This is part II of our series consisting of a law school paper by Daniel Reiter on the legal issues involved in sourcing product from China.  Part I can be found here.

Patents

We advise Mango to register its patent as an “invention” under the Patent Law of the People’s Republic of China, which is analogous to a utility patent in the US. Patent protection in China is subject to novelty, inventiveness and practicability. The qualified patent agent (which, like a trademark agent, is required for patent registration) can also assist and advise the client throughout the process.[17] The registered patent agent can also assist in translating Office Actions, issued only in Mandarin, into English.[18]

Mango will also want to take steps to protect its patent from infringement. Patent infringement in China, under Article 57 of the Patent Law, includes manufacture of the patent without authorization of the owner.[19] It is essential to ensure that Silverwolf employees do not begin manufacturing knockoff Orange Boxes and selling them in violation of the patent.[20] Mango can do this by including a clause in the manufacturing agreement prohibiting the manufacturer from stealing the patent.[21]

Tariffs on Imports

Mango will be required to comply with the applicable customs laws of the US and pay the appropriate tariff on its imported goods. The Harmonized Tariff Schedules of the United States (“HTSUS”) provides the applicable tariff rates and statistical categories for all merchandise imported into the US. There are three steps in tariff calculation.

  1. Customs classification — under which category of the HTSUS does the good fall?
  2. Tariff valuation — what is the price of the good for which the tariff is applied?
  3. The country of origin allows the importer to determine from what country the good comes from for customs purposes.[22]

In addition to exporting the finished WEAs from China, Mango may need to import materials and parts into China in order to make the WEAs. Mango will be required to comply with the pertinent import laws of the PRC. Under the Customs Law of the People’s Republic of China, both importers and exporters must register with Customs before filing declarations. Importers are required to file declarations with Customs at the port of entry within 14 days of the goods’ arrival. Exporters are to file declarations within 24 hours before the goods are loaded for shipment.[23] China’s tariff rates are determined by the origin of the goods and via its tariff codes, the Harmonized Commodity Description and Coding System (“HS”), which is a “multipurpose international product nomenclature developed by the World Customs Organization.”[24]

Mango will also be required to comply with a Value-added Tax (“VAT”) on some of its imported goods. Under the Provisional Regulation of the People’s Republic of China on Value-added Tax, “All units and individuals which and who, in the territory of the People’s Republic of China … import goods, shall be the taxpayers of value-added tax … and should pay the value-added tax in accordance with this Regulation.”[25] The VAT applies to imports of goods within China of 24 specified items.[26]  Metal mineral products used to make the Orange Boxes, which fall onto the specified list, will be taxed at 13% and other off-list materials used to make the Orange Boxes will be taxed at 17%.[27] The VAT does not apply to exported goods.[28]

 Import and Export Issues: National Security

Since Mango will be transferring technology to foreign nationals, it will need to comply with certain export controls promulgated by the US government for purposes of national security. Specifically, Mango will need to ensure the patents and know-how it is licensing to Silverwolf are not subject to the US Department of Commerce’s Export Administration Regulations (“EAR”), the US Department of State’s International Traffic in Arms Regulations (“ITAR”), or the US Department of State’s Arms Export Control Act (“AECA”).

If the technology is determined to be an export-controlled material under the EAR or ITAR, it will be unlawful for Mango or its agents to disclose the “Export-Controlled Materials” orally or visually to any foreign persons.[29] Therefore, if the WEA technology is determined to be an “Export-Controlled Material,” Mango may need to abandon its plans to have the technology manufactured overseas. Still, as discussed below, counsel does not find it likely that the WEA technology will be determined an “Export-Controlled Material.” Moreover, even if the technology is subject to certain export controls, a license can be obtained to allow Mango to continue with its plans.

The Commerce Department’s EAR administers the export of US origin goods and technology.[30] Mango’s technology is new and is intended for retail consumer purposes; it is not entirely clear whether the WEA technology should be subject to licensing before export. Still, it is possible it will be subject to such licensing because WEAs may serve a “dual-use” application — a technology capable of being used for both civilian and military purposes.[31] Moreover, commercial items that may not have an obvious military application may be subject to the EAR.[32]

WEA technology is not specifically numerated on the Commerce Control List (“CCL”), and will likely not be subject to a license. However, the spirit of EAR would leave counsel to believe Commerce may classify the WEA technology under EAR99, the portion of the CCL which applies to technologies not specifically numerated in the EAR (and items not controlled by another agency).[33]

Mango will also need to reference the Commerce Country Chart to identify the “reasons for control” of certain items being exported to China.[34] Because the WEA is not specifically listed in the CCL, it is not clear whether it falls under one of the reasons for control subject to export to China. In addition, Mango will not be subject to any “person-based” controls because Silverwolf, the potential end-user, is not included on any of the pertinent lists (Entity List, Treasury Department Specially Designated Nationals and Blocked Persons List, The Unverified List, or Denied Persons).[35] Mango will need to apply for an export license unless it determines its technology is outside the scope of the CCL or another agency’s controls (see below).[36] We believe Mango should apply for an export license with Commerce regardless of its determination because of the novelty and unique characteristics of the WEA technology, and the uncertainty as to whether Commerce would consider it a dual-use item.

In addition to Commerce’s CCL, Mango’s WEA technology may be subject to the US State Department’s Defense Export Controls of the AECA.[37] WEA’s are not listed in the US Munitions List. However, there is a section for miscellaneous articles.[38] Because of the novelty and uniqueness of the WEA technology, we advise Mango to file a Commodity Jurisdiction request to determine whether the technology is subject to export controls under the AECA and ITAR.[39]

 Shipping

Mango has determined that it will be shipping the Orange Boxes via boat and truck. Silverwolf will load the packaged Orange Boxes onto trucks leased by the China Ground Shipping Company, a state-owned enterprise with a fabulous reputation for efficiency. From there, the goods will be loaded onto the Water Lily, a ship Mango contracted from American Sea Shippers, Inc. The Water Lilly will deliver the goods to a port in New York, NY, where they will be unloaded onto a truck operated by American Logistics, LLC. The truck will then deliver the goods to a warehouse owned by Mango in Newark, NJ. There are three important bodies of law that may govern this transaction — the United Nations Convention on Contracts for the International Sale of Goods (“CISG”), the Carriage of Goods by Sea Act (“COGSA”), and potentially the International Commercial Terms.

First, the United Nations Convention on Contracts for the International Sale of Goods (“CISG”) applies to the sale of goods between parties whose places of business are in different contracting states.[40] Both the US and China are signatories to the CISG.[41] The CISG will apply to this transaction unless the parties decide to “opt-out” of the CISG, which they may do under Article 6.[42] According to Article 6, parties may expressly state in their contract that it is not to be governed by CISG.[43] It is also important to note that the CISG is not all encompassing as certain types of transaction and portions of transactions are excluded from outside its scope. Therefore, domestic law or a choice of law analysis may come into play if a dispute arises.[44]

Second, the Carriage of Goods by Sea Act (“COGSA”) will apply to the shipment of the goods while at sea. COGSA is a mandatory US law governing the bill of lading (“B/L”), a document that functions as a receipt, contract of carriage, and document of legal title during the shipment of goods. The B/L is an agreement that runs between the shipper and carrier.[45] COGSA deals with those aspects of the B/L concerning the carrier’s obligations to transport and protect the goods during carriage. It limits the liabilities of damaged goods to $500 per package unless the parties agree otherwise. In addition, the parties may contract to extend COGSA to the inland portion of the shipment.[46]

We advise Mango to include two important clauses in the bill of lading, subject to negotiations. First, the Clause Paramount is a provision that specifies which jurisdiction’s law will govern the agreement.  Second, an Intermodal Clause should also be included. COGSA only applies “tackle-to-tackle,” but an Intermodal Clause allows the parties to extend the limitations of liability under COGSA to the land portion of the shipment.[47]

Finally, the parties may agree to implement International Commercial Terms (“Incoterms”) into the sales contract. Incoterms are a form of soft law and are promulgated by the International Chamber of Commerce (ICC) – Incoterms only apply when the parties agree to include them in the sales contract. Incoterms allocate certain tasks and the risk of loss during delivery to the buyer and seller of the goods (Mango and Silverwolf, respectively). The agreement between Mango and Silverwolf calls for the release of the goods by Silverwolf at its factory to Mango (through its leased shipping companies). Therefore the proper Incoterm to use in the instant case is the three letter EXW, short for Ex Works.[48] 

Arranging Payment

In negotiating a method of payment with Silverwolf, the manufacturer, it is advised that Mango arrange for payment via a letter of credit, as bank transfers create substantial risks. Letters of credit tend to be more favorable to the buyer, and for this reason, Silverwolf may be unwilling accept payment via this method.[49] Still, not all is lost as there are certain steps Mango can take to mitigate risk when making payment via bank transfer. This is especially true in this instant case because there is a prior relationship between Mango’s CFO and the manufacturer.

A letter of credit is a financing device that ensures payment to the seller of goods (in this case Silverwolf).[50] A letter of credit allows a buyer to purchase goods even if it does not have the financing on hand because it is an undertaking between the buyer and an issuing bank — it is not a transaction that runs directly between the buyer and seller. The “applicant,” usually the buyer, has its “issuing bank” promise to honor drafts on itself against the presentation of specified documents, which usually includes the B/L and a commercial invoice. The “beneficiary” of the letter of credit, usually the seller, arranges its local “confirming bank” to engage with the issuing bank to receive reimbursement from the issuing bank after it pays the seller. Letters of credit are usually governed by the Uniform Customs and Practice for Documentary Credit (“UCP”), a form of soft law incorporated into the contract by the contracting parties.[51]

A letter of credit can protect Mango because it allows a buyer to cancel when a supplier does not ship on the agreed upon time, allows a buyer to cancel when a supplier does not match the specifications or there are to many defects, and allows a buyer to cancel when the documents do not fully conform to the letter of credit’s requirements.[52] A bank’s ability to refuse payment for even the tiniest of discrepancies is called the “strict compliance principle.”[53]

If Silverwolf requires that payment be arranged via bank transfer, there are certain steps Mango can take to limit risks. The standard form of bank transfer payment in China is called “30/70 TT,” which means a 30% down payment is to be made upon placement of the order, with the remaining 70% to paid upon shipment.[54] The risk involved here is that 100% of the payment is to be made before shipment, which means inspection may not occur until arrival; therefore, seeking reimbursement for a non-conforming good may be difficult. In addition, even if inspection is done before shipment, a 30% down payment will have already been made, and a refund of the 30% may become difficult.[55]

However, Silverwolf and Mango’s CFO do have a history, so the likelihood of this occurring may be lower than most alternative manufacturers, but the risk still exists. To mitigate this risk, Mango should inspect the goods as early in the process as possible, should not make the second 70% payment until after the inspection, and once the relationship is further established seek to arrange a different method of payment.[56]

Conclusion

            Mango’s plan to source its manufacturing of WEAs is quite feasible, but certain expenses should be taken into consideration including numerous legal expenses, taxes and tariff’s, and shipping costs. Through negotiations many risks can be mitigated, but there remain numerous challenges and uncertainties. Therefore, counsel advises Mango to continue with its current plan to source 25% of its manufacturing of WEAs, but to wait at least several years to build relationships and gain experience before it decides to source an even larger percentage of its WEAs for manufacturing.

 

[17] Embassy of the United States Beijing, China, Patent, http://beijing.usembassy-china.org.cn/iprpatent.html.

[18] This is general knowledge I occurred during an internship at an IP Agency in China in 2011.

[19] Chow, supra note 12, at 433.

[20] Letter from Stephen Y. Chow, Adjunct Professor of Law at Suffolk University Law School  (Dec. 26, 2012) (on file with author).

[21]  Dan Harris, China Manufacturing Agreements. Watching The Sausage Get Made, China Law Blog (Apr. 26, 2011) http://www.chinalawblog.com/2011/04/china_manufacturing_agreements_watching_the_sausage_get_made_1.html.

[22] Daniel Reiter, International Business Transactions outline (This outline was prepared in connection with a Fall 2011 International Business Transactions class taught by Professor Christopher Gibson at Suffolk University Law School. The sources used in preparing the outline include class notes taken by the author, class slides distributed by the professor, the class text book, and other materials)(on file with author).

[23] Helen Wong, Doing Business in China, HSBC Bank Company, http://www.hsbc.com/1/content/assets/business_banking/110328_hsbc_doing_business_in_china.pdf.

[24] World Customs Organization, What is the Harmonized System (HS)?, http://www.wcoomd.org/en/topics/nomenclature/overview/what-is-the-harmonized-system.aspx

[25] Provisional Regulation of the People’s Republic of China on Value-added Tax, Art. 1,

http://english.ccpit.org/Contents/Channel_101/2006/0525/847/content_847.htm.

[26] Richard Hoffman, China’s VAT System, Beijing Review (Aug. 6, 2009) http://www.bjreview.com.cn/business/txt/2009-08/03/content_210354.htm. See Also Press Release, Tax Policy Department, Ministry of Finance, Briefing of VAT Under China’s Tax System (March 13, 2007) (http://www.china.org.cn/english/LivinginChina/202770.htm).

[27] Press Release, Tax Policy Department, Ministry of Finance, Briefing of VAT Under China’s Tax System (March 13, 2007) (http://www.china.org.cn/english/LivinginChina/202770.htm).

[28] Id.

[29] Miami University, Export-Controlled Materials and Information,

http://www.units.muohio.edu/compliance/exportcontrol/.

[30] International Business Transactions outline, supra note 22.

[31] Ian F. Fergusson, The Export Administration Act: Evolution, Provisions, and Debate, Cong. Res. Service, July 15, 2009, at 1.

[32] Introduction to Commerce Department Export Controls, Department of Commerce’s Bureau of Industry and Security, http://www.bis.doc.gov/licensing/exportingbasics.htm.

[33] ECCN Questions and Answers, Department of Commerce’s Bureau of Industry and Security, http://www.bis.doc.gov/licensing/do_i_needaneccn.html#qfour SEE ALSO http://www.ecfr.gov/cgi-bin/text-idx?c=ecfr&sid=c5cc9a1c749a6f225283bdfa124431d0&rgn=div9&view=text&node=15:2.1.3.4.45.0.1.3.87&idno=15.

[34] Introduction to Commerce Department Export Controls, supra note 32

[35] International Business Transactions outline, supra note 22. See also Introduction to Commerce Department Export Controls, supra note 32.

[36] Introduction to Commerce Department Export Controls, supra note 32.

[37] Getting Started with Defense Trade: The Directorate of Defense Trade Controls (DDTC) and the Defense Trade Function, http://www.pmddtc.state.gov/documents/ddtc_getting_started.pdf.

[38] 22 C.F.R. § 121.1

[39] Commodity Jurisdiction, U.S. Department of State Directorate of Defense Trade Controls, http://pmddtc.state.gov/commodity_jurisdiction/index.html.

[40] 1980 – United Nations Convention on Contracts for the International Sale of Goods (CISG), UNCITRAL, http://www.uncitral.org/uncitral/en/uncitral_texts/sale_goods/1980CISG.html. See also International Business Transactions outline, supra note 22.

[41] Status: 1980 – United Nations Convention on Contracts for the International Sale of Goods (CISG), UNCITRAL, http://www.uncitral.org/uncitral/en/uncitral_texts/sale_goods/1980CISG_status.html

[42] United Nations Convention on Contracts for the International Sale of Goods art 6.

[43] International Business Transactions outline, supra note 22.

[44] Id.

[45] Ussually the seller also acts as the shipper, but in this case Mango has agreed to handle all aspects of shipment.

[46] International Business Transactions outline, supra note 22.

[47] Id.

[48] Id.

[49] Dan Harris, Using Letters Of Credit With China Suppliers, China Law Blog (Nov. 20, 2012) http://www.chinalawblog.com/2012/11/using-letters-of-credit-with-china-suppliers.html.

[50] When I say “letter of credit,” I mean a “general letter of credit” as apposed to a back-to-back letter of credit or a standby letter of credit, which I do not discuss.

[51] International Business Transactions outline, supra note 22.

[52] Using Letters Of Credit With China Suppliers, supra note 49.

[53] International Business Transactions outline, supra note 22.

[54] Dan Harris, China Manufacturing Payment Terms. Limit Your Risks, China Law Blog (Nov. 11, 2012) http://www.chinalawblog.com/2012/11/china-manufacturing-payment-terms.html.

[55] Id.

[56] Id.

This is a guest post from Renaud Anjoran. Renaud runs a product quality inspection business in Shenzhen and he also writes the truly excellent and perennially helpful Quality Inspection Tips. My firm has worked with Renaud on a number of China product matters and we have consistently found him to be highly knowledgeable about China product sourcing. This post arose from a long email “conversation” between co-blogger Steve Dickinson and Renaud, which ended as so many of those do: with me suggesting that it be turned into a blog post.

So here’s the blog post, written by Renaud Anjoran.

 

Most transactions with Chinese suppliers are done through bank transfers. This payment method was described in a previous China Law Blog post, China Manufacturing Payment Terms. Limit Your Risks.

Many importers/foreign manufacturers are not familiar with Letters of Credit (LC) as an alternative to bank transfers. Letters of Credit were designed to protect both product buyers and product supplier in international trade. In practice, they are usually more favorable to the buyer.

How a letter of credit protects the buyer

An importer that pays by LC does not have to wire a deposit before production and it usually has the option to cancel the payment in the following cases:

  • If a supplier does not ship at the right time.  Typically if this happens, the LC simply expires, but the buyer still has the choice to pay if it wants the goods.
  • If a supplier does not honor the product specification or if there are too many defects. One of the conditions of the LC should be that the LC will not be paid on unless and until the product buyer has signed off on product quality or a specified third party QC agency has issued its certificate of inspection.
  • If the seller fails to provide any document listed as required in the LC or the documents do not fully conform to the LC’s requirements.

Why letters of credit can be cancelled by the buyer in most cases

Even something as small as a typo in the LC, or the fact that a quantity is written in dozens rather than in pieces in the invoice is usually enough to cause a discrepancy in the LC, which in turn allows the buyer to cancel payment.

In practice, a small minority of LCs are “clean,” i.e., without any discrepancy. In all other cases, the buyer has the option to refuse payment and cancel the transaction, even if the goods are already on a boat (in which case the buyer will not get the documents to get the products out of custom).

CLB Note:  We are aware of a Seattle buyer company that refused goods that had already arrived in Seattle because the street address (which was irrelevant) of one of the parties in the letter of credit was off by a single letter.

Tips for negotiating payment by letter of credit

For the reasons mentioned above, Chinese suppliers typically refuse to accept Letters of Credit. Here is how you can increase your chances of finding a Chinese company that accepts this payment method:

  • When sourcing your product, try to identify as many potential suppliers as possible. This will at least increase your chances of finding one that will accept an LC.
  • In your first conversation with your potential suppliers, mention that you always pay by LC on your first order. Try to get the supplier to accept this payment method in writing
  • Sell your project to your potential suppliers. Good manufacturers are inundated with customer inquiries, so you need to make yourself stand out. Explain why they should work with you. Call the Chinese company’s sales manager if necessary
  • Send your potential Chinese manufacturer a draft of the LC before opening it. You will usually need the commercial invoice, the packing list, the certificate of origin and/or GSM form A, the bill of lading, and an inspection certificate. Try to avoid putting “soft terms” into your Letter of Credit that will make it even more difficult for suppliers to collect payment.
  • If possible, use a major international bank. This will tend to reassure your suppliers.
  • Unfortunately, bank fees are much higher for an LC than they are for a bank wire, so an LC only makes sense for transactions of at least USD$30,000.
  • Chinese exporters are good at guessing whether a project is likely to become a source of long-term business. When they see what they think will be a a one-shot deal, they generally insist on getting a deposit and will not agree to an LC payment arrangement.

In summary, Letter of Credit are a payment tool that makes it unnecessary to transfer a 30% (or more) deposit to your Chinese manufacturer. They are usually more favorable to the buyer’s side, and for that reason, many Chinese companies refuse to accept them. But some Chinese product suppliers have been paid via Letters of Credit from some of their foreign customers for years, and sometimes Chinese manufacturers will accept your Letter of Credit if they really want your orders.

 

What do you think?

With President Obama talking about doubling U.S. exports and with China’s economy booming, it seems appropriate to talk about what should go into a sales contract with China, when you, the foreign company, are the one doing the sale.

The big thing — almost, but not quite the only thing — in such a transaction is the payment terms. In turn, the payment terms greatly influence the complexity and the terms of the contract. The old saying that “possession is nine tenths of the law,” is actually great advice when it comes to international sales contracts. If you are selling product to China and you get paid in full in advance, you are at least 90% of the way towards full protection.

Unfortunately, it is the rare sale into China that involves full payment up front. So if you cannot get full payment upfront, you should consider, at minimum, getting a sufficient upfront payment to cover your costs, thereby ensuring that even if you receive nothing more, you will have covered your costs.

If you are not going to get full payment upfront, then you need to figure out what you can do to maximize your chances of getting the rest of your payments. There are many things you can do to improve your chances, including the following, many of which can and should be combined:

  1. Conduct due diligence on your Chinese buyer. There are services that can do this at relatively low cost (typically USD $500 to $1500, depending on the depth of research performed).
  2. Hold back title. Write your contract so that title to your product does not pass to your Chinese buyer unless and until you receive full payment.
  3. Choose your venue for contract disputes wisely.
  4. Secure payment by using a Letter of Credit. The International Business Law Advisor did a post, entitled, “How to Secure Payment from Your Overseas Customers with Letters of Credit” [link no longer exists] nicely explaining how these work:

There are four participants in a letter of credit transaction — two businesspeople and two banks:

  1. The buyer. That’s your customer.
  2. The opening bank. This bank normally issues the letter of credit, so it is sometimes referred to as the “issuing bank.” They assume responsibility for the payment on behalf of the buyer.
  3. The paying bank. This is the bank under which the drafts or bills of exchange are drawn under the credit. A paying bank in an L/C transaction might also act as the negotiating bank, advising bank or confirming bank, depending upon what responsibilities it accepts.
  4. The seller. That’s you.

To summarize the process: Once you and your customer agree on payment by letter of credit, it is the customer’s responsibility to take your proforma (an invoice that reflects all estimated costs involved to move product door to door) to her bank and open the L/C (letter of credit) in your favor. Once the opening bank has all the appropriate information from the customer, it advises you, the seller, that the L/C has been opened. Oftentimes this will be done by cable or e-mail to the paying bank. Your bank then forwards that information to you. The letter of credit is final and subject to correction only for errors in transmission.

The post correctly notes how “accuracy in all details of your letter of credit is critical.” The problem with letters of credit is that, contrary to what some believe, they do not guarantee you will be paid, even if you fully comply. My firm handle a case involving a fake letter of credit and another case involving a dishonest bank that failed to honor its letter of credit without any basis for doing so, beyond its own desire to stay in good stead with its client.

What do you do to make sure you get paid?