A few weeks ago, one of the lawyers in my office, emailed me an article co-written by a law school friend. The article was on trademark infringement in the clothing industry and on what clothing companies/fashion companies should do to protect their China trademarks, written by Yujing Shu and Hai-Ching Yang of KLGates. The note with the email said that she thought I “would be interested in the article because we represent so many clothing companies with their China IP.” I was very interested in the article for those exact reasons, but then chose not to write about it because it did not say anything “new.”

Since then, one of our IP lawyers spoke at a “Legal Protection in Fashion” event and later told me of how interested the audience (and even the other panelists) were in how to protect fashion IP in China. Then the other day, I spoke with a large clothing company and was surprised at their lack of knowledge regarding how to protect their IP in China. They essentially did not even know it was important or even possible.

All of this is my incredibly round-about way of noting that I should have weeks ago written about the article that was emailed to me.  The article is entitled What Your Company Should Know About Protecting Against Trademark Infringements in China’s Fashion Apparel Industry and it does a nice job setting out the basics of what fashion apparel companies need to do to protect their IP in China.  And though the article does not contain anything particularly new, that is only because the way to use China’s legal system for trademark protection has not changed in quite some time and does not vary much by industry.

Here is their spot-on advice:

  • Register your trademark as quickly as possible.  Since China follows the “first to file” policy, registering your trademark as quickly as possible is the key to protecting your IP.  
  • Properly register your trademarks by registering multiple categories and subcategories of goods.  As a preventative measure, companies should register their trademarks in as many closely related categories and sub-categories of goods.
  • Vigilantly monitor infringement actions and use China’s administrative process.  Companies should use the administrative process to cease infringing products and tools, impose fines, and seek court imposed raids if necessary. 
  • Use court proceedings to seek damages and to obtain well-known trademark status.  As courts have become the main channel to protect IP, companies can use litigation to serve as warnings for other violators.  Companies can also seek the court’s recognition of “well-known trademark” status in current or future cases for increased trademark protection.

Just what every China lawyer has been saying for years now to companies in all industries.  We have been saying it because it is true and necessary.  Here are some more tips on protecting against trademark infringement in China, all of which apply to the fashion industry:

  • Register your trademark or copyright in your home country.  Typically it makes sense to do this before you start doing business with China.
  • Before doing business in China, consider which provinces do the best job of protecting intellectual property.
  • Review and revise your own Web site with an eye towards removing anything that makes for a good target for intellectual property thieves.
  • Stay ahead of the copiers by rapidly introducing new products, improving on your existing ones and building your brand image.
  • Have a contract with your Chinese factories that clearly forbids copying and specifies liquidated damages for violations.
  • Use tracking technology to monitor the product you are having made in your Chinese factories.
  • Have anti-counterfeiting elements put into your products and/or packaging.  I am always amazed at what can be done in this arena.
  • Monitor your manufacturers.

What else?

Those who say China is innovating often cite to the massive numbers of IP filings being made by Chinese companies in China.  I use those numbers to counter those who allege that filing trademarks, copyrights and patents in China is a waste of time, but I do not think they show much regarding innovation.

The numbers show that Chinese companies are willing to spend money to protect their IP and I just do not think they would be spending on anything that was not perceived to have value.  And if Chinese companies think filing for IP in China has value, then it is fair to think that it does.

But on the innovation side, the reality is that a lot of IP gets filed that isn’t terribly innovative.  This is true of patents as well.  So how what can we use that relates to IP filings to show innovation or a lack of it?

The Financial Times/BeyondBrics just did an article, entitled Chart of the week: China’s patent / royalty disconnect, use patent licensing as a measure of innovation.  The article starts out noting how the “number of patent applications from China has overtaken those from the US “and then asks whether  this means “China will soon be exporting ideas in the way it has exported manufactured goods.  It then notes that China is ranked only 7th in the number of patents granted in the US in 2012, behind “smaller trading partners such as Japan, Germany, South Korea and Taiwan.”

But the new (to me anyway) numbers that I found most salient are those relating to patent licensing.  In 2012, “China had a record deficit in royalties and license fees of nearly $17bn — compared with an $82bn surplus for the US.”  China’s $17bn deficit is a result of China paying out $18bn in royalties and license fees and collecting only $1bn in such fees.  I see these numbers as extremely meaningful and what they say is that China is having to pay huge sums to other countries for innovations created outside of China and substantially less is being paid to China for innovations created there.  Indeed, it is quite possible that a large chunk of the $1bn going into China for licensing and royalty payments is for innovations created by foreign subsidiaries doing research and development work within China.

Clearly though, these numbers reflect two very important things.  One, China cannot yet be deemed to be an innovation economy.  Two — as we have been saying for years — there is a lot of money to be made by Western companies in licensing to China.

For more on China licensing, check out the following:

During the first 25 years of China’s opening up process, joint ventures were the favored vehicle for FDI in China. In 2005, the favored form of investment shifted away from JVs to direct investment through WOFEs (Wholly Foreign Owned Entities). During the last year, however, foreign SMEs have been shifting away from WFOEs and back to joint ventures. An even more dramatic shift has seen SMEs decide not to have any direct involvement in China at all. For these companies, licensed manufacturing and sales has become an attractive alternative.

The shift away from WFOEs has occurred because of the worsening environment for small private businesses in China.  Consider just the following in terms of the shift that has occurred in the last ten years:

  • Taxes: In 2003, WFOEs operated in China tax-free. WFOEs are now subject to basic income tax, VAT taxes and a host of local taxes and fees.
  • Wages: In 2003, Chinese wages were some of the lowest in the world. Now, the wage for the average worker on the coast is higher than in Mexico. In 2004, a WFOE could hire and fire workers at will and employ them for as many hours a week as the workers would tolerate. Now, employment is subject to a strict employment contract law system that makes firing workers difficult or impossible and that requires overtime for work in excess of 40 hours per week.
  • Benefits: In 2003, foreign employers could safely ignore paying benefits to their workers. Now, foreign employers are required to pay benefits to both foreign and Chinese employees that amount to almost 40% of the employee wage.
  • Rent: In 2003, rent in Chinese cities was low by world standards. Employers who located outside the major cities often negotiated free rent merely by agreeing to locate in a rural or relatively undeveloped area. Now, free rent is unheard of and rents in general are some of the highest in the world.
  • Environmental and safety regulations: In 2003, a foreign manufacturer could operate in China with minimal concern about environmental and safety regulations. Now, in virtually all jurisdictions, the Chinese authorities require compliance with relatively strict standards.

As this list of major changes shows, the business environment for foreign investors in China has changed dramatically in just one decade. However, many foreign companies that are planning operations in China assume the situation is the same as it was in 2003. It is a nasty shock to most when they evaluate their potential China operation under the current conditions.

Stated simply, many small WFOEs simply do not “pencil out.” However, because China remains an absolutely critical market for countless foreign companies, simply abandoning the China market is not feasible for many. Companies that must operate in China are starting to shift their Chinese investment plans. We are seeing two trends along these lines:

First, joint ventures are experiencing a revival. In the most basic situations, what the joint venture means is that the foreign investor is saying to its Chinese partner: we cannot make this project work by ourselves in China. We need your help. We will provide you with funding and expertise. What we want from you is management and guidance to allow the venture to earn a profit in this difficult environment.

In addition, more complex forms of joint venture are being considered. Two variations we have seen lately are:

  • The foreign company has technology but no money and no ability to manufacture or market anywhere in the world. The foreign company seeks to do a Joint Venture with a  Chinese company that will provide both necessary funding and the support needed to commercialize the product based on the technology. The structures for these China Joint Ventures are complex and are made more difficult by the antiquated and inflexible Chinese laws on joint ventures, financing and IP protection.
  • The foreign company has an existing successful product that it wants to manufacture and then market in China. Licensing is one option. The other is a complex joint venture. As above, the Chinese side of the proposed joint venture is seen not just as a source of manufacturing expertise, but also as a source of funding.
Years ago, my law firm developed a reputation for not liking joint ventures and there was some truth to that.  We did not like joint ventures that were mainly based on the Chinese side claiming that was our client’s only option.  We did not like joint ventures for joint ventures’ sake when there were other, better options for our clients.  We fully recognize that Chinese landscape has changed and whereas six or seven years ago eight out of ten joint venture proposals that crossed our desk did not make good sense, that ratio has probably completely flipped today, to the point that in the overwhelming number of instances, we make no effort to talk our clients out of their proposed joint venture.
The second trend we are seeing is companies abandoning the concept of directly investing in China and instead moving to a contractual approach. We are seeing this especially with foreign SMEs that are determining they do not have the resources to do manufacturing WFOEs in China. Basically, they are determining that Chinese owned factories are better/cheaper at manufacturing in China than foreigners. This includes multi-nationals such as Apple and HP.

In response, the current trend is to work towards purely contract manufacturing (product outsourcing), with no JV and no WFOE involved. This often involves complex IP issues and can also involve complex issues of start-up funding for the Chinese manufacturer. In connection with this trend, the foreign parties are finding that they need to work with their manufacturers to bring up their level of product quality to obtain required certifications such as HACCP and GMP.

Non-manufacturing businesses are also following this trend. In the creative industries, foreign companies are licensing their expertise to Chinese companies who then do the work on the ground. The same approach is taken even where a final product will be produced, such as a magazine or website.  I estimate that my law firm is doing at least five times this sort of work as opposed to just a few years ago and I am seeing the same sort of numbers with China joint venture deals.

This approach also requires complex contracting. In 2004, few foreign businesses had any faith in the enforceability of contracts within the Chinese legal system. This (justified) lack of faith meant that these contract-based approaches to doing business in China were not considered feasible. China’s dramatically improving legal system (at least with respect to contract enforcement where it is now ranked 19th in the world) has made it possible to shift to contract-based approaches to doing business in China. As with WFOEs, many foreign SMEs and their lawyers are not aware of this improvement in the legal system and continue to make their decisions about their China investments based on outdated, 2003 conditions.

The New York Times has an excellent article on doing business in China. The article is entitled, “New Path for Trade: Selling in China,” and it is replete with good advice.  Except mine.

Let me explain.

The article is on selling goods in or into China and it talks of the great opportunities there and of how to do it well.  It presents the following good advice:

  • Bilingual is not bicultural.  Lou Hoffman of The Hoffman Agency notes something I am always saying: do not mistake language for culture.  Someone can speak your language and still have no clue about how you want to conduct your business.
  • Let others open the door.  Ric Cabot of Cabot Hosiery Mills/Darn Tough Socks tells of how his company “edged into the Chinese market” by testing it with a Chinese distributor.  “But if it gets to the point where we see we’re leaving too much money on the table, we might consider doing something different.”
  • Don’t get knocked off.  Earl Kluft, owner of E.S. Kluft & Company talks of the knock-off problems his company had in its first foray into China and of how things are going better this time due to a better a better China-based partner. Kluft found its new partner “through a friend” and with that partner it has “cautiously re-established a sales channel with minimal upfront investment.” The Chinese partner pays royalties and is able to buy Kluft’s mattresses at “a special discount.” I then chime in, advocating finding “reliable partners on the ground…. through people you know, and then pay for whatever due diligence is necessary to make sure that you have made the right choice.” And to do all of that “before you start doing business with them.”
  • Look locally before leaping.  The article talks of how some states have government-run international trade programs that offer counsel. Samar Ali, Tennessee’s assistant commissioner of international affairs then discusses the sorts of issues his group raises with those seeking to do business with China.  “We’ll help them see if there’s a need for their product in China and to think it through: Do they need to set up a WFOE? Do they need to have a presence or not? Should they go the e-commerce route? And tell them how much they should budget going forward.” This assistance includes help with business-to-business matchmaking through already vetted Chinese companies.
And then there is the one I do not like so much and it’s mine.
  • Set up shop as a WFOE.  The article notes that “it is possible to scout opportunities with a so-called rep office and to do business in China by selling through distributors or by licensing products to a Chinese company, most American businesses that are serious about selling in China invest the time and money to establish themselves as a wholly foreign-owned enterprise, or what is known as a WFOE (pronounced WOOF-ee).” It then adds this: “We do probably 100 WFOEs for every rep office,” said Dan Harris, a lawyer with the Seattle firm Harris & Moure who writes a blog about Chinese law and business.

What I do not like about this is that I am concerned that it will be read as my saying that setting up as a WFOE is virtually always the best way to sell to China and I did not say that because I do not believe it. I was asked about what it takes to set up a company in China and what sort of entity usually makes sense.  To that, I unequivocally answered with “WFOE.”  But what I was not asked was whether one can or should consider selling to China without any entity at all and had I been asked that, I would have unequivocally answered, “yes, that is often the best way so long as it is possible.

We are actually big believers in getting product into China via distributorship or licensing arrangements:

What is so funny about the NYTimes article coming out when it did is because we received some criticism of our last blog post, Getting Your WFOE Approved In China. What It Really Takes, in which we had this to say about forming a WFOE in China:
No wonder I use words like “slog” and “excruciating” and “unending” to describe to our clients what it is going to be like as we secure their WFOE registration in China.
The New York Times article rightly discusses the difficulties in registering a WFOE in China:
And think months, not weeks, to get all of the paperwork approved. “In China, you can’t do anything last minute,” said Savio S. Chan, president and chief executive of U.S. China Partners, which is based in Great Neck, N.Y., and which helped Vision Quest move its light fixtures out of regulatory limbo. “It can easily take up to six months to set up a WFOE.”
Mr. Chan has it right, which is one of the many reasons why anyone looking to sell their product to China needs to consider all options, not just a WFOE.
WFOEs, distributorships, licensing deals and yes, sometimes even a Rep Office can all make sense, depending on the specific situation.  When it comes to China (and just about anything else), there is no one size fits all.  I just hope that nobody thought I was saying otherwise.
What do you think?

I spent all day yesterday co-chairing a Doing Business in China Seminar and I suspect that I will be doing a number of posts on that over the next week or so. I’m starting at the start though, with who should be going into China and why.  Ben Shobert of Rubicon Strategy Group gave a fascinating and highly informative talk on China healthcare/China senior care.  At one point in his talk, Ben went into MBA mode (he has an MBA from Duke, so this is excusable) and talked about the analysis companies should use to determine whether they should be going into China.

Before he talked of this, however, Ben attributed at least some of his thinking on this to a book, The China Ready Company, by Steven Ganster of Technomic Asia and Kent Kedl of Control Risks.  Ben called that book the best he had read in terms of determining whether it makes sense to go into China, or not.  I read that book many years ago and I wholeheartedly agree.

Ben had this to say about what it takes for it to make sense for a company to go into China:

  • China should be a strategic, not purely opportunistic, pursuit.
  • The decision to go to China should reflect a holistic appraisal of internal capabilities, financial resources, and risk appetite versus other domestic or foreign investment opportunities
  • The process of choosing should allow key management team members and other stakeholders to ask questions, raise concerns, and feel their input has been sought and incorporated into the final decision.
  • If a decision to go forward in China is made, your management team should have several different market access strategies presented with a comprehensive analysis of each, along with an idea on how to properly market your services to the Chinese consumer.
He went on to say that the analysis should consist of the following four “distinct questions”:
  • Question 1: Do we, as a company (management team & ownership) have the bandwidth and cultural DNA to export our business model to China’s emerging healthcare economy?
  • Question 2: If yes, what is it going to take to export our business model? This is a resource and process question that isn’t specific to China
  • Question 3: Could we more easily export our business to another country versus China? Here, the analysis begins to get China- specific, but also is looking at opportunity costs for China.
  • Question 4: If China is the right choice, what will it take to successfully export our company to China? What should we be prepared for, what can we do to avoid the typical China market entry errors specific to the healthcare industry?
Our seminar focused on the “new China,” where opportunities for foreign businesses are just as likely to be on the selling of products and services than on the manufacturing of products.  Just as ten years ago, there was the idea that “we have to start manufacturing in China now or we will fall behind,” the idea that “we have to start selling in China or we will fall behind” is pretty prevalent now.  Though it is certainly true, that many companies should be (and are) looking at China as a market for their goods and services, it is also true that going into China to sell those goods and services is not the right thing for all companies right now.  Some should sell their products or services into China using a distributor relationship.  Some should profit from their goods or services by licensing some aspect of that to China.  Others should just stay in their home country and sell direct from there.  And for still others, China may make no sense at all.
When it comes to China there is obviously no one size fits all.  I take it you-all agree?

We have been drafting an increasing number of contracts for foreign companies licensing their concept or technology for use in China. In the old days, this type of licensing was primarily in the industrial sector. These days, most of our work has been on licensing agreements in the services sector in China. Much of this licensing is for operations in China that are prohibited from direct participation by foreign companies, such as in publishing, media, telecom, insurance and finance. Most of these foreign companies are choosing to license, rather than to participate in a China Joint Venture.  This post describes the negotiating tactics I so often see from the Chinese side and sets forth how foreign companies can counter those tactics.

The Chinese government is internally conflicted on how to treat this new form of licensing. In industrial sector licensing, the Chinese government is eager for the technology transfer to occur. The same is not true in the service sector. On the one hand, the Chinese government formally welcomes the transfer of Western expertise in the service sector. On the other hand, the Chinese government fears that U.S. participation in China’s service sector will result in unacceptable control of the Chinese system. As always, the Chinese government is uncomfortable with the introduction of Western intellectual concepts into China.

This ambivalence is mirrored by many of the potential licensees that we deal with in the service sector. Industrial licensees bargain hard, but the bargaining is similar to any commercial negotiation. In the service sector, we are finding that the Chinese side works to strike a much harder deal. This often surprises our clients, since they expect the service side to be softer than the industrial.

As part of this process, in service sector licensing contracts we are starting to see the Chinese side dust off negotiating tactics that were common in the 80’s and 90’s when the Chinese were negotiating their famously dysfunctional joint venture agreements.  In negotiating service sector licensing agreements with Chinese companies, we are seeing the following tactics from the Chinese side:

  • The most common tactic is for the Chinese company to seek to wear the foreign side down with endless issues. This tactic actually has two variants. In the first variant, the Chinese side raises a series of issues. As these issues are resolved, the Chinese side then raises a series of unrelated new issues. The list of issues is endless and the process never stops. The second variant is for the Chinese side to make a several unreasonable demands and then refuse to address the concerns of the foreign company on the other side. As in the first variant, the discussions proceed with no attempt at all by the Chinese side even to pretend to address the concerns of the other side. All of this is designed to simply wear down the foreign side in the hopes that the other side will simply concede. When the other side concedes, the Chinese side then inserts provisions in the agreement that are beneficial to the Chinese side, under the assumption that the foreign side is simply too tired to object. The success of this strategy rests on the negotiators on the foreign side being busy people with a lot to do, while the negotiators on the Chinese side are functionaries who have no other job but to involve themselves in the endless negotiation.
  • My favorite tactic is the artificial deadline. It is my favorite because it is such an obvious manipulation of the foreign side and yet it seems to work extremely well. The tactic works like this. At the very beginning of the negotiating process, the Chinese side sets a fixed date for executing the contract. It then sets up a public signing ceremony on that date, at which high-level officers from both sides will participate amidst much pomp and circumstance. The date is set far enough in advance to ensure that parties negotiating in good faith can reach agreement on the contract. The Chinese side then ensures that no agreement is reached. This results in panic on the foreign side, since failure to get an agreement that the bosses will sign is seen as a loss of face. The Chinese side then uses this concern to extract concessions from the already exhausted foreign side negotiator.  This tactic also has two variants. The first variant is the crude approach. The Chinese side simply refuses to concede on key points under the quite reasonable assumption that the foreign side will crumble when faced with the fixed signing deadline. The second variant is much more subtle. In this variant, the Chinese side initially concedes on key points, while still holding its ground on numerous minor points, consistent with the “wear them down” tactic. Then, just a day or two before the signing ceremony, the Chinese side announces that the contract must be revised on one or more key issues in a way that entirely benefits the Chinese side. The Chinese side usually justifies this by refering to the demand of a “government regulator” or an outside source such as a bank or insurance company. The claim is “we don’t want to go back on our word, but these other folks have forced us to do this.” Again, the plan is that the combination of the pressure of the impending signing ceremony and the general fatigue of the negotiators will result in a crucial concession favoring the Chinese side.
  • The final technique is to come back to the key issues after the lawyers have left the room. Again, though this is an obvious technique, it seems to work very well with service businesses. This tactic involves the Chinese side signing a contract, conceding on the key issues. By virtue of the contract having been signed, the key negotiators, China advisors and most importantly the lawyers, are off working on other projects. The Chinese side then waits a reasonable time and works to get the project started. Once the project is started, the foreign side is then invested in the project. Since service projects involve people, rather than machines or product, this means certain key persons on the foreign side are now fully committed to the project. Once this happens, the Chinese side then comes to the committed parties on the foreign side and announces that certain key provisions of the contract must be changed. The Chinese side usually claims this change is mandated by law, government regulators or banks and insurance companies. The only people left at this point are the “committed parties” with a strong incentive to allow for the change so the project can proceed. Often, these people do not even fully understand the implications of the change the Chinese side is now demanding. The foreign side then presents the change to busy upper level management as a minor technical revision and it gets signed. Everyone remembers how the initial negotiation was so troublesome and nobody wants to bring in “legal” to start the process over again.

Though crude and obvious, the three tactics work wonderfully well and so Chinese companies do not hesitate to employ them regularly (pretty much always).  There is one simple antidote for each tactic:

  1. If the Chinese side uses the “wear ’em down technique,” the foreign side should refuse to participate. The foreign side should firmly state its position and not bend unless and until the Chinese side agrees or at least moves closer to the foreign side’s position.
  2. Never agree to a fixed signing date. Make it clear that the signing ceremony will be scheduled only after the contract has completed final negotiations. If that takes forever, then it takes forever. Never allow the Chinese side to use a deadline as a tool. This seems like obvious advice, but we see the rule constantly violated. Chinese companies love signing ceremonies and foreigners fall into the trap because they do not want to cause offense at the start. The Chinese have contempt for a sucker, so refusing to go along on this obvious technique will not cause offense: it will instead earn the respect of the Chinese side.
  3. Make it clear to that there will be no changes to the contract after signing and any attempt by the Chinese side to change the contract will be treated as a material breach, leading to termination and a lawsuit for damages. Chinese companies are well known for using the signing of a contract as the start of a new negotiating process, not the termination. If the foreign party is willing to accept this approach, then a clear procedure must be instituted on the foreign side that brings back in the legal and China advisory team. The neutral players on the foreign side must make the decisions. The decisions should not be made by the foreign side players who have already become committed to the project.

Negotiating a good licensing agreement with Chinese companies is difficult and time consuming, but not so much if you know how to handle Chinese negotiating tactics.  There is no reason to make the situation worse by falling for the simple negotiation tactics discussed above.

‘You sit by yourself grasshopper. What do you think of?’ -Master Po
‘My mother, my father. Both gone. I am alone.’
‘You hear the flock of birds flying overhead? You hear the fish? The beetle?’ To all of this the young Caine nods. ‘In this crowded place you feel alone. Which of us is the most blind?”

Kung Fu, Episode 1.

Lawyers (myself included) are loath to weigh in on someone else’s pending legal matter for fear of being proven wrong by not having all of the facts. So despite having received a couple of emails from readers suggesting I discuss the brouhaha between Groupe Danone and Wahaha (yes, that was an attempt to rhyme), I had read nothing more than a few headlines.

I started reading some articles today on it though and my eyes just about popped out of my head.

By way of very brief background, Danone is a food conglomerate based in France, the maker of Danone dairy products and Lu biscuits, and the bottler of Evian and Volvic water.  Wahaha is China’s leading and best known domestic beverage company.  It was also the focus of a full chapter in James McGregor’s book, One Billion Customers (a true must-read for anyone doing business in China).

In a Xinhua story, entitled, Fight between beverage giants spills out in public, Wahaha’s president, Zong Qinghou, is quoted as saying that “the original agreement between the two beverage giants was never approved by China’s trademark office and so is not in force or effect.” Wahaha’s president says Wahaha signed the contract, but admits it is not valid because it was never properly recorded.

In a letter posted on one of China’s major web portals, Sina.com, Zong said a trademark-license contract must be approved by the Trademark Office of the State Administration For Industry and Commerce but he never submitted the original which restricts China’s largest drink producer from independently expanding.

“We did sign the contract,” admitted the president of the Hangzhou-based conglomerate. “At the time, Wahaha was only focused on management concerns and the interests of employees and knew nothing about capital operations.”

“My ignorance and breach of duty brought trouble to the development of the Wahaha brand,” said Zong.

“Wahaha has fallen into a trap deliberately set by Danone,” he said.

Near as I can piece together from this article and from another article in the Wall Street Journal, it appears the joint venture agreement between Wahaha and Danone had Wahaha licensing all rights to its name and other trademarks to the Danone-Wahaha joint venture.  It also appears Danone either thought Wahaha was going to record this licensing agreement with the government or never even realized such a recordation would be required.

Now if what it appears (from the above) to me to have happened here did in fact happen here, Danone has fallen victim to one of the oldest tricks in the book. I describe it as such because back in the “pre-China days” when licensing IP in Japan was so popular, Japanese companies commonly did this to foreign companies in Japan, and Chinese companies now commonly do this to foreign companies in China. The “this” that was commonly done was intentionally failing to record an IP licensing agreement so as to prevent any licensing transfer from actually taking place.

In China today, some IP licenses must not only be recorded for the licensing transfer to take effect, they must first be approved by the government. I understand there was a time in China when all IP licensing needed not only to be recorded with the government, but also pre-approved by the government and I think this may have been the case back when the Danone-Wahaha licensing agreement came into effect, but I do not know if the newer laws on this operate retroactively or not.

Wahaha seems now to be justifying its actions to the Chinese media by going on the offensive, claiming Danone “trapped it” into licensing out its important, Chinese, IP. The thing is that if the licensing agreement was never recorded, Wahaha may well be entitled to prevail under the prevailing interpretation of Chinese law.

I find it very interesting that the Western media and blogosphere have so far completely ignored this licensing recordation requirement and are instead focusing on how Wahaha “breached” its agreements with Danone. But if the licensing transfer never in fact took place, we must start at least raising questions as to whether Wahaha actually breached its agreement with Danone at all. I say “raise” questions because I am woefully short of sufficient facts to give any answers to this question. There is also no way I am going to engage in the hundreds of hours of legal research that will likely prove necessary to answer this question once armed with the facts.

Not only is this Danone-Wahaha fight interesting for what it appears to teach regarding Chinese IP licensing laws, it is also a fascinating story of what can (and nearly always does) go wrong with Chinese joint venture deals.  In a Wall Street Journal article written by James T. Areddy, entitled, Danone’s China Deal Goes Sour: French Food Firm Accuses A Leading Businessman Of Undermining Venture, Areddy talks about how Danone is accusing Wahaha of undermining their joint venture with “a mirror organization” of manufacturers and distributors.  The article calls this dispute an opportunity to take “a rare peek at tension inside a joint venture between a Chinese company and its foreign partner,” and that is exactly what this is.

Emmanuel Faber, president of Danone Asia Pacific accuses Wahaha of producing “the whole range of our [the JV’s] products.” Wahaha responds to this by stressing its Chinese roots:

Danone’s accusations follow a report Mr. Zong released last week on a Chinese Web site that accused Danone of trying to take control of businesses he owns and saying terms of their existing agreements are unfair.

Mr. Zong founded the Wahaha group in the late 1980s. In 1996, he and Danone started to set up a series of joint ventures to sell products under the Wahaha name. Danone says that in China, it now owns 51% of 38 joint ventures in partnership with Mr. Zong, who remains chairman of the joint venture’s umbrella company.

When Danone and Mr. Zong struck their initial deal in 1996, joint ventures were often required to do business in China or were seen as a quick way for entry into the market. But increasingly, foreigners have tried to go into China on their own, concerned by stories of partnerships gone awry.

The stakes for both sides are high. Danone’s main toehold in China is Wahaha, and the accusations challenge the integrity of one of China’s most famous consumer brands, which remains closely identified with its founder, Mr. Zong. China represented 10% of Danone’s global business last year, and the company says 75% of the ‘1.4 billion ($1.9 billion) in Chinese revenue it reported last year came from legitimate sales of Wahaha products.

Yet, Danone now estimates Mr. Zong’s own operations sold nearly as much as the joint ventures. The calculation is based partly on Mr. Zong’s own assertion that his private businesses rival the joint venture in size.

Wahaha does not appear to deny any of these accusations, but instead invokes Chinese nationalism in its defense, saying that if Wahaha signed a contract requiring Wahaha to do X, then Danone must now sign a contract requiring Danone to do X:

In his online comments, the 61-year-old Mr. Zong pitted himself as a defender of China against Danone. He didn’t specifically address some of the company’s assertions. Instead, Mr. Zong said it is unfair that Danone has separate joint ventures in China making juice and milk under other brand names that compete with the Wahaha-branded products. “So these terms are unfair and need to be revised. Either you call off the restrictions on us, or I add restrictions on you,” Mr. Zong said.

The extent of Wahaha’s “mirror operations” appears to be so huge and so intertwined with the operations of the Danone-Wahaha joint venture, that virtually nobody is capable of figuring out who is who and who owns what anymore:

Mr. Faber said yesterday that Wahaha products are being made at factories owned and managed by Mr. Zong’s family interests that haven’t been approved under the joint venture. Some of these products are secretly fed into the joint venture’s existing sales network, the Danone executive said; others are sold separately. “It’s normal that employees, distributors and others would get confused,” Mr. Faber said.

My favorite quote from the article, because I am constantly telling our clients to be on guard for this, is that the Danone-Wahaha joint venture is using factories secretly owned by Mr. Zong’s family to do outside manufacturing for the joint venture:

In addition, he [Mr. Faber] said, some factories designated as third-party manufacturers for the joint venture are secretly owned by Mr. Zong’s family.

Using a joint venture to enrich relatives is probably the oldest, the simplest, and the most common joint venture trick known to man. It is nearly always the first example my law firm’s China lawyers give to clients for why they must be so careful when considering a China joint venture.

Here goes.  Typically, the reason for a joint venture is to make profits by taking advantage of a local company’s on the ground knowledge and expertise.  Typically, this means the local, in this case Chinese, company will be in charge of hiring and/or subcontracting out.

The goal of both the foreign and the Chinese company is to make as much money as possible from the joint venture. This “common goal” leads the foreign company to believe its interests are aligned with its Chinese joint venture partner, when in reality, nothing could be further from the truth. The foreign company is expecting to profit from the joint venture’s sales. The Chinese company, however, may very well be planning to profit from its right to operate the joint venture.

The joint venture company may need only 25 employees, but the Chinese company goes out and hires 50 relatives. The joint venture may be able to hire good employees at $150 per month, but the Chinese company goes out and hires 500 employees at $250 per month to get $100 monthly kickbacks from each of them. Company A may be the best outside company to make a component part for the joint venture and it can do so at $1 a part. The joint venture company, however, goes out and contracts with company C to make the component part at $2 a part because company C is secretly owned by the owner of the Chinese company in the joint venture.

It goes on and on, but it is tricks like these that make profitable joint ventures about as rare as a coconut in Antarctica.

Beware the joint venture.

For previous posts on the China joint ventures pitfalls, check out the following:

For more on the Danone-Wahaha war, check out the following:

I am now hooked on this story and I will report back when I learn more.

I spent much of last weekend on an airplane going through stacks of documents I had been meaning to read for month. While doing so, I came across a big US government Commercial Services print-out I had picked up at a doing business in China seminar many moons ago. Darned but there was some good stuff in there and I was planning to post on it in due course.

Due course became today after I read how Diddy, a well-known entertainment mogul, record producer, and actor, (f/k/a and a/k/a Sean John Combs, Puff Daddy, and P.Diddy), is paying a big price for having violated the first rule on the list of what the US Commercial Services sees as the “Major Causes of Business Problems in China” [link no longer exists]:

  • Inadequate vetting and due diligence of Chinese partners, distributors and suppliers.
  • Giving away too much in joint ventures.
  • Absence of contract clauses guaranteeing licensing compliance spot checks.
  • Lack of appreciation of what differentiates a commission from a kickback in the Chinese context.
  • Failing to register your IP (patents, trademarks and copyrights) “in a timely fashion.”
  • Failing to keep a detailed eye on the always changing legal and regulatory environment in China.
  • Failing to retain a qualified China lawyer to help navigate the ins and outs of China law

Interesting how many of these (really all of them) relate to the law.

I like this list and I think it appropriate to list a failure to conduct due diligence at the top.  This failure is particularly common among SMEs (Small and Medium Enterprises).  Far too often I see companies entering into transactions worth hundreds of thousands to millions of dollars, knowing shockingly little of the Chinese companies with whom they are dealing.  Is it not worth the $2,500 to $10,000 to know with whom you are dealing?

Diddy’s China problems are instructive.  Diddy heads up clothing company, Sean John, which is now facing a public relations nightmare after it was discovered that the “faux” fur on its coats from China is actually real fur.  This discovery has precipitated a recall of the coats and will no doubt lead to a considerable loss of money and prestige for the company.

These problems almost certainly would never have occurred if the company had conducted sufficient due diligence on the company from whom it was purchasing its coats and/or conducted quality control monitoring of the product.

If you are doing business in China, read the list so as to avoid your own “faux pas.