Getting your product made in ChinaYou are a new company just starting out. You have a great product and you have no other options but to have your product made in China, a country to which you have never been and know little to nothing about. What do you do?

You essentially have two choices. You bring in and pay a person or a company to help you find the right Chinese manufacturer or you do it yourself. Both of these have their pros and cons but in our experience, using an intermediary tends to be riskier, and that need not be the case. If you were to understand the role of your intermediary and work to smooth out the rougher edges of that role, you could make using one no riskier than going it alone.

In working with an intermediary to get your products manufactured in China, you must understand how you are paying them and even how much. There are multiple ways to pay these intermediaries, including the following:

1. You pay the intermediary an upfront flat fee for the intermediary to, among other things, find you a China manufacturer and to negotiate with the China manufacturer on your behalf. Typically, in this sort of arrangement, the intermediary drops out after you place your first order and that order is completed. The biggest pro to this method is that you pay once and the intermediary has less incentive to permit the China manufacturer to overcharge you. The biggest con is to this method is that you must come up with a large chunk of money right away and it is still possible (and not all that uncommon) for your intermediary to strike a side deal with your China manufacturer to get a 5-40%+ secret commission on every sale. If your intermediary does have a side deal with your manufacturer, it also has incentive to use a too-cheap manufacturer so as to be better able to hide its secret commission from you. Too-cheap manufacturers are more likely to have quality control and delivery problems.

2. You pay the intermediary by the hour to, among other things, find you a China manufacturer and to negotiate with the China manufacturer on your behalf. In this sort of arrangement, it is not uncommon for the intermediary to remain on board indefinitely to help with quality control issues. The pros and cons of this payment method are similar (though a bit reduced in terms of the upfront payment) to the pros and cons of method one.

3. You pay the intermediary some percentage on top of what the China manufacturer charges. In this sort of arrangement, it is typical for the intermediary to find you a China manufacturer, negotiate on your behalf with the China manufacturer, and remain on board indefinitely to help with quality control and to keep collecting the percentage payment. The biggest pro to this method is that you do not have to pay anything up front. The biggest con to this method is that it seems like 90% of the time when our China lawyers have been called in on one of these once problems have arisen, we discover that the intermediary’s 5% commission was actually anywhere from 20% to 300% — yes 300%. Again, to the extent your intermediary is hiding the amount of its commission from you, it has incentive to use a too-cheap manufacturer, which heightens your risk of quality control and delivery problems.

4. You pay the intermediary some predetermined fixed amount for your widgets and the intermediary steps in and essentially becomes the seller. This means that the intermediary is clearly responsible for quality control issues and — if you have an appropriate contract with this intermediary, this also means that the intermediary is legally liable for bad quality and late deliveries, etc. The biggest pro to this method is that it is usually the most honest. You know what you are paying for your widgets and the intermediary does not lie to you about what it is paying for your widgets because that figure is irrelevant. When I buy cheese at my grocery store for eight dollars, I hardly care what my grocer paid for the cheese and no representations about what it paid are being made. If the cheese is bad, the grocer is on the hook, plain and simple. But, I am no doubt paying more than if I were getting my cheese straight from the dairy farmer.

We have seen competent and incompetent and legitimate and illegitimate intermediaries use all four methods. Is going it alone better? Much of the time it is, but certainly not always. When is it best to go it alone and when is it best to use an intermediary? Answering that would take a book and we as China lawyers are not the right people to write that. In the end, you pretty much just have to trust yourself and your own comfort level.

BUT, no matter whether you go it alone, there are certain things you can do to reduce your chances of problems. On what problems should you focus and how can you minimize those problems? I will discuss these issues in parts 2 and 3 of this mini-series.

 

China Lawyer
Intentional sharing is fine; unintentional sharing isn’t.

Use your China contract and China’s sophisticated and fair and relatively cheap (yes, those are the right descriptions) to clarify who owns what in China. Who owns your product design? Who owns your software? Who owns your IoT device? Who owns your molds and tooling? Who owns your trademark when you license it out? If you don’t have the appropriate contract in place, the answer will be the Chinese company (not you), way more often than not. Too many times I have had to inform Western companies that they have unknowingly relinquished ownership of XYZ to their Chinese counter-party and now we just need to try to try to limit that damage as much as possible.

We are constantly writing about the need to clarify “ownership” in China but always from the perspective of who we are: China lawyers. Today, while reading Seth Godin’s Blog, I had an aha moment regarding ownership in China. But let me digress just a bit.

I am a huge fan of Seth Godin, such that it would not be an overstatement to say that he has influenced my law firm. I must have read his missive, Small is the New Big, at least twenty times. We even used to post it on our website, we thought it so important. And his overall theme of always always always (no matter what) being truthful to your clients, is yet another constant Godin theme we try to embody. I regularly read Godin’s excellent blog, but more for my own law firm business than for China Law Blog ideas.

But Godin’s post today, entitled, Joint Ownership, is just so China relevant and so clear that I have to quote it:

Before you create intellectual property (a book, a song, a patent, the words on a website, a design) with someone else, agree in writing about who owns what, who can exploit it, what happens to the earnings, who can control its destiny.

This is sometimes an uncomfortable conversation to have, but it’s far worse to have it later, after the thing you’ve created has been shown to have value.

It’s almost impossible to efficiently split a soup dumpling after it’s been cooked…

As someone who spends a huge chunk of his time trying to split the IP soup dumpling after it has been cooked, I vehemently agree. As is true of so much in law, doing it right from inception costs around one tenth as much and is around ten times more likely to succeed than trying to fix things later.

China Due Diligence
China Due Diligence: Sherlock required

Every few months, one of our China lawyers will get an email from a company seeking to buy our due diligence checklist (as though we have just one) for their (usually not described) deal in China. My pat response is usually something like the following:

We don’t have just one due diligence checklist for China because the due diligence we recommend always varies depending on all sorts of factors, including the nature of the deal, the value of the deal, the industry of the parties, and even what we know about the parties before we conduct any due diligence. The location of the parties also can be important.

Though we do use our previous due diligence checklists in formulating due diligence checklists for current deals, we never just re-use an old one for a new deal. For this reason, we are not willing to sell any of our due diligence checklists because the risk of their not working well for you are just too high and we do not want our law firm name in any way attached to what could very well turn out to be inadequate due diligence. Not to mention that I find it nearly impossible to believe that anyone without a huge amount of China legal and business experience could appropriately use a due diligence checklist even if it does perfectly fit the deal.

If you want to see what I mean about how important it is to tailor your due diligence to the China situation at hand, I urge you to read a just completed three part series on China partner due diligence best practices over at the Health Intel Asia Blog. Go here for Part 1, here for Part 2 and here for Part 3. Ben Shobert — a true expert on China senior care — wrote this three part series to set out due diligence “best practices” when dealing “with real estate developers, property management companies, or institutional investors” in the senior care industry.

Ben begins by listing out the following as the most important factors you should consider and then he provides a massive (yet no doubt too general to apply perfectly to your specific situation):

  • Financial ability of the partner to execute.
  • Reputation of the partner.
  • Relationships in the locality where development will take place.
  • Experience in real estate development or investing.
  • Track record in development – residential, mixed use, etc.
  • Track record in developing senior housing.
  • Commitment to senior housing vs. senior housing as a way to acquire land use rights.
  • Dedicated development team.
  • Dedicated senior housing team – familiarity with development and operational issues.
  • Long term investment horizon – commitment to operating senior housing vs. build and sell.
  • Common strategic vision for their involvement in the industry.
  • Experience dealing with foreign partners.

The above is about 15% of the information Ben advocates securing from your China senior care partner> I list it not merely to give you some flavor of how complicated it is to tailor your China due diligence to your specific deal. If you read the remaining half of Ben’s initial post and his two subsequent posts I am sure you will be convinced as to why no off the shelf checklist can be adequate.

For more on what is involved in China due diligence, check out the following.

 

China attorneysTen years ago, our China lawyers probably wrote around one product sales agreement a year for our Western clients selling their products or services into China. These days with Chinese companies having become serious consumers of Western products and services, we probably write one a month. The below is an email from one of our China attorneys to a client, written to gather up sufficient information to create a first draft of a product sales agreement for the sale of a product from an American company to a host of Chinese automobile companies.

I am running this email (long after the fact and stripped of any identifiers) because it addresses many of the key points you should be thinking about if you are selling into China. The below email is to a client that was selling its products into China, but much of the email is relevant to those selling products into China as well.

Please find below an outline of a PRC product sales agreement with questions designed to provide me with the information required to draft the document.

The first step for drafting a sales agreement for China is to deal with the basic sales terms. The terms for customization and cooperative design can come later. For this reason, the outline and questions below apply only to sales of your_____________ product [customized for each buyer] and your other standard product from your China catalogue. Please consider the questions below and provide answers where you can. I will draft a sales agreement based on your answers. Where you do not have an answer, I will either a) insert a standard provision or b) provide for resolution by a separate document.

If you have questions or need further clarification about any of these items, please email me or arrange for a phone conference.

  • Product. How do you identify the Product? Do you simply use a catalogue part number? Or do you provide specifications? Or do you use some combination of these two? For __________, do you do any customization of the product, or are all sales straight from your line?
  • Price terms. How do you work with prices? Are your prices based on your catalogue price, or do they vary for each of your Chinese customers? How do you deal with price changes? That is, for how long are your prices effective? Do you have the right to raise prices at any time?
  • Payment terms. What are your standard payment terms? Do you require an upfront deposit? When is payment due and upon submission of what documents? How do you typically respond when a Chinese customer requests a variation from your normal terms?
  • Shipping Terms. What are your standard shipping terms? Does your pricing include freight, insurance and similar? Do you use a standard shipping term such as Ex Works or FOB or DDP?
  • P.O. Processing and acceptance procedures. How do you work with purchase orders? How many days do you allow for processing and acceptance? What happens when you do not formally accept a purchase order in writing? Without acceptance, is the PO considered to have been rejected? Are you required to accept all purchase orders submitted, or do you have the right to reject POs?  If you have the right to reject a purchase order, are there limitations to this right, and if so, what are they?
  • Scheduling and Timing. How do you deal with scheduling regarding timing and quantity of shipments? In our experience, some China buyers do not want to be tied down to any sort of schedule, while others want to tightly schedule both quantity and time of delivery. Still others want to treat their arrangement as a “requirements contract,” meaning they are not obligated to purchase anything from you, but you are obligated to fill all of their orders, no matter how unreasonable in terms of quantity or timing.
  • Facility, subcontractors and component suppliers. Do your China buyers have the right to inspect your manufacturing facility? Do they have the right to limit what manufacturing facility you can use for their products? Do they have any grounds for blocking you from using any subcontractors? Do they have the right to approve your component suppliers? Are they able to review and approve a bill of materials?
  • Packaging and labeling. Does your quoted price include packaging? What are your company specific policies concerning packaging and labeling of your products? How do you respond if a customer makes specific requests concerning packaging and labeling? Do you ever custom package and label? That is, do you ever package, label and mark using the name and logo of your China customer?
  • Molds and tooling. Are customer designed/customer owned molds and tooling used in your producing your_________ products? If yes, please describe.
  • Quality Control. How do you normally work with your China buyers in terms of quality control for your products? For example, do your buyers have the right conduct inspections and/or QC tests in your facility? How do you deal with special requests for quality control procedures from your customers. What form of testing or inspection do you use (if any) to confirm that your products conform to QC standards upon delivery to a customer? Are your buyers permitted to delay acceptance and payment for product until after they have conducted their own QC inspection and testing
  • Warranty. Do you have a standard warranty? If yes, please provide. If you do not have a standard warranty, PRC standard seller warranty terms for products similar to yours are generally as follows:

a. Seller warrants product will meet specifications for a period of one year from delivery to buyer.

b. Warranty remedy is as follows:

1.  For general warranty claims, remedy is limited to either a refund of the purchase price or the seller repairs or replaces the defective item at no cost to the buyer.

2.  If the defect rate exceeds 3% in any specific time period (Epidemic Failure), seller is additionally liable for the direct costs of dealing with the failure.

3. The seller is not liable for consequential damages of any kind.

Your buyers are likely going to want pretty much the “opposite” warranty; they will want you to be liable for all damages, direct or consequential, of any kind.

  • Warranty service. There are two types of warranty service:

a. For defects identified at the factory, before the product is incorporated into a manufactured item.

b.  For defects identified in the field, in a manufactured product that fails while in the possession of a third party purchaser.

What are your procedures for dealing with warranty claims in both situations? Note that for b), the most common approach is for the buyer to be responsible for dealing with the claim and for the seller to provide an appropriate reimbursement.

  • General service. What form of service/training do you provide in connection with the product? What service manuals or other written material do you provide in connection with the product? What other service do you provide in connection with the sale of the product?
  • Intellectual property. What registered intellectual property (if any) is used in the sale of the product: trademark, logo, design patent, utility patent? Will any buyer IP (such as buyer trademark and/or logo) be used with the product? Do you have proprietary (copyright) package designs that you will use? Will you use buyer package designs? Will you exchange any information with buyers that should be treated as confidential information by your buyers? Will you require the buyer to identify your product/trademark in the sale of their product? That is, when a special product like the _________ is used, it is sometimes required that the buyer identify that item in their description of their own product. For example, intel often requires this on computers sold in the U.S.
  • Dispute resolution. Since you are operating in China with Chinese entities, for dispute resolution we normally provide for litigation in the PRC People’s Court in the district where the defendant is located. Note that this particular client had a China WFOE through which it was making the bulk of its China sales. Many of our clients that sell their products or services into China do so from the United States or from Canada or from Australia or from Europe and our dispute resolution analysis for them might be very different. There is no one-size-fits-all dispute resolution clause.
  • Other special matters. If there are other matters you think we should be addressing for your products, please specify.
China attorneys
Oh, but it can and it does.

The day before yesterday, I wrote a long post (with a long title), China, The World, Greed, Cognitive Dissonance, The Best and the Brightest, and Why People Seem to Encourage/Almost Enjoy Getting Scammed, on why people are so susceptible to getting scammed. My thesis is that once someone has convinced themselves that the deal is lucrative, they have a hard time convincing themselves that it might be a scam. I concluded that post by promising a part two describing how to avoid getting scammed. This is that part two and it too is going to be quite long, so please bear with me.

The first thing to avoid getting scammed is to have the right attitude, and that means you must question and doubt EVERYTHING. Why would a legitimate Chinese company in Shenzhen contact you for an oil and gas deal when you are just a school teacher in Vermont? And why would an oil and gas company be located in Shenzhen anyway (it’s possible, but not likely)? Why is a Chinese company contacting me out of the blue to make a $3 million purchase of my widgets when there are 3,000 other widget companies and when we’ve never previously made a sale for more than $30,000? How can this Chinese company charge $11 per widget when everyone else is charging at least $22? And after you have compiled your list of questions and doubts, do not pay a penny (other than perhaps to your own investigator) to anyone until you truly have compelling answers to all of your questions.

One of the classic tactics of a scammer when asked tough questions is to give complicated and convoluted answers. And then when you even hint at wanting an answer you can understand, the scammer seeks to paint you as an idiot and/or a bad person for not trusting them. Do not fall for either. Chinese companies spend weeks, sometimes months, conducting due diligence on their potential counter-parties and your doing the same will be viewed by legitimate Chinese companies as a sign of your savvy and your intelligence, not as a sign of any moral failings. As for your being made out to be an idiot, well just remember how you will feel like much more of an idiot after you are scammed than if you prevent a scam. Oh, and if you don’t understand how the business or the deal is going to operate, that, standing alone — fraud or no fraud — is a great reason for you to just walk away.

The second key to not getting scammed when dealing with a China company is to make sure you are actually dealing with a China company. Though our percentage estimates vary, all of the China lawyers in my firm estimate that at least half the time when a Western company is scammed by a “Chinese company,” the company is either not Chinese at all (oftentimes they are from Nigeria) or they are not a company at all because they have never actually registered with the Chinese corporate authorities. This means that just confirming you are dealing with a real registered Chinese company will lower your chances of getting scammed.

In China Due Diligence. The Most Basic Things To Do. I set out the following basics for how you can determine whether you are dealing with a legitimate Chinese company.

The first thing you do is ask the Chinese company to send you a copy of its business license. Do not be afraid to do this. Chinese companies do this all the time. If the Chinese company refuses to send this to you, walk away.

You then have someone fluent in Chinese and with knowledge about Chinese business licenses examine the one that you have been sent.

Our China attorneys typically look for the following:

To determine whether it is real or not. This is done by comparing the information on the business license provided with the corresponding information on the relevant Chinese government website — usually the local State Administration for Industry and Commerce (SAIC). If the business license you have been provided is fake, you walk away.

To see when the company was formed. We like to compare what the real business license says against what we were told (by email or whatever) and also what the Chinese company says on its English language and its Chinese language website. If different years are given in different places, we get suspicious and we ask more questions.

To see where the company is located. We like to compare this against both what we were told (by email or whatever) and also against what the Chinese company says its English language and its Chinese language website. If there are different addresses in different places, we get suspicious and we ask more questions.

To see what the scope of the Chinese business is, as listed on its registration. If the scope is “consulting” and our client thinks it will be ordering five million dollars of widgets from a factory, we get really suspicious. Looking at the scope is a good (though not always fool-proof) way to determine whether you are dealing with a manufacturer or a broker.

To see the amount of registered capital. If the amount is too low, the odds are good that it is not a manufacturer. If the amount is really high, the odds are good that this is a big company. Note that this information is not going to be as commonly listed in the future.

Lastly, you should go visit the Chinese company or send someone you truly trust to do so.

Doing the above is not nearly enough due diligence for big deals, but it is a relatively fast, relatively cheap way to at least get some sense about the Chinese company with which you are thinking of doing business and it oftentimes will be enough to let you know whether or not you even wish to conduct additional due diligence or just walk away.

In China Business Due Diligence, I went into a bit more depth on some of the basics that should be undertaken to prevent fraud, and I listed out the following:

Construct your own fraud scenario. Ask yourself how the Chinese company could have staged everything it has shown you. Did it switch the factory signs before you arrived, so that it looks like it owns the factory, rather than someone else? Did it paint the old machinery to look new? Is the person with whom you are speaking really a PwC accountant, or just someone paid $100 to pose as one? We have encountered fake factories, fake Chinese lawyers, fake documents, fake accountants, fake foreigners, fake owners….

Focus on the operations. Look carefully at the Chinese company’s operations. Why does the company have only 100 boxes in storage when it claims to be selling 5,000 widgets a week? How can the company make 5,000 widgets a week with only enough of x material to make 100 total? Why did the company have a completely different set of employees on the same day and time two weeks apart? It pays to visit two or three (or more) times — a good fraudster can put on a show, but they are unlikely to be able to do it the same way each time. Watch for the subtle differences.

Get the official records yourself. Use your own people to get the Chinese company’s official corporate records from the official Chinese government sources. Though doing this is neither inexpensive nor easy, information gleaned from the official government records can often be helpful. Then compare the official records with the documents the Chinese company gave you. This is key.

Take company-provided introductions with a grain of salt. Speak with your target Chinese company’s vendors, neighbors, employees, and customers, especially those you find on your own. When talking with people to whom your target Chinese company has introduced you, take everything that is said with a grain of salt. It is not difficult for an unscrupulous company to buy someone’s loyalty for the duration of a meeting or a phone call and this sort of thing goes on all the time. And again, do you really know whether these people are as claimed? We love sending our own people to just hang out around the Chinese company for a week or two as it is amazing what they can learn just by watching and by talking with employees and others in the vicinity.

Speak with the Chinese company’s competitors. Competitors with real businesses can and usually will tell you about their competitors, but, of course, any information gleaned this way should be taken with at least a bit of salt as well.

Do not delegate. Use your own trusted network to gather information on your potential Chinese counter-party. If you don’t have such a network, get one. If you can’t get one, don’t do the deal.

Co-blogger, Steve Dickinson, wrote a post, entitled, Three Keys to Spotting a Fraudulent Chinese Company, describing some of the things he looks for to determine the legitimacy of a Chinese companies listed on foreign stock exchanges for investors that have retained Steve because they are concerned about the value of their investment. Steve’s first step in these situations is to determine whether the Chinese entity is an empty shell. If the Chinese entity is an empty shell, then there is no value in China to protect and further analysis of the company is a waste of time. Steve describes this analysis as follows:

I have done this research so many times that I have developed a three step test to determine whether a Chinese company is a fraud. I take a look at the annual or quarterly report of the Chinese company and if it meets these three tests, it is virtually certain to be a complete fraud, with no operations, no assets and no funds in the bank.

The three indicia of fraud are as follows:

1. The company has a large amount of cash in the bank. I often see supposed cash holdings greater than 50% of the company’s annual gross revenues. Interest rates at Chinese banks are very low and legitimate Chinese companies do not usually keep large amounts of their cash in interest bearing bank accounts. Usually the supposed large cash account is accompanied by bogus explanations explaining why the Chinese entity is unable to repatriate the funds to its investors as dividends. Later investigation usually reveals that these funds were never actually deposited in the bank. That is, these large deposit accounts are simply falsified. The odd thing is that auditors will normally verify that the accounts are real. Once the fraud has been exposed, I have asked auditors what they did to verify the account. They usually state that they relied on reports from the management of the company. In China, the only way to verify the authenticity of a bank account is to arrive at the bank unannounced and look at the computer screen while standing BEHIND the counter as the clerk makes an unplanned query. Virtually no bank in China will allow this, which means that audit verifications of Chinese bank accounts are typically of no value.

2. The company reports profit margins in excess of 30%. I often see fake companies report profit margins of 50%. Doing business in China is difficult and I have never seen a legitimate Chinese company with profit margins even approaching this level, not even state owned monopoly companies. These high margins are then the explanation for why the company has so much free cash; they are so profitable they are printing money. The claim is that they have some unique product or some technical monopoly. In my experience, these claims are never true, as just a few minutes of careful thought would reveal.

3. The company is formed as a VIE (variable interest entity) when it is operating in a business sector where foreign investment is not restricted and the VIE structure is not required. A VIE is required only when a foreign invested company intends to operate in a restricted sector such as the Internet. This is why Baidu, Sina, and AliBaba are organized as VIEs. But most Chinese business sectors are open to foreign investment. When a company that operates in manufacturing or retail sales chooses to organize as a VIE, there is typically only one reason: the organizers are planning to commit fraud against the foreign investors.

 

I cannot resist closing out this post by talking about how to avoid getting caught in what I see as perhaps the most common, most insidious scam of all: The China bank switch scam. This is the scam where someone hacks into either your computer or that of your Chinese counter-party and then sends you an invoice (and you actually do owe the money) directing you to make payment to a bank account held by the scammer, not by your Chinese counter-party. In How to Conquer China Payment Scams I discuss this scam in more detail and advocate engaging in the following actions to prevent it from happening to you:

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, be it Hong Kong, Taiwan or anywhere else.

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.

7. Have an internal procedure for confirming all payments over a certain amount.

Anyone have any additional scam prevention tips? If so, please share them in your comments below.

 

 

China LawyersThis is part three in a three-part series of posts on why foreign companies doing business in China so often lose their proprietary information (intellectual property) to their competitors in China. The first post focused on how so many of these losses arise from what we call leakage — the situation where the foreign company has a contract preventing its Chinese counter-party (usually the manufacturer) from using the foreign company’s proprietary information, but fails to prevent that information from leaking to third parties that are not bound by such a contract.

The second post focused on the most common forms of leakage our China lawyers see from companies doing business in China, particularly those that enter into manufacturing contracts with Chinese companies.

And this third and final post focuses on what you can and should do to prevent such leakage.

The first step to preventing your information from leaking in China is to have contract provisions written to prevent this. If your contract with your manufacturer does not cover the issue, you have little hope. This is why a contract is required and why a simple purchase order is virtually never adequate. But what sort of contract provisions are appropriate? The key is to deal with related parties (See Part 2 for a list of the riskiest related parties) by stating that all disclosures to related parties are prohibited and that your Chinese counter-party will be liable for all improper use of the information by a related party. That is, for related parties the approach is a simple matter of absolute prohibition.

In dealing with third parties other than related parties, the situation is more difficult. An absolute prohibition will not work. It is obvious that the manufacturer must disclose the key information to its employees. And in the modern manufacturing world, few factories are wholly self contained, so sharing of information is virtually always required as part of the manufacturing process.

There are two ways of dealing with the situation. The approach we previously took was to require the Chinese factory identify each individual and entity that would be a recipient of our foreign client’s confidential information. Our foreign client would then, in turn, enter into a separate NNN Agreement with each of these individuals or entities. Under this approach, the Chinese factory would be liable only for damages caused to our foreign client that arose from disclosures to persons or entities the Chinese factory never identified to us. But as China’s manufacturing practices evolved, and especially as Chinese factories began to manufacture increasingly complex products (such as Internet of Things devices) that required a whole slew of different companies this careful system has become less and less workable. The Chinese factory will seldom identify every involved party and those who have been identified are becoming increasingly unwilling to execute their own NNN agreements, and the fact that the factory ends up “off the hook” means that the factory becomes careless with information.

So our most common approach today is to provide that the factory can disclose information as necessary, but the factory is liable for all damage caused our client from misuse of the confidential information. If a key employee steals the information, the factory is liable. If a subcontractor steals the information, the factory is liable. If a mold manufacturer steals the information, the factory is liable. You get the idea. This approach allows the Chinese factory the flexibility to get its job done but it also provides it with a strong incentive for it to impose its own mechanisms for maintaining the confidentiality of the information provided to it by the foreign buyer. Chinese factories will often complain that loading the liability on them is unfair. The response to this should be that “if you cannot trust the persons to whom you disclose our information, you should not make the disclosure. Our record in getting these sorts of agreements signed is shockingly good.

When you manufacture in China, your goal must be to stop leaks of your information. This is not an easy job, but it is doable.

China lawyersStick with me as the title of this post will eventually become clear — sort of.

So I just read a long and really good Reuters article by Engen Tham and Carolyn Cohn, entitled, How British firms built a pyramid scheme in China that lost millions. Had I written the article, I would have given it the title I have given this post, but then a lot fewer people would have read it.

The article is about a massive (how massive is yet to be determined) scam that used a London address to convince Chinese investors to invest millions into what now appears to have been a wholly fake currency hedge fund:

A London address helped draw Chinese investors to EuroFX. But the venture was not regulated in the UK. It was a scam that flourished in the gaps between national systems.

The scammers encouraged investment in EuroFX, a great sounding company name but a company that in fact may never even have existed. Needless to say, the scammers made the company look great by, among other things, using a prestigious London address and by printing “full-colour Chinese brochures, seen by Reuters, which predicted fat returns”:

For an investment of $10,000, investors could expect a return of 6 percent a month. For $100,000, that climbed to 12 percent. A few months later, a separate EuroFX product offered up to 16 percent to anyone who invested $250,000.

The brochures boasted that EuroFX had 13 years’ experience in foreign exchange trading.

In fact, there was no company called “EuroFX.” Its brochure said EuroFX was a brand name for Euro Forex Investment Ltd. This was a dissolved company that an Australian businessman, Bryan Cook, had bought only the month before, according to Eurofinanzza, the company formation agent which arranged the transaction.

The mere fact that the company was run by Europeans was enough for many of its Chinese investors:

He invested 800,000 yuan ($120,000), he said. He did not understand foreign exchange, but believed the scheme was regulated: “I trust Europeans not to lie to me.”

Other Chinese investors who put money into EuroFX also told Reuters they did so because Euro Forex Investment Limited was a company registered in Britain. They assumed it was regulated by Britain’s financial authorities.

It was not.

As someone who has been doing international law for adeades I have seen way more than my share of scams. Scammers love conducting scams that cross borders because merely crossing a border can usually increase confusion stemming from a lack of knowledge regarding language, culture, and regulation.

Now for the Best and the Brightest/ cognitive dissonance part. When I was in college, I read David Halberstram’s The Best and the Brightest as part of an international politics course. Wikipedia does an excellent job at distilling the book in the following one paragraph:

The Best and the Brightest (1972) is an account by journalist David Halberstam of the origins of the Vietnam War….The focus of the book is on the erroneous foreign policy crafted by the academics and intellectuals who were in John F. Kennedy’s administration, and the disastrous consequences of those policies in Vietnam. The title referred to Kennedy’s “whiz kids”—leaders of industry and academia brought into the Kennedy administration—whom Halberstam characterized as arrogantly insisting on “brilliant policies that defied common sense” in Vietnam, often against the advice of career U.S. Department of State employees.

In my class, our professor used the book as a platform for discussing the relevance of cognitive dissonance theory to politics. Cognitive dissonance theory is the following:

Leon Festinger (1957) proposed cognitive dissonance theory, which states that a powerful motive to maintain cognitive consistency can give rise to irrational and sometimes maladaptive behavior.

According to Festinger, we hold many cognitions about the world and ourselves; when they clash, a discrepancy is evoked, resulting in a state of tension known as cognitive dissonance. As the experience of dissonance is unpleasant, we are motivated to reduce or eliminate it, and achieve consonance (i.e. agreement).

As someone who is constantly contacted by people in the midst of being defrauded, I have become convinced that much of the time it is their efforts to achieve cognitive consistency that leads to their becoming scammed. They so much want to believe that they have entered into a good deal that they rationalize everything that should be telling them to get out. Sadly, this drive for cognitive consistency becomes stronger the deeper one has dug themselves into the deal. The more one has already spent, the more one wants to believe that they have not just flushed away their money and the more willing they are to ignore key indicators that they have.

And it is bad. When I first started practicing international law and would get contacted by people who I strongly suspected were being defrauded I would flat out give them my opinion on this, without charging them a thing. But after doing this maybe twenty times and getting nothing but anger back in return maybe nineteen times, I started clamming up. The final straw was the following:

Some 66 year old farmer from rural Missouri sent me an email of his drop-dead gorgeous Russian “girlfriend” of about 22 years old who was on her way to Missouri to marry the farmer. But she was being held up at the airport because the Russian authorities were requiring her to put up a $15,000 bond to make sure that she would eventually return to Russia. The farmer asked me if this made any sense to me and I immediately told him that it did not make any sense at all and that his girlfriend was scamming him. The farmer then accused me of being jealous of him because he was marrying such a gorgeous woman and that the scam was clearly being perpetrated by the Russian authorities, not his girlfriend.

Now when I get these, I am far far more circumspect and my usual response is that for us to be able to help, we need to be paid x dollars to conduct our own due diligence. And here’s the thing: on the rare occasions when these people do pay us for the due diligence and our due diligence (pretty much every time) shows that they are being scammed, they believe us. What’s the difference? They have a stake in believing us because they paid us. In other words, it takes a countervailing cognitive consistency desire to overwhelm the previous one.

Just a few weeks ago a medical doctor wrote me attaching what at first glance looked to me to be a fake Chinese government document and he asked whether the Chinese government charges a $15,000 fee for X. My response was that I didn’t know whether that particular branch of the Chinese government charges a $15,000 fee for X but I very much doubted it. I then said that we would be happy to check that out for him at our regular hourly rates but that at first glance the document he sent me looked like a fraud and I was concerned that he might be getting scammed. His response was to essentially question my abilities as a China lawyer for not knowing off the top of my head what some (obscure) government agency charges for some (obscure) action and to essentially demand that I make up for my ignorance by telling him who he can talk to who actually knows these things. I very nicely suggested he should keep trying with other China attorneys. Cognitive dissonance.

The following are representative of some of the scams our international lawyers have seen over the years:

  • Company documents showed a subsidiary in the Marshall Islands, yet always spelled the country as Marshal Island. It had no such subsidiary. Why would a company not know how to spell one of its locations correctly? I mean, come on.
  • Company claimed to have a multi-million dollar account at a non-existent bank. It was a bank in Australia and five minutes on Google revealed the bank did not exist. We did the search because we thought the banks’ name (an Ocean not contiguous with Australia) was very strange for a bank allegedly in Australia.
  • 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. Again, come on.
  • Company claimed to be bringing in twice as much product as physically possible on a particular ship. When I first saw the amount of product involved I thought “this must be a massive ship.” I then thought, gosh, I didn’t realize Cambodia had ships of this size. So I spent about five minutes checking out this particular ship on the Internet and quickly realized it was not nearly large enough to carry the cargo it claimed it had carried.
  • 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. Had a lawyer friend check this out in the applicable country (Russia).

Saw a judgment from a federal judge in Florida and the order struck me as funny. So I did a search on the judge and learned there was no such judge in the court listed on the order.

A year or so ago, a company sent me some documents to get an estimate from us on what we would charge to represent it on a deal. Within ten minutes I wrote back saying that we would not be interested in representing it on the deal because I thought that the alleged Chinese company was a scam and we did not want to in any way participate in it. I instead suggested that this company retain us to conduct basic due diligence on the company to determine its bona fides. The potential client (who no doubt had dollar signs in its eyes) seemed a bit offended and sought to challenge my suspicions of fraud. My response to his challenge (with some key identifiers changed) was as follows:

I spent less than ten minutes looking at just the proposed contract you sent me and from that one document and in that short amount of time I noticed the following:

If a company is named China, it is almost always huge. Massive. Very unlikely that sort of company would have reached out to you out of nowhere for a $350,000 order when there are so many other potential sellers in other countries (including within China) it could have contacted. This makes no sense.

The Chinese company with this name is in the X business. Why would a company in the X business be looking to buy Y product? This makes no sense.

The bank is in Shenzhen. The company is in Shandong Province. It would be like you in Nashville using a small bank in Seattle for your banking. This makes no sense.

Your contract is not a contract at all. Standing alone, this is not a sign of fraud but it does not make sense for a large company (which this company purports to be) to send out a document like this because it is not even close to being a real contract.

After the American company got over its anger at my questioning their deal (which they saw as the start of something really really big), they had us conduct due diligence on the Chinese company and the situation and within a week, they too were convinced they were being scammed. No deal, but no massive losses either.

So what’s the trick to not getting scammed? Stay tuned for part 2.

China LawyerReally good, really interesting article, by Melissa Twigg on how Chinese factories are starting to produce their own-label products “that bear a strong resemblance to the products they make for global luxury companies.” The article is China’s Factory Brands: Clones or Clever Business? and though it focuses on luxury goods (with an especial focus on handbags), it has relevance for pretty much any company using Chinese contract manufacturers.

These Chinese factories are not necessarily creating duplicates of the foreign products they are making for their foreign buyers. They are instead applying what they have learned from manufacturing for their foreign buyers and using that information to compete directly with them. As our China lawyers have become fond of pointing out to our clients, “since you will essentially be educating your Chinese manufacturer in how to compete with you, you need contracts that will at least limit what it can do when it does so.”

This article nicely explains why Chinese factories are risking the loss of existing customers to go into business competing with them:

In recent years, China’s manufacturing sector has taken a hit due to a slowdown in global demand and the migration to cheaper sourcing centres across South East Asia. With a highly skilled workforce and not enough work, some factory owners that supply major luxury companies have decided that the solution now lies in creating brands of their own.

Most of these factory brands are not in the business of yuandan, the high-quality ‘factory extra’ replicas recently cited by Alibaba’s chairman Jack Ma as fakes that are so good, they are better than genuine luxury goods in a controversial interview. However, there are some instances where Chinese factories produce branded goods that bear a strong resemblance to products they already make for their Western clients. And sometimes tracing the origin of these brands can lead to a rather murky trail.

“They’re making this kind of move to protect themselves,” says Gerhard Flatz, the managing director of KTC, a manufacturer of premium sportswear in China. “Manufacturing is moving elsewhere, so in order to survive the factories feel they have to do something different. Sure, it’s a tricky business practice but factories are in a difficult position. There’s a war out there and they have nothing to lose.”

Agreed.

We have gotten more calls in the last year from companies whose China factories are now directly competing with them than in probably the three years before that combined. Chinese factories are more confident now than they have ever been about going out into the world with their own products, and more willing to toss their foreign customers to the curb early. Amazon and Alibaba do not help matters as we are getting roughly a call a week from someone whose product is being sold on Amazon and/or Alibaba by their Chinese factory.

What we can do to help these companies varies tremendously, depending on what they have already done to protect themselves. For what you can do to protect yourself from this sort of competition, I suggest you read the following

In a subsequent posts I will discuss the various options companies have to try to stop their Chinese factory from competing with them, largely depending on the protections they put in place before the competition began.

 

China lawyers for doing business in ChinaThis is part two in a series of posts on why foreign companies doing business in China so often lose their proprietary information (intellectual property) to their competitors in China. The first post focused on how so many of these losses arise from what we call leakage — the situation where the foreign company has a contract preventing its Chinese counter-party (usually the manufacturer) from using the foreign company’s proprietary information, but fails to prevent that information from leaking to third parties that are not bound by such a contract.

This post focuses on the most common forms of leakage our China lawyers see from companies doing business in China, particularly those that enter into manufacturing contracts with Chinese companies. Part 3 will focus on how to prevent such leakage.

 

Related parties. When a China factory intentionally seeks to appropriate proprietary information from a foreign party, leaking that information to a related third party company is the most common technique it will employ to achieve that. There are three basic ways that this happens: First, a state owned enterprise will leak the information to other state owned enterprises in the same industry. For example, an SOE engaged in will obtain proprietary information from a foreign company and then — after mastering that technology — will share it with other SOEs. Since the owner of all of the companies is the same (the Chinese Government), the SOE often does not see anything wrong with sharing the information, particularly when the information is related to health care or environmental protection or some other industry that benefits the Chinese public.

Second, many Chinese companies are organized as part of a large group company. Many of these group companies consist of myriad separate companies ultimately owned by a single shareholder or shareholder group. In the classic scheme, the group company will form a special purpose entity that then enters into the contract manufacturing contract with the foreign company. This special purpose entity then leaks the proprietary information to a different company which, though a separate legal entity, is actually a member of the same group. The U.S entity has no contract with the entity that actually manufactures the infringing product. The factory that entered into the contract with the foreign company then asserts that it is free from liability because it is not the offending manufacturer.

Third, in a similar way, many private company contract manufacturers are part of a network of companies connected by family relationship, clan, village affiliation or other local guanxi networks. In fact, in south China (from Wenzhou south to Shenzhen) it is unlikely any contract manufacturer will not be embedded into this type of related party network. In this setting, a factory owner commonly will leak design information to one of the other member companies in the network on a product it finds valuable. The argument is the same: the factory will claim it did not commit the violation and should therefore not be on the hook. .

The list of other common ways leakage or proprietary information/intellectual property occurs is long, with the following the most common:

Employees. It does not take much investment to set up a factory operation in China, particularly in the south where many contract manufacturers are located. You should assume that many employees of your contract manufacturer are on the look out for a new idea (i.e., your idea) that will give them their start as factory owner rather than wage slave. Appropriating confidential information revealed by a foreign customer is a convenient way to get this kind of head start. Employees are quite enterprising: they will not only run off with your design, they will also run off with your customer list. In just a few months, they will be contacting your customers with offers to sell your product at 30% below your wholesale price.

Subcontractors. Our foreign company clients are nearly always surprised at the number of subcontractors involved in manufacturing their products in China and in some cases, their “factory” does not actually manufacture the product. All production is actually done in a different factory down the street. In other cases, when their factory has too much work, it subcontracts out its excess production. Complex products nearly always require subcontractors. Take Internet of Things products (IoT) as an example. Such products are usually a mix of a main product with numerous subassemblies and the contract manufacturer will often subcontract out production of subassemblies and related components, acting as little more than a assembler. These subassemblies and components often embody the truly innovative portion of the product. To get production done, the main factory is generally quite free in disseminating the foreign buyer’s confidential information through a large group of loosely related factories, none of which have any contractual obligation to protect the confidential information or refrain from using it to directly compete with both the foreign buyer and the Chinese contract manufacturer.

Molds and tooling. The key step in contract manufacturing is oftentimes the designing and production of the molds and tooling used in the manufacturing process. The molds are often the primary repository of the unique design of a product and the tooling often embodies years of manufacturing know-how on the part of the foreign party. Foreign buyers will often take great care in specifying the ownership of the molds and tooling. Few foreign buyers, however, understand that the molds and tooling are rarely made by their contract manufacturer. Instead, that factory hires third parties to do the mold design and tooling manufacture. As a part of this process, the factory discloses the foreign buyer’s confidential information related to those designs, who can (and often does) freely sell the design to a third party or use it for its own purposes. Consider the case of a foreign buyer who has not obtained a design patent on its basic product look and feel: its molds are likely the most important element of its product value. If the mold design leaks away the value of its product design can be destroyed.

Third party programmers and designers. Few small or start up companies have their own product designers, graphic artists or software programmers and so most contract out these tasks to third party shops. Foreign buyers frequently leave these tasks to their Chinese factory, which takes us back to the standard situation: to get the work done, the Chinese factory is required to disclose the foreign company’s proprietary information. Often, no one in the process pays much attention to who really has the rights to the work product of these third parties. Consider an example: say the GUI for the interface for your smartphone app that controls your IoT product becomes popular and is identified with your company and you want to use that GUI design as part of your branding. Do you own the copyright? Does your China factory own the copyright? Does the third party designer own the copyright? Does anyone know? Did anyone clarify this from the start? Do you know what Chinese or even United States or EU law says on this? This use of third party “shops” has become a significant source of leakage.

So how do we prevent leakage? Stay tuned for Part 3.

China lawyersThis is the first in a series of posts I will be writing on why foreign companies doing business in China so often lose their proprietary information (intellectual property) to their competitors in China. This first post focuses on how so many of these losses arise from what we call leakage — the situation where the foreign company has a contract preventing its Chinese counter-party (usually the manufacturer) from using the foreign company’s proprietary information, but fails to prevent that information from leaking to third parties that are not bound by such a contract.

When our China lawyers draft a manufacturing contract with a Chinese factory one of the main things we engage in is “contract plumbing.” That involves us working to make sure the contract is thoroughly sealed so as to prevent leakage of proprietary information to third parties outside of the contract.

What do we mean by leakage? Most foreign buyers are concerned about the owner of the Chinese factory appropriating their product design and making that product for his own use. Since most Chinese contract manufacturers are direct competitors of the foreign buyer, this is a realistic concern. So we naturally draft the manufacturing contract to prevent this sort of direct appropriation of the product design.

However, experience in China shows that just preventing direct appropriation by the contract manufacturing company is not nearly enough. If you block just the Chinese factory owner from appropriating  proprietary information, they will almost inevitably find ways to provide your propriety information to other parties who will make use of the information. Since the factory owner did not commit the deed directly, it will then claim that it is off the hook and simply “not responsible for any misappropriation that may have occurred.”

Sometimes the Chinese factory owner sincerely seeks to maintain control over the product design because its contract with its foreign buyer is valuable and it makes better economic sense for it to maintain good relations with its foreign buyer than to go to the trouble and expense of marketing the appropriated product in the United States and in Europe. In this case, however, there are still other parties involved in the manufacturing process that will benefit from stealing the design from both the foreign buyer and from the Chinese factory owner. In this sort of situation, proprietary product information “leaked” away from the Chinese factory to a third party benefits the third party, not the factory owner.

No matter the cause of the leakage though, the effect is the same. The foreign buyer has lost its proprietary information to a Chinese company. In our experience, the losses from this sort of third party leakage far exceed the losses from direct appropriation by Chinese factory owners. For this reason, we focus on preventing such leakage in any contract manufacturing arrangement, even when our clients insist that their relationship with the Chinese factory owner is so good that “there is no way this factory owner would ever take our proprietary information.”

In tomorrow’s post, I will highlight where and how the leakage typically occurs and set out the best ways to plug these leaks.