Distribution agreement

One of the themes of this blog for years has been that China is making things tougher for foreign businesses by increasing the strength of its business laws and by stepping up its enforcement of them against foreign companies.  We hear that the same thing is happening to Chinese domestic companies, but starting from a much lower base.

But virtually whenever we write about this, someone leaves a comment or emails us to say that we are making this up to scare people.

The American Chamber of Commerce in China recently came out with a survey of its members and hidden and far more publicized fact that 78% of the respondents said they had been hacked was that only 28 percent of respondents view China’s investment environment as improving, down from 43 percent just last year.  In other words, China is getting tougher on foreign businesses doing business in China. Running a foreign business in China has never been easy, but it has in the last few years gotten even harder still.

So what can or should you do?  One, consider whether it makes sense to move some (or in very rare cases) all of your operations somewhere else.  In the last two years, we have experienced an uptick in our clients expanding beyond China (Vietnam and Thailand and returning home have been especially popular lately) or at least considering doing so.  Two, consider not entering China at all by way of actually setting up shop to do business there.  At least think about how you can profit from China’s growth without having to set up and operate a Joint Venture or a WFOE there.  Selling into China via a distributorship relationship or a licensing deal are just two obvious ways that have grown rapidly in popularity over the last couple of years.  For more on these two methods of “entering” China, check out the following:

What are you seeing out there?  Do you think the AmCham results reflect reality?

Excellent economic analysis of China by Yiping Huang, a professor of Economics at Peking University and at the China Economy Program at the Australian National University and Barclay Bank Hong Kong’s Chief Economist for Asia.  His analysis can be found in an EastAsiaForum article, entitled, “China’s New Growth,” in which Huang talks of how the Chinese government is fine with China’s GDP growth slowing to between 6 to 8 percent per year and of how that is what we should expect going forward.  According to Professor Huang, the days of China needing GDP growth of eight percent and above merely to avoid increased unemployment are over.  Super high growth was needed in the late 1990s when China’s labor force was increasing by more than ten million people per year, but not now when its labor force is actually declining.

Huang goes on to talk of how China’s external account is balancing out, its currency is probably close to equilibrium and its gini coefficient is improving.  Perhaps most importantly, he talks of how the percentage of China’s growth from consumption has risen and is likely to continue to do so, much of it brought about by rising wages, which will soon be followed by rising capital and energy costs:

I have long argued that China’s reform approach can be characterized as asymmetric liberalization, that is, complete freeing of the product markets while heavy distortions are maintained in factor markets. The generally depressed costs of production have the effect of subsidies for the corporate sector but taxes on households. This was the key mechanism contributing to both strong economic growth and growing structural imbalances during China’s reform period.

This pattern has begun to change over the past several years, starting in the labour market. Rapid wage increases squeeze profit margins, slow economic growth and escalate inflationary pressure. They improve income distribution, since low-income households rely more on labour income, while high-income households depend more on corporate profits and investment returns. Rising wages also redistribute income from the corporate sector to households and, therefore, boost consumption as the share of household income in GDP increases.

China’s new growth model is still in its early stages. So far, we have only seen the first wave of cost shocks — changes in the labour market — which have a significant impact on labour-intensive manufacturing industries. The second wave of cost shocks — a rise in the costs of capital and energy — has just started. This could affect state-owned, highly leveraged and heavy industries more dramatically because they were previously built on a distorted cost structure. Consolidation of heavy industries could lead to the first recession of the Chinese economy since the beginning of its economic reforms.

This will not necessarily lead to a period of stagnant growth, as analysts such as Michael Pettis suggest. While cost normalization would shrink economic activity in the state sector, it should benefit the non-state sector, which accounts for 80 per cent of total industrial output.

I think Huang is right and I think what this means for foreign companies is what we have been saying on this blog for years:

  1. Yes, China is still the factory to the world.  But it is also a great and ever-improving market for goods.  And I don’t want to act like a TV ad pitchman, but for most products (both consumer and b2b), the longer you wait to get into China, the greater the odds that someone else will have established what should have been your market share.  For what it takes to sell into China, check out the following:

2.  China wages and other manufacturing costs are going to continue rising. This means that if you are making a product that can easily be made somewhere less expensive than China, you need to consider China alternatives.  For more on your options, check out the following:

3.  If Huang is right (and again, I think he is), we should expect the economic power of China’s State Owned Entities (SOEs) to decline and the economic power of  China’s privately held companies to increase.  Though I think Huang is right on the economics of this, I am not sure if politics will allow this to happen. But if Professor Huang is right, the value of doing business with China’s private companies has just gone up as compared to doing business with China’s SOEs.

What do you think?  Do you agree that China’s economy is changing?  What ramification do you see China’s Changing Economy having for you or for foreign businesses in general?

I spoke last week on China IP at Columbia University. During my talk, I mentioned how common it is for the Chinese side in a licensing or a joint venture deal (or really any deal) to claim that the law requires the foreign company to transfer ownership of IP for the deal to go through.  I talked of how when my law firm is confronted with such a situation we ask the Chinese side to provide us with the legal cite to the law that allegedly requires this. To which we typically get one of the following in response:

  1. An English language translation of a law that does not exist;
  2. A Chinese language version that does not say what the Chinese side says it says;
  3. A claim by the Chinese side that it is an unwritten law.

I then stressed how there is no such law, though we have on more than one occasion seen American companies turn over their IP because they believed otherwise.

After my talk, Andrew Hupert told me of how on more than one occasion he has worked with American companies that have entered into exclusive distribution arrangements with Chinese companies based on the assertion by the Chinese company that Chinese law requires such agreements between foreign companies and Chinese companies grant the Chinese company exclusive distribution for all of China.  Andrew described one situation where an American had signed a long-term China exclusivity deal with a Chinese company that had no capabilities outside Shanghai.

There is no such exclusivity requirement!

In fact, as commentators love to point out, (see for example, Patrick Chovanac’s Nine Nations of China), China is a very large and very diverse place and a really good distributor/marketer/seller of a product or service in one region might very well not know anything about distributing/marketing/selling in another region.  The good news though is that you are not required to use the same distributor throughout China, no matter what you are told.

We have found this exclusivity claim particularly common with wine and with food products where the Chinese party claims that the approval to sell these items in China is restricted to only one seller/distributor.  There are though some product areas (such as pharmaceuticals) where it is very common for a distributor/reseller to require nationwide distribution even though it is not legally required.

Bottom Line:  Chinese companies love claiming something has to be done a particular way in China whether that is really the case is not.  This holds true with respect to the law as well.  Your job is to confirm or deny.

For more on distribution agreements in China, check out the following:

My law firm has probably written more product distribution agreements in the last year than in the three years proceeding. There are two main reasons for this.  First, China’s increasing wealth (despite the slowdown) directly translates to increasing demand for quality foreign product.  Second, we are dealing with a “second wave” of foreign companies, not the first wave which went into China years ago as Wholly Foreign Owned Entities (WFOEs).

So what is involved in successfully having product distributed in China?  There are essentially two keys.  One, a good distributor. And two, a good contract with your distributor.  In other words, pretty much the same as what it takes to succeed in having your product distributed in Peoria.

What does it take to secure a good China-based distributor for your products?  It is like just about everything else in China: due diligence, due diligence, due diligence.

In an article entitled, “Pre-Screening Overseas Distributors: 50 Questions to Ask,” Laurel Delaney, who writes the Import & Export column for About.com, asserts that the best way to find a good overseas distributor is to gauge the answers you receive to 50 very specific questions.  I really like Ms. Delaney’s question list, though I would probably reduce it at least somewhat, but I would be sure to leave the following ten:

  1. How long have you been in business?
  2. Can you share a few success stories about similar, yet non-competing products you have sold?
  3. Have you represented other foreign companies? Explain what you did.
  4. How long has your relationship lasted with the top three companies you represent?
  5. How will our line fit in or complement your existing portfolio of products?
  6. What’s your game plan for building our brand in your country?
  7.  Do you have good market coverage, including a trained and educated sales force?
  8. What specific territory are you interested in covering?
  9. Can you deliver on pre-agreed sales targets?
  10.  Where do you see our brand in 3, 5 or 10 years?

If you take only one thing away from Ms. Delaney’s article, take away that you will be establishing a long-term and important relationship with your Chinese distributor and that means you absolutely should find out whatever you can about them before you do the deal.  In other words, you need to conduct thorough due diligence.

As for the deal itself and the contract you will use to reflect that deal, the issues are really quite similar to what you would face in the United States or in Europe, but with additional legal issues relating to the legality of your product and the duties that will need to be paid to bring it into China.

The typical issues we see in Chinese distribution contracts are the following:

  • Will your Chinese distributor be your agent? Do you want to structure your deal so that your Chinese distributor essentially becomes your agent in China and you pay it by commissions, with the actual sales transactions being between you and the end user (as opposed to between the end user and your distributor)?  We virtually always suggest that the deal be done with you simply selling your product to your Chinese distribute and your Chinese distributor, in turn, selling your product on to the end users. This distribution method usually makes sense for a whole slew of reasons.
  • Will your distribution arrangement constitute a franchise arrangement? Generally, you want to be be careful not to inadvertently create a franchise arrangement because franchise arrangements in China (just as in the United States) must comply with a whole host of regulations. Speaking very generally, the more your distribution agreement mandates that your China distributor follow your marketing plan or business system and spotlight your brand/trademark, the greater the likelihood that you are tipping into a franchise arrangement.
  • Will you grant your Chinese distributor an exclusive?  Will your Chinese distributor have an exclusive territory, customer type or product range? If so, for how long? Generally, if you grant an exclusive, you should be sure to set sales quotas/performance targets that will allow you to terminate the contract if not met.  My law firm has been contacted by far too many American companies that granted their Chinese distributors long term exclusive distributorships only to have the Chinese company do absolutely nothing to try to sell the American companies’ products in China. Beware the Chinese company that wants exclusive distribution rights to your product not to sell it, but to mothball your products so they do not compete with their own products or with the products of other companies for whom it is a distributor.  Setting adequately high minimum sales quotas will protect you from getting stuck with an under-performing or non-performing distributor.  Clearly defining the sales quotas/performance targets is essential. The typical provision mandates a certain minimum dollar value of sales or a minimum number of units sold.  Your Chinese distributor’s failure to meet the minimum for a certain period might result in termination or, alternatively, it might just lead to it losing exclusivity.
  • Who is responsible for what on sales and marketing?  The key here is clarity.  Chinese distributors oftentimes expect their foreign product supplier to engage and pay for at least some of the China sales and marketing costs.  There is no right way to handle this other than being sure that both sides of the distribution deal understand who is responsible for what.
  • What about your trademark(s)? If you are going to sell your product into China (whether through a distributor or otherwise), you absolutely must register your trademark in China before doing so and you absolutely must register that trademark in your name, not that of your distributor. To be sure that your trademark remains yours in China, your distribution agreement should license the limited use of your trademark to your China distributor. Your distribution agreement should make clear that the use of your trademark is subject to compliance with the contract by your distributor and also to compliance with the limitations on the use of your trademark.
  • What happens if the relationship terminates?  A good distribution contract makes clear what happens upon termination because doing so greatly improves your chances of smoothly transitioning to a new distributor.  Is your distributor allowed to sell down its remaining inventory of your product or must it cease sales immediately?  Are you required to buy back the inventory and, if so, at what price?  You want to put in your contract that the distributor must inform you of any pending and future sales.  Where will your disputes with your distributor be resolved, and by whom?
Distribution agreements with Chinese companies can be an excellent way to get your product into China relatively quickly and inexpensively, so long as you follow the basics.


Our China lawyers often get calls from companies that want to get their product into China or increase sales there. Many times, these companies are under the false impression that they have two choices: go it alone via a China WFOE or form a joint venture with a Chinese company. Entering into a distributorship relationship with a Chinese company (or companies) is another option. From a strictly legal perspective, distribution (and reseller) relationships between foreign and Chinese companies are actually fairly straightforward and are far easier and generally less risky than joint venture deals and typically far less costly and time consuming than going it alone.

From a business perspective, taking most products into China (be they industrial or consumer), marketing it, selling it, and then delivering it, is a massive task for any foreign company. I hate to trot out a cliche, but China is a big and diverse country and it should be viewed as many markets, not just one. Yet with China’s wealth rapidly increasing, it is the rare company that is not at least desirous of adding China to its list of markets. China is becoming a consumer/buyer nation.

We have written a number of times about some of the issues foreign companies face in getting their products sold in China, including in the following posts:

Distribution contracts with Chinese companies can have much in common with US and European distribution agreements, but they also have stark and interesting differences. The United States and 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 do not bother with provisions devoted to trying to work around distributor protections.

One big issue in China (of course) is IP protection and so it usually makes sense to put into the distributor agreement 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 or other IP that might be at risk, that the distributor gains no rights to those trademarks, and that the distributor will not register any IP in any way related to our client’s IP. We 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.

Since China’s Anti-Monopoly Law prohibits retail price maintenance (requiring someone like a distributor sell the goods at a minimum resale price to third parties), distribution agreements generally must not mandate that the distributor sell its goods at a certain price to retailers or consumers.

Anyway, do not forget the possibility of using a distribution relationship to get your product into China as they can be both relatively simple and effective.

What are you seeing out there?

I have never written a will, not even for friends or family. I have never handled a DUI, a divorce, or a real estate closing, not even for friends or family. I have never negotiated with a union, drafted a pension plan, or handled a debtor-side bankruptcy. I could go on for pages listing out the legal matters I have never handled and will never handle.

And there is a reason for that.

There is a reason why I have never handled any of the above matters and there is a reason for my telling you all this in this post. I have never handled any of the above matters for the simple reason that I am either wholly unqualified to do so or there are so many other lawyers out there far more qualified (and efficient) than me at such matters, that my handling them would be a disservice to the client.

I wish more lawyers thought like I do when it comes to international contracts as I am getting tired of cleaning up their messes.

In just the last few months, I have seen the following:

1.  An employment contract between a United States company and its three ex-Chinese employees. The United States company brought me this contract after its Chinese subsidiary was sued by these three ex-employees. The United States company wanted to argue in China that the three ex-employees could not sue the subsidiary both because they were not employees of the subsidiary and because the contract made very clear that any disputes needed to be resolved in a U.S. court. They had actually paid a U.S. lawyer to draft this document. I told them to ask for their money back from the U.S. lawyer and try to settle with the three ex-employees as quickly as possible. Their employee agreement was illegal on multiple counts.

2.  I met with a company who wanted us to draft a supplier agreement with their new Chinese manufacturer on terms “somewhat similar” to those in the distribution agreement they provided me. Upon further questioning from me, I learned that they had been using this distribution agreement with their other suppliers, but they were having doubts about its efficacy. Not only was this distribution agreement written all wrong for China, it was the complete wrong agreement. It set out a relationship whereby the U.S. company was acting as a distributor of the Chinese company’s product, when in reality, all the U.S. company was doing was buying OEM product from Chinese manufacturers. Very strange.  I also told this client to ask for their money back.

And here’s the kicker. The law firms that wrote these two contracts are decent law firms, though neither do any international work. Not sure if they are so hard up for work that they are willfully deciding to cross into legal arenas in which they do not belong, or if they simply do not know any better. Not a good thing. 

What do you think?