china distribution contracts

Received the following email this morning from a China businessperson I have known and greatly respected for many years.

This is a good article on what is coming down the road for manufacturing and large service WFOEs in China. The basic goal of the CCP is to drive all private enterprise away, to be replaced by SOEs.

This reinforces what we were saying about how foreign companies are crazy not to consider doing their China business from outside China.

As we discussed, Apple is ahead of the curve by doing its manufacturing through third parties. The fate of Foxconn remains unclear. The fate of all the large-scale assembly WFOEs remains unclear: Dell, HP, Nike: they all operate as WFOEs. They are the targets of the program in the forwarded article.  Not to mention KFC.

It is not clear what will happen.

The view that China will not continue with this because it will be bad for business and will harm them economically is untenable. The Chinese government does not really care about this. China is driving out Japanese companies right now even though doing so has negative economic impact. They don’t care. This is also another reason not to do big WFOEs in China. Why do a large amount of fix asset investing in a country that behaves like China? It makes little sense. The idea was that China would move more towards the EU model. The opposite is happening. Investors/companies should take that into account.

The article referred to in the email was a recent Wall Street Journal article by two Baker & McKenzie employment lawyers, Andreas Lauffs and Jonathan Isaacs, entitled, “Rebalancing the Workplace: In its drive for domestic consumption and social harmony, Beijing steps up labor interventions.”  The thesis of that article is that China’s efforts to rebalance its economy by increasing household income are related to “increasing labor unrest throughout the country.” According to the article, these two things “are related in a way, and add up to a new concern for foreign companies operating in China.”

The article then cites various CCP actions highlighting its intentions to democratize the workplace:

In February, new national regulations required that employee representative councils be established in enterprises to carry out democratic management of the enterprise. The councils are bodies directly elected by the employees at large, that are distinct from and have different powers than unions; for example, while a union would negotiate a collective bargaining agreement, councils would vote to approve or reject the negotiated agreement.

Such councils have long been mandatory at state-owned enterprises, but this is the first time national regulations have expanded this requirement to all enterprises. Although the text of the rules is vague on this point, it is generally believed that the regulation also applies to foreign-invested companies.

Meanwhile, in May, the Central Committee of the CCP circulated a notice urging lower-level CCP party committees and local governments to strengthen and improve the CCP’s work in private companies. All private companies with at least 50 staff should have at least some CCP members, the notice said, and if a company employs at least three CCP members, then a Party organization should be established within that company.

The writers see all of this as pointing “to an overall goal of asserting more CCP oversight over labor relations at private companies” and they conclude their article by calling this “the latest example of Beijing’s rebalancing process in action, and one foreign companies can’t afford to ignore.”

I agree with the Wall Street Journal article and I sort of agree with the email writer.  I agree with the email that Chinese government decisions (like those of every other government I know) are based on more than just economics.  I also agree with the email writer that foreign companies too often unthinkingly conclude that they must go into China as a WFOE, without analyzing the real life pros and cons of doing so.  And though I think that it is rough sledding for foreign businesses going into China and I do not see all that many signs of it getting any easier, I do not think for a moment that the Chinese government has the goal of shutting down or shutting out all foreign or other private companies. WFOEs do make sense much of the time for foreign companies looking to profit from China, but definitely not as often as consultants and accountants and lawyers who stand to profit from another company being formed make it out to be.

But what are the alternatives for foreign companies looking to “get into China”?  If you are looking to sell your product or service into China, doing so via a licensing or distribution or franchising arrangement might make better sense. For more on this, check out the following:

What are you seeing out there?

Excellent post on King & Wood’s China Law Insight Blog on resale price maintenance in China, entitled, “Rules Governing Resale Price Maintenance in China.” Now before you just up and run away from this post, believing there is no way an antitrust concept can be relevant to your business in China, let me tell you that you may well be wrong.  

If you are selling your product in China through a third company, you need at least a passing familiarity with China’s resale price maintenance laws.

Wikipedia nicely explainsresale price maintenance:

Resale price maintenance is the practice whereby a manufacturer and its distributors agree that the latter will sell the former’s product at certain prices (resale price maintenance), at or above a price floor (minimum resale price maintenance) or at or below a price ceiling (maximum resale price maintenance). If a reseller refuses to maintain prices, either openly or covertly (see grey market), the manufacturer may stop doing business with it.

China Law Insight points out that China prohibits resale price maintenance:  

Article 14 of the Anti-Monopoly Law (AML) prohibits the fixing of resale prices (and in particular minimum resale prices) to third parties. In other words, Manufacturer A is prohibited from stipulating that Distributor B must resell Manufacturer A’s goods at a certain price to Retailer C.

I have seen a number of American companies get tripped up on China’s resale price maintenance laws and when my firm writes its China distributorship contracts, we are always mindful of it. We typically see problems when the American company’s agreement with the Chinese company requires the Chinese company to sell the American company’s product at a certain minimum amount so as to prevent the Chinese company from undercutting either the American company (which too is selling its product in China) or the American company’s other China distributors.

We have had American companies come to us wanting to “do something” about its Chinese distributor pricing its goods below the allowed contractual amount and the problem is that, in most instances, there is little to nothing the American company can do other than watch its Chinese company continue to undercut until their contract expires. At least one American company told us that it would never have entered into the distributorship agreement had it known that its Chinese distributor would be free to engage in its own pricing. 

The benefit of knowing China’s resale price maintenance laws is that you can then decide for yourself whether or not you want to take the risk of having a Chinese company free to price “your” goods.   

China’s prohibition on resale price maintenance is, however, not absolute and as China Law Insight points out, if “an entity can prove that it fixed resale prices to fulfill the following objectives,” its conduct “may be exempt” from the prohibition against resale price fixing: 

• RPM was undertaken with the objective of undertaking technological improvement or research and development of new products;

• RPM was undertaken to raise product quality, lower costs, improve efficiency, standardize product specifications and standards or implement specialization;

• RPM was undertaken to raise the business efficiency of small and medium business operators and to strengthen the competitiveness of small and medium business operators;

• RPM was undertaken to fulfil matters involving the public interest, including energy conservation, environmental protection and disaster relief;

• RPM was undertaken to alleviate a serious drop in sale quantity or obvious over-production in times of recession; or

• RPM was undertaken to protect legitimate interests in relation to foreign trade and economic cooperation.

China Law Insight goes on to correctly note how beyond that set forth above, there is little China law guidance as to how the Chinese courts and governmental authorities will analyze these exceptions and it then concludes with this salient advice:

Businesses should be aware of and take note of the strict RPM [resale price maintenance] prohibition in China, when formulating their distribution agreements. In the event where it is commercially imperative to impose vertical restraints (including RPM) in distribution agreements, businesses may wish to consider if their agreements could fall under the exceptions listed….

I would add that if you find it essential to engage in resale price maintenance in China, you should explicitly set out in your distributorship agreement why you are mandating price requirements and you should make sure that your reason(s) track one or more explicitly permitted exceptions.  

We recently did a post, entitled, “That’s Hot: Made In China For China. By Foreigners” in which we talked about seeing a massive increase in licensing agreements for foreign companies licensing products to Chinese manufacturers. We have also been seeing a correspondingly massive increase in work for foreign companies entering into distribution contracts with Chinese distributors. Both of these increases are no doubt due to China’s rising status as a consumer/buyer nation.

Many of the companies that come to us to draft their distribution contracts with Chinese distributors are already experienced with distributor relationships and already have a “standard” distribution contract. Though China distribution agreements can have much in common with US and European distribution agreements, they also have stark and interesting differences.

Our clients’ standard distribution agreements (usually with a United States or a European company) typically make for an excellent starting point in our drafting of the Chinese distribution agreement. These standard distribution contracts have usually been honed and customized over the years to match what our client wants and needs from its relationships with its distributors.

But we always need to modify them to make them work for China. 

One reason for this is that the United States/Europe generally provide distributors with all sorts of legal protections. These countries often make it difficult or expensive to terminate a distributor and it is not at all unusual for distributors in these countries to sue or threaten to sue when a distribution relationship sours.  

Chinese law has no special protections for distributors. In particular, there is no legal requirement in China for payment of any special compensation to a distributor upon termination of the distribution agreement. For these reasons our China distribution agreements call for applying Chinese law.  For these same reasons, we usually also delete those provisions in US or European standard distribution contracts devoted to trying to work around distributor protections. 

We add in what we call a “no registration” provision to further protect our clients’ China trademarks. In this provision, the distributor agrees our client has exclusive ownership of all trademarks, that the distributor gains no rights to those trademarks, and that the distributor will not register any trademarks in any way related to our client’s trademarks. I use the words “further protect” because the first line of protection for your trademarks in China is to register them properly in China. 

One other difference between a Chinese distribution agreement and that for the United States or Europe is that the signature line in a Chinese distribution contract should provide a place for the distributor to affix its company seal; unsealed distribution contracts are arguably not valid under Chinese law.