this happening elsewhere in China? For more on the importance of “scope,” check out How To Form a China WFOE. Scope Really Really Matters, Part II.

5. Just this week, I personally have received three phone calls from American companies wanting our help in figuring out how to get their Chinese investors’ money out of China. One was a real estate development company in the Midwest that has been expecting $2 million dollars each from two different Chinese investors and that money has not been cleared by China. The other two were from residential realtors in the Northwest who are working with China-based buyers whose funds have been blocked from leaving China. In both of these instances, the realtors told me that they have heard that China allows its citizens to transfer only $50,000 a year outside the country, but in the past Chinese home buyers have circumvented that rule by paying ten or twenty or thirty or more of their relatives and friends to each transfer $50,000 to the same bank account in the United States. Seems that all of a sudden China is stopping that and these people are not able to buy their U.S. houses and these realtors are not able to make the sale and get their commision. I forgot about these three calls (until I got two just today) simply because my response is just to tell them that our China lawyers are not the right lawyers to assist both because it is their Chinese clients who need the lawyer and there is no reason for a Chinese citizen to hire a U.S. law firm for what is for the most part a China (not transnational or international) issue.

The common theme here is that if you are a foreign company doing business in China, you need to get legal. And fast. China as Wild West — at least for foreign companies —  is no more.

What are you seeing out there?

Beijing Wins World’s Most Livable City Honor: Fong’s Pizza Proves The Point

Posted in China Business, China Travel, Good People, Recommended Reading
Fong’s Cat. Des Moines, Iowa. Photo is from Fong’s Website at www.fongspizza.com

Fong’s Cat. Des Moines, Iowa. Photo is from Fong’s Website at www.fongspizza.com

According to yet another highly scientific and thoroughly researched study, Beijing was just named as the world’s most livable city. No big surprise there, what with its recently cleaned air, its friendly cab drivers, and its overall friendly and polite vibe. The fact that it has such pure drinking water and low rents no doubt aided in this choice. Paris came in second, which makes complete sense, particularly if you are Jewish and have no problem living in a city where large swaths are no-go zones. It also may be the only city in the world with cab drivers as pleasant as in Beijing, and its citizens match Beijing’s really one for one in both friendliness and politeness.

And rounding out the top three — again no surprise here — is Des Moines, Iowa. If you doubt this choice, I have two words for you Fong’s Pizza.

How do you rank the world’s cities on livability?

China vs. Vietnam For Product Sourcing

Posted in China Business, Recommended Reading

As my law firm’s Vietnam practice continues to grow, I have become fascinated with how company’s make the decision on where to outsource their product manufacturing as between China and Vietnam, both for new products and for products currently being made in China. One of the reasons I am so fascinated by this is because so many factors must go into the decision and unless IP is paramount for the company, the legal issues are not usually central.

So I was delighted to read the post, 3 Key Factors for Sourcing in Vietnam, particularly since it is written by InTouch Manufacturing Services, a company I know to have substantial China sourcing experience.

That post starts out talking about how the media has been writing often of late about manufacturing shifting from China to Vietnam. It then notes that Nike now gets 42 percent of its product from Vietnam, as compared to 30 percent from China, widening the gap even since 2010. The post then presents the following wage chart from the Japan External Trade Organization showing that China factory workers make, on average, three times as much as factory workers in Vietnam.

Factory Wages in China and Vietnam

The post calls this wage disparity “significant for any labor-intensive product like footwear, garments, and electronics.” It is, but as I am always saying, if wages were the only factor, every company would be looking to start sourcing in Afghanistan, South Sudan or Yemen, and of course they are not.

Most importantly though, this post analyzes from a sourcing perspective the following three key issues involved in choosing between China and Vietnam.

1. Product Type. The post notes that “Vietnam has proven to be quite capable of producing labor-intensive products like footwear and is now starting to win over major technology companies for significant investments in more technical manufacturing.” However, though “capabilities and confidence in Vietnamese manufacturing are growing … China still maintains a significant competitive advantage.”

The post rightly warns those looking to shift production from China to Vietnam to consider “the risks posed by a [Vietnamese] workforce that is relatively new and inexperienced” and suggests asking “what might you be taking for granted in China now that you may find yourself struggling to manage or live without in Vietnam?”

2. Your Existing Supply Chain. The post rightly points out that Vietnam’s infrastructure is not as good as China’s and this could be particularly problematic for smaller companies that cannot essentially fund their own infrastructure:

Vietnam’s fragmented manufacturing industry makes it harder to identify suitable suppliers, especially for those new to Vietnam. Lack of basic infrastructure is a main cause of this fragmentation. Contrast that with China where you can find just about anything you want – and usually more than a handful of viable options that aren’t too far away from where you need them. With well-paved roads, 7 of the world’s 10 busiest shipping ports, and a massive network of high-speed and commercial rail lines, infrastructure in China is extremely well established.

*     *     *     *

Both countries pose their own unique challenges to foreigners looking to establish operations there, but the path is clearer in China. Tons of businesses have already set up shop and blazed the trail for mega corporations and small-time entrepreneurs alike. Potential foreign buyers and business owners of all sizes will have a relatively easier time finding guidance about China than for Vietnam.

This is very true and one of the things we are finding we are having to do for our clients looking to go into Vietnam is to connect them with appropriate people in Vietnam, far more often than we do for our clients looking to go into China.

3: Foreign-owned Manufacturers. The post discusses how so many of the “manufacturers in Vietnam established for export are actually foreign owned,” with a large portion of those owned or operated by Chinese or Taiwanese. Very true, and for more on that, check out this post, What’s Your Vietnam Strategy? on my time in Vietnam during last year’s anti-Chinese riots.

Interestingly, the post notes how this foreign ownership means that the time and energy you have spent “learning the nuances of Chinese culture and manufacturing will not have gone to waste. This makes it easy to transfer existing QC checklists, specification sheets, or other documentation that might have been written in English and Chinese. You’ll generally find that these factories also employ Vietnamese staff proficient in both English and Chinese.”

The post also wisely notes that with so many Chinese manufacturers themselves having set up in Vietnam, you should discuss with them how you “may be able to work with your Chinese supplier to keep some of the production processes in China, while outsourcing others.”

It makes for a really good read and I recommend that you read it.

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 Basics of China Business Law, China Business, Legal News

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.