Not sure why (the still bad economy?) but my law firm has been getting a rash of China joint venture deals and possible deals over the last six months or so.  Many of these have involved a United States company that wants to enter into a Joint Venture with its China manufacturer so as to work jointly on manufacturing and marketing and selling some combined product or products around the world.

An email from one of our lawyers to a client doing such a China joint venture recently crossed my desk and I am setting it out below because it provides a good introduction to what is involved in “doing” a China joint venture.

There are two steps in forming an equity joint venture in China. The first is to enter into a written joint venture agreement between the Chinese and foreign participants in the joint venture. The second is to formally register the joint venture as a corporation under Chinese law.

With respect to these two steps, please note the following:

a. Since the JV agreement is required, we will move forward with drafting that document first. Issues related to the JV and its structure can be worked out in the process of drafting this document.

b. Please indicate at this time who you will want to use to actually register the joint venture company. There are several options:

  • The Chinese JV partner can be responsible for the registration process.
  • You can engage the services of the local investment development bureau to handle the registration.
  • You can engage our law firm to manage the registration process. If you want to use this option, I can begin working with you to obtain the required    documents and information required for JV company registration.

For the JV Agreement, I have the following questions:

  1. You have provided your desired company name. Please provide that name in Chinese. English versions of company names have no legal effect in China.
  2. Please provide a one or two paragraph statement of exactly what the joint venture company will do in China. In particular, please describe:
  • The proposed facility.
  • If you will manufacture, what will be manufactured and what will be the source of the materials.
  • If you will import, what exactly will be imported.
  • Where will product be sold? In China, for export or both? What entity will handle sales of product.
  • Will any foreign intellectual property be transferred to the JV?

Please note that, in general, Chinese JV companies are free to sell their own manufactured product. A JV company is also permitted to import product manufactured by its shareholder parent. However, in general, it is not possible for a JV company to operate both as a manufacturer and as an importer of product manufactured by companies other than the shareholder. In your emails, you indicate that you desire to obtain approval for what is normally prohibited. If this is the case, we will need to review this issue with the local governmental authorities. If they will provide you with a special approval, you should understand what that is and then make sure that you hold them to their agreement.

Please also note that a primary requirement for company formation in China is that you have a lease on a premises that is approved for the business approved for the company. For a manufacturer, this means a factory, for a trader, this means a warehouse. However, it is also possible to have an initial address that is simply an office in a case where the business plan contemplates later selection of an appropriate factory/warehouse site. Some jurisdictions will permit this, some will not.

Your proposed registered capital is $2,000,000. This means that the Chinese company will need to contribute the RMB equivalent of $400,000 in cash. Are they  aware of this requirement? Do they have the cash? I assume that your group is also planning to contribute cash. As you mention in a related email, it is best from the start to develop a basic plan for contribution of the capital. There should be a basic business plan that provides how much will be contributed, when it will be contributed and for what it will be used.

China’s legal rules for contribution of capital are as follows:

  • 15% of the total amount of the registered capital must be contributed within 90 days after registration approval.
  • The remaining amount must be contributed within two years.

It is common for local governments to impose even stricter requirements and we will need to check with the local government officials on this point. Note that they do not have the power to make the requirement LESS restrictive; they only have the power to make the requirement MORE restrictive.

You asked us how we plan to draft documents that provide for the contingency of your key Chinese counterpart dying.  Since the shareholders in the JV are corporations, the death of any one person is irrelevant to the future life of the joint venture. We will write the JV Agreement to say that your Chinese joint venture partner company has the right to select a single director for the joint venture and that the director will be Mr. ______ at the outset.  However if you believe that the participation of Mr. ______ in management of the JV is critical, you can provide the following:

  1. Mr. _______ agrees to act as a director.
  2. If Mr. ______ is not able to be a director for any reason (refuses to serve, disability, death, etc.), then the foreign shareholder [you] has the right but not the obligation to purchase the stock of the Chinese shareholder. The purchase price will be $400,000, which is the initial amount paid by the Chinese shareholder. It is your choice whether or not you want to add this provision to the agreement. You could also provide the following: in the event that Mr. _______ is not able to be a director for any reason, then 1) all three directors will be chosen by the foreign shareholder but 2) the Chinese shareholder will have a continuing right to 20% of the profits of the joint venture company. I personally prefer the second alternative since it does not require restructuring the stock ownership.

There are a number of alternative ways to deal with this issue. Please consider the options that I have proposed and let me know whether you need additional information in to make your decision on how to proceed.

You are right to ask about dispute resolution.  Dispute resolution should be in China. You can use the Zhanjiang Courts or arbitration at CIETAC in Shenzhen. Arbitration in Hong Kong will be of little to no benefit to you in resolving any disputes because Chinese courts do not recognize their decisions regarding the corporate governance of Chinese companies.  We will need to discuss the pros and cons of Chinese courts and Chinese arbitral bodies.

We also will need to discuss who you will want to be the Representative Director. The day to day business of a Chinese companies is conducted by the general manager, not the representative director. The representative director role is limited to executing important contracts. This can be done by that person without any need to be physically located in China. In any Chinese company with a foreign representative director, there is always a challenge in allocating responsibility between the two individuals. The key issue is usually control of the company seal (“chop”). However, it is always best to appoint officers who are willing and able to travel to China freely. This is not a requirement, but it does make it easier to operate the company.

In answer to your question about scheduling contribution of capital, yes you are correct that it is an important issue for China joint ventures and one that should be resolved before executing the joint venture agreement.

I trust that the above answers your initial questions and lays out a bit of what we will need to be working on over the next few weeks.  If you have any additional questions based on the above, please don’t hesitate.

My firm has been gearing up for a couple of CIETAC commercial arbitrations against Chinese companies and one thing we can state with near certainty is that neither will settle. The reason for this is Chinese companies virtually never settle their in-country litigation matters. In the United States, something on the order of 97% of all cases in the United States settle or are otherwise resolved before trial.  I actually think the settlement numbers are even higher on business litigation matters, but I am not aware of any study on this.  Nearly every litigation matter settles in the United States because the costs are so huge for litigating a case through trial and both parties usually have a pretty good idea of how the court or arbitral body is going to rule.

Neither of these things hold true in China where so many of its laws are too new to have clear Supreme Court decisions on them.  Without clear and established law, nobody knows how a court will rule.  Parties in the United States can settle cases because they essentially agree on the likely outcome.   There is always a 10% chance of an aberrant verdict either way, but within the 80% of expected rulings, the numbers are usually close enough so that both sides can reach agreement at some number near the top of the bell curve.  But since China cases have no bell curve and no 80%, settlement is as much of a gamble as trial.  Since going to trial often costs only marginally more than not going to trial, there is little incentive to do anything but see the case through.

Adding to this is that many cases in China do not require an outside lawyer (this is also true of CIETAC arbitration) so Chinese companies often fight their lawsuits without having to pay for any lawyer at all.  Chinese courts rarely award the winning party its attorneys fees and they are also slow to award much in interest, further reducing the risk of going to trial and further reducing the incentive to settle.

On top of all this, even when one company prevails in a China lawsuit, collecting from a Chinese defendant company is typically anything but easy.

We hear that around 90% of the business cases filed in China actually go to trial. So if you are going to sue in China, you must be prepared to participate in the litigation for the long haul.

All of this only increases the need to have a well-written (preferably in Chinese) clear-cut contract with clearly set out liquidated damages provisions for breaches.  Such a contract will not only decrease your chances of ever needing to litigate, the certainty it will bring will make settlement of any dispute far more likely.  A contract that is so clearly written that both sides will have an easy time predicting how the court will rule increases the chances of settlement.  A contract provision that requires the losing party pay the winning party’s attorneys’ fees also helps, but such a provision may not always make sense.

China litigation. Have fun with that.

For more on litigating against Chinese companies, check out the following:

The Legal Insight Blog has a long and comprehensive post, entitled, “Overview of Doing Business in China” [link no longer exists]. And that is exactly what it is. Written by King & Wood, one of China’s leading law firms, the post sets out the basics of China’s systems as they relate to business and it does so very clearly and succinctly.

The post is broken out into the following sections:

  1. Governmental Structure
  2. Legal System
  3. Establishing a Business Vehicle in China
  4. Operating in China

It really does provide only the most cursury information, but it does a great job of doing so and it can serve as a great first source for you. Just by way of example, I pull the following from it on dispute resolution in China:

 

4.9 Dispute Resolution

As an increasing number of foreign investors penetrate the Chinese market, commercial disputes are expanding quickly both in number and in scale.  China has made significant progress in increasing the integrity and reliability of its courts.  The formal processes available for resolving such disputes in China have, in recent years, become increasingly similar to those elsewhere in the world.

If a dispute cannot be settled through negotiation between the parties, the case must be submitted for litigation or arbitration.  Under PRC law, it is permitted for the parties to choose for binding arbitration to resolve their disputes and the courts will generally enforce arbitration judgment without inquiry into the merits.  It is worthy noting that arbitration is only possible if the parties expressly agree to arbitrate. In practice, the arbitration is favored by many foreign investors in China.

(a) Litigation

The PRC courts consist of four (4) layers: the People’s Court (at the district or county level), the Intermediate People’s Courts (at the municipal level), the High People’s Courts (at provincial level), and the Supreme People’s Court (at the national level).  The level of the competent court should be generally subject to the nature and size of the disputes.  In most cases, disputes with a foreign connection may be initially in the Intermediate People’s Courts.

Court judgments may be appealed once, but the judgment of the second instance is final and binding upon the parties immediately.  Under the PRC Contract Law, it is permitted to select a foreign law to govern the contract with a foreign connection and to provide for exclusive jurisdiction in foreign courts.  In fact, it may be difficult for Chinese courts to enforce a judgment made by a foreign court, but Hong Kong’s judgments are exceptions.

(b) Arbitration

In comparison to litigation, the arbitration seems much quicker, more efficient and more reliable, thus major foreign investors would like to include an exclusive arbitration clause in their contracts.

Under PRC law, an express clause clearly indicating the parties’ selection of binding arbitration is enforceable, which should be in writing and contain a clear statement of the parties’ intention to submit the dispute to arbitration, the scope of disputes subject to arbitration, and the specific arbitral commission to resolve the dispute.  In addition, it is possible for the parties to reach an arbitration agreement after a dispute arises, but in most cases an arbitration clause is included from the outset in the operative contracts.

The China International Economic and Trade Arbitration Commission (the “CIETAC“) is one of the most frequently selected arbitration forums when the arbitration will be held within the PRC.  Foreign investors sometimes do not agree to arbitration in PRC, including arbitration at CIETAC, because they believe that Chinese parties will have a home advantage, meanwhile, Chinese parties concomitantly often object to arbitration aboard.  Therefore, Hong Kong seems as acceptable compromise to both parties.  Of course, to select a third country’s jurisdiction for arbitration is also common in practice.  Since China is a party to the United Nations Convention of Recognition and Enforcement of Foreign Arbitral Awards, it is generally possible to obtain the enforcement of an arbitration award issued by a panel in any member country.

I encourage anyone new to doing business in or with China to check it out.

 

Last November, the Asian Studies Program and the Law School of Pontificia Universidad Católica de Chile (Catholic University of Chile) hosted a Summit on Chinese Business Law and Practice in Santiago.  As I mentioned in my post on that event, I had very high hopes for the Summit, in part because it was organized by Marcos Jaramillo, the head of the University’s Asian Studies progrm and someone I have known and respected for years.

Sure enough, the 2010 event was a great success, and I am happy to announce that the Second Summit on Chinese Business Law and Practice is now just around the corner.  It will be held on Friday, November 18th, again at the Catholic University of Chile in Santiago.  Sponsors include the Chilean-Chinese Chamber of Commerce, the Asia Pacific Chamber of Commerce, Clifford Chance, and the Chilean Federation of Industry.

And this time, yours truly will be among the speakers. I will be presenting on “Avoiding and Winning Chinese Disputes.”  The Summit will also feature the following:

  • Marcos Jaramillo, giving an “Overview of Dispute Settlement and Options”
  • Tzu-Hsin Shen, speaking on “Litigation in the People’s Courts”
  • Patrick Zheng, speaking on “An Insider’s Perspective: CETAC Arbitration in the Mainland”

Detailed information on the summit is available here.  I hope to see you there/Espero verle allí.

Major apologies to John Lennon.

Arbitration provisions fascinate me. They are the Rodney Dangerfield of the legal world in that they get no respect, not even among international lawyers.  This is a mistake.

I can nearly always judge the legal thought that went into an agreement through its arbitration/litigation provision alone. I usually can instantly tell from just the dispute resolution provision whether an international contract was drafted by a lawyer or not, and if it was drafted by a lawyer, whether that lawyer knows international law. Mistakes in this critical provision are rampant. Huge mistakes.

Some examples:

  • Company wants us to sue on a contract that calls for Arbitration before the International Court in Geneva Switzerland. Problem is there is no such court in Geneva. At a cost of at least ten times what it would have cost this company to have retained a qualified international lawyer to draft this contract, we successfully convince the Chamber of Commerce and Industry of Geneva that the parties intended for it to arbitrate their dispute before that body.
  • Denver lawyer contacts us about suing a large Chinese company on behalf of their client. Contract calls for litigation in Denver.  We tell the Denver lawyer this is probably the worst provision possible and he is shocked, asking why it does not benefit his client to be able to sue in its local court. We explain this provision means we will have to sue the client in Denver, spend months serving the opposing party in China (under the Hague Convention for service rules), spend another month or so getting a default judgment in the Denver Court against the Chinese company, and then take that judgment to China, where the Chinese court will almost certainly ignore it.
  • U.S. Company comes to us complaining of a company in China making its product with its molds and requesting we help it get a Chinese court to put a stop to this. We learn the Chinese company was until recently manufacturing this same product for our client under an OEM (Original Equipment Manufacturing) contract that provides for arbitration in New York. We tell the US  company we will probably first need to arbitrate this case in New York and even if we could get an order from the New York arbitration panel requiring the Chinese manufacturer cease production, no Chinese court will enforce it. We also tell the client we can go to court in China, but the chances are the court will refuse to do anything until the case is arbitrated first, if ever.

All of these situations could have been easily prevented with the right arbitration or litigation provision.

The first problem could have been avoided simply by naming a real arbitration panel. The second problem would not have occurred had the contract simply called for arbitration, not litigation. Had the contract called for arbitration in Denver (not litigation), we could have taken an arbitration judgment to China where the courts would have been required to enforce it pursuant to the United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards (usually called the “New York Convention”), of which China is a signatory. Not that China is great at enforcing foreign arbitration awards, but at least the law would have been on our side.

The third situation could have been avoided had the contract explicitly carved out a litigation exception for injunctive relief or called for litigation in China.

What got me to thinking about arbitration today was a very nicely done article by the Patton Boggs law firm (no individual lawyers were listed), entitled, “Seven key points when considering an arbitration provision” [link no longer exists]. Though this article is geared towards all contracts (not just international ones), the advice it gives is both concise and thoughtful. I particularly like how it explains the importance of arbitration provisions:

To the untrained negotiator, an arbitration provision may be legal “boilerplate,” which means typical clauses that require little or no negotiation — a throw-in type provision. The reality is that parties should carefully weigh the benefits and disadvantages of arbitration in every transaction . . . .

The decision to use or write an arbitration provision in commercial transactions should not be made with a mechanical “one-size-fits-all” approach. It is critical that transaction parties consult with their litigation lawyers, not just their transactional counsel, and take the long view of the business relationship at hand and how the parties are going to resolve disputes. To neglect to tailor a dispute resolution provision to your needs at the outset of a transaction may lead to unnecessary disadvantage, expense and distraction down the road.

Amen to that.

Update: One of my firm’s China lawyers just got called in to assist an American company with their CIETAC Arbitration. Boy were they shocked when I told them that arbitration would be conducted in Chinese because the arbitration does not explicitly state otherwise.

On October 10, 2006, the American Bar Association will be putting on a teleconference called “China: The New Frontier in Arbitration.”  The conference will be on “available dispute resolutions for companies that are doing business in China” and it will examine arbitration issues that arise both before entering into an agreement and after a dispute has arisen.   The speakers will “explore developments at the major Chinese arbitral institutions — the China International Economic and Trade Arbitration Commission (CIETAC) and the Hong Kong International Arbitration Centre (HKIAC).”  The risks and strategies for negotiating effective dispute resolution clauses in China-related transactions and the enforcement of arbitral awards will be discussed.

The conference will have the following speakers:

For more on this conference, click here [link no longer exists].

A couple weeks ago, an American company contacted us about representing them before the China International Economic and Trade Arbitration Commission (CIETAC) in Beijing.  The American company claimed to be owed hundreds of thousands of dollars by a Chinese company that had failed to make final payment on a large piece of industrial equipment.  The Chinese company was contending the equipment did not work as it should.

The American company was absolutely convinced that if we brought the arbitration, the Chinese company would settle quickly.  We insisted the exact opposite would likely be the case.  I know we are right, and here is why:  Chinese companies almost never settle their in country litigation matters.

In the United States, something on the order of 97% of all cases settle.  Indeed, Houston based mega-firm, Fullbright & Jaworski concluded that 60% of the cases it took to trial settled before a verdict could be reached.  I actually think the settlement numbers are even higher on business litigation matters, but I am not aware of any study on this.  The reasons usually given for nearly every case settling are the huge costs of litigating and that both parties usually have a pretty good idea of how the court is going to rule.  I agree with both these reasons and neither usually apply in China.

Chinese lawyers often complain to us how cases in China almost never settle.  They attribute this to the newness of so many of China’s laws and so few Supreme Court decisions on them.  Without clear and established law, nobody knows how a court will rule.  We hear that around 90% of the business cases filed in China actually go to trial.

Adding to the problem is that many cases in China do not require an outside lawyer (this is also true of CIETAC arbitration) so Chinese companies can and do fight their lawsuits without having to pay anything at all.  Because Chinese courts rarely award the winning party its attorneys fees and are slow to award much in interest, there is little incentive to settle quickly.

So using the American company’s breach of contract case as an example, one can quickly see a smart Chinese company defendant in this case being very reluctant to settle.  First off, the Chinese company will probably choose to handle the case without a lawyer, so its costs will be minimal.  The American company, on the other hand will, ideally, use an American lawyer who speaks Chinese.

Secondly, it is likely the Chinese company will either fully prevail or lose entirely, depending on whether it can convince the arbitrator(s) the product was bad.  If the Chinese company prevails, it will owe nothing.  If it loses, it will almost certainly owe the full amount of the claim.  But, is it not better to fight until the bitter end and at least gain the time value of the money?

Thirdly, even if the American company prevails, there is still the very sticky matter of collection.  The Chinese company might shut down and form a new company.  The Chinese company may just shut down.  And, even if it keeps operating, it very well might take a lot of time and even more money on legal fees to get them to pay.  In the meantime, if it wishes, the Chinese company could initiate settlement discussions.

The Hoaran blog [link no longer exists] recently did a post commenting on the thrills and the agonies of how everything in China is “in progress”:

living in china is like peeking behind the scenes of how things work. nothing is finished and everything is “in progress”. because of this, you get to see the infrastructure of a society and see how it functions – its built environment and transportation infrastructure, its economy, its legal system, its workplaces and schools, its shopping malls.

on the surface, you are confronted first with endless construction. in fact, i don’t think there is a person living in Beijing who is not within a block of a building site. so if you observe, you see how a field is cleared for construction, how the foundation is laid, the concrete structure established, the scaffolding erected, the worker’s temporary housing built, etc.

at the workplace, you see basic filing systems and h.r. policies being set up. management strategies, business processes and procedures, consistency between offices and other basic systems are still being figured out.

The Hoaran blog is written by an attorney and he sees this same “in progress” situation in the legal arena as well:

in the legal system, practicing judges, lawyers and customs authorities are being trained in basic legal issues. laws are being adjusted all the time. cases are constantly being tried for the first time with no predictable outcome because there is no precedent, no body of legal theory, and no previous experience to rely on

Parties in the United States can settle cases because they essentially agree on the likely outcome.   There is always a 10% chance of an aberrant verdict either way, but within the 80% of expected rulings, the numbers are usually close enough so that both sides can reach agreement at some number near the top of the bell curve.  But since China cases have no bell curve and no 80%, settlement is as much of a gamble as trial.  Since going to trial often costs only marginally more than not going to trial, there is little incentive to do anything but see the case through.

Bottom Line: A good contract can not only help prevent the need to litigate, but it can make settlement of any dispute more likely.  A contract that is so clearly written that both sides will have an easy time predicting how the court will rule increases your chances of an eventual settlement.  A contract that requires the losing party pay the winning party’s attorneys’ fees also helps, but may not always make sense.  A contract calling for mandatory arbitration without appeal and requiring the posting of a bond will often also make sense.

Just read a very practical article in Legal Times, entitled, “When Your IP is Far Away,” written by Bruce F. Metge, an attorney with East Coast mega-firm Mintz Levin.  The article is appropriately subtitled, “To safeguard IP assets in an outsourcing deal, develop a strong contract and an even stronger business relationship.”

Nothing revelatory here, but good basic information that applies everywhere, including China.  Mr. Metge puts forth the following seven items “companies should consider” when “establishing any outsourcing arrangement that does or might involve valuable IP assets” (my comments are in italics):

  1. “Document the intellectual property.”   Keep records of your trade secrets, trademarks, copyrights and patents. Register where appropriate. 
  2. “Deal with reputable and reliable parties.”  “Spend the money for the level of inspection warranted by the value of the intellectual property at risk.” 
  3. If possible, learn whether and how much your vendor can be trusted before providing it with your critical Intellectual property.
  4. “Identify in your contract the specific intellectual property that will be shared in the outsourcing arrangement and identify who owns the property.” Metge recommends playing “out the ‘what if’ situations.  Establish rules for what happens to improvements and modifications to the intellectual property as the relationship progresses. Specify what happens to the property and related records in the event of a breakup.”  Because China’s laws on ownership to IP improvements are not at all intuitive and are very different from those in the United States and the EU, I strongly recommend using an attorney familiar with China’s laws in this area. 
  5. “Be aware of the intricacies of international law.  The laws of other countries do not always play well with the laws of the United States [or the EU].”   Yes.  See number 4 above. 
  6. “Consider a mandatory arbitration clause in the contract.” With respect to China,  we often seek Canada, Hong Kong, or Singapore arbitration for our clients, but we generally consider CIETAC (China International Economic and Trade Arbitration Commission) arbitration in Shanghai or Beijing as well. I would also note that sometimes the best solution (believe it or not) is the Chinese courts because they often best-positioned to stop IP theft quickly. Be aware, however, that without a separate provision in the contract allowing for injunctive relief either through arbitration or the courts, mandatory arbitration may make it more difficult to secure injunctive relief to stop your vendor from improperly using your intellectual property.
  7. “Last but not least, Make sure that the company’s intellectual property will not be made available to your competitors.  Diligence as to the employees of a future business partner, and its employment agreements and controls, are a part of this exercise. After the company’s property has left the building in the hands of a business partner’s disgruntled employee, even a successful suit for breach of contract may be small solace.” The person most likely to steal your intellectual property owns or works for your vendor.   

In summation, companies outsourcing to China can best protect their IP by choosing their partner wisely, having a good contract, registering their IP, and, whenever possible, minimizing situations where their IP might be appropriated.  Good advice.