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.

There have been countless articles written on how the end of cheap China will mean the end of foreign companies going to China, but that has barely happened at all.  This article, “Analysis: Investors make $100 billion bet on China’s drive up value chain,” by Kevin Yao of Reuters, nicely encapsulates what is going on out there by way of foreign direct investment (FDI) into China.

Essentially, FDI has slowed a bit, but is still massive and all of the talk of companies going into places like Indonesia or Vietnam has been to a large extent just talk.  This is what I have been seeing as well and I have to admit that it is NOT what I have been predicting:

I am particularly surprised at how so few of my law firm’s clients have moved over to Vietnam, especially those in industries, like clothing, shoes, and pet toys where to me it makes complete sense for them to do so.  I am even more surprised at how few of our new clients going into Asia for the first time are looking to countries other than China for their manufacturing.

And I have a new theory as to why this is the case.  My theory, which may be less a theory than a fact-based observation, is simply that these companies do not know how to go into any country other than China. I will call this the “I would love to, but…” theory.

Let me explain.

My law firm represents a large number of clothing and shoe companies, most of which are fairly well known brands and have fairly high margins, but most of which are not massive.  In the last year or so, these companies have seen an increase in bad product from China. The typical scenario goes something like this:

  1. Chinese company provides US company with bad product.
  2. US company refuses to pay whatever is still owed for the bad product.
  3. Chinese company goes ballistic and threatens US company that it will do horrible things to it if US company does not pay.
  4. US company complains to me and I suggest that now might be a great time for US company to just walk away from China and set up manufacturing in a place like Vietnam.
  5. US company says that it has heard great things about Vietnam and it would love to go there but it has no clue how to do so.
  6. US company then strikes a deal with Chinese company and keeps producing in China, slowly diversifying to other Chinese manufacturers.

So why does the US company not go to Vietnam?  Simply because it lacks the people in its organization with any Vietnam expertise and because there is no clear and easy path for SMEs to get into Vietnam. The path is less than clear because Vietnam lacks a “soft infrastructure” of well known and highly regarded experienced consultants with offices in the United States. Vietnam also lacks a network of people (and even seminars) in the United States who can talk of their Vietnam experience.  There is at least a couple of how to do business in China seminars in every good sized American city every year, but one on Vietnam anywhere is a rarity.   Vietnam is simply too much of an unknown.

So for SMEs, there is this massive knowledge and fear gap regarding places like Vietnam and that gap is creating an “I would love to” Catch-22.

That’s my new theory.

What do you think?

My law firm is right now defending a large Chinese company in a big United States litigation matter.  Our client is being sued, for among other things, having provided a product that failed to meet U.S. environmental standards.  Our defense to this claim is that the American plaintiff had the responsibility to make sure that its imported product met those U.S. standards, not a company in China that ships its product around the world.

Earlier this year, my firm was consulted by an insurance company that had provided coverage for a U.S. company that had sold a product in an East Coast state that had caused a death. Though legal in most states, it was not legal in the state in which the death occurred.  We were brought in to help figure out whether it made sense to go after the Chinese manufacturer, but one of the key questions was whether anyone other than the American company that sold the product in the East Coast state had an obligation to make sure the product was legal there or not.

A few years ago, a U.S. company called me regarding a product it had been required to recall because it had not met U.S. consumer product safety standards. This U.S. company was interested in suing its Chinese manufacturer over this shortcoming. The U.S. company told me that it had just assumed that the product it was buying from the Chinese manufacturer had met all safety standards because they knew this Chinese manufacturer was selling a similar product to one of its leading competitors and it “just knew” that competitor would never sell a non-complying product. So when the US company learned that its competitor’s product was in compliance, they were sure that meant they would have a great lawsuit against the Chinese manufacturer. I have since heard of a number of other cases where the U.S. buyer/importer “just assumed” that the Chinese manufacturer was aware of U.S. safety (or other standards) because the manufacturer was so big/so competent/so experienced in selling to U.S. companies.

I make the above examples to try to drive home a fairly basic point. When buying product from China (or from anywhere else for that matter), it is your job to make sure that the product you are buying complies with the laws of the city, state, province, or country in which you are selling it.  Even if the Chinese manufacturer insists that your product complies with your jurisdictions standards, you need to verify.  Merely assuming your product is in compliance could prove costly.

Enhanced by Zemanta

By: Steve Dickinson

As I mentioned, my first post on Myanmar, “Myanmar Foreign Investment. Initial Impressions Are That It Is China’s Opposite.” was heavily theoretical. Dan and I did have a chance to travel and to meet with local lawyers and business people. This gave us the chance to find a little of the reality behind the statements of aspiration expressed by government officials at the Summit. I will provide my observations below, organized in accord with the three stages of development described in my first post.

1.   Political reform.

 I saw a remarkable change in the openness of the society. Some of the changes are quite striking. Some of these changes are:

  • The Internet seems to be completely open, at least for English language web sources. All news sites that I accessed were unblocked. There was no attempt to filter news from unblocked sites. Information on the situation in Rohinga and on Aung San Suu Kyi were all available. Karen and Kachin separatist sites were accessible. Facebook, YouTube and Twitter were all available. Internet cafes were open and were well attended. No one blocked my access to the Internet at such locations. This is a complete change from even one year ago when the entire Internet was blocked.
  • Cell phones are generally available and the people have taken to using cell phones actively. One lawyer told us that right now less than 5% of the people in Myanmar have cell phones but that more than 50% will have them within two years. Right or wrong, this shows the kind of optimism we were hearing.
  • Newspapers and magazines are generally available. The situation in Rohinga was openly discussed. Aung Sang Su Kyi was widely quoted. Criticism of government corruption and bureaucratic incompetence was widely published.
  • Book publishing activity is exploding and I found a large number of well-stocked bookstores throughout the downtown area. Though technical books prevailed in numbers, there seemed to be no real restriction on book topics.

Though all of these are just surface observations, they do show a remarkable opening up of civil society when compared to the closed system that prevailed only a year ago. The contrast with China is striking. After I left Yangon I went to Beijing where even at our five star hotel, Google news and Bloomberg news were not accessible. Facebook, YouTube and Twitter also were not available. Foreign news magazines were not available on the street and book topics were highly restricted.  The contrast was dramatic and telling.

 2.   Banking and Foreign Exchange.

In the old Myanmar, the visitor noticed three things about money. First, much of the economy ran on U.S. dollars or the Euro and many services simply were not available in local currency. Second, there was a big difference between the official exchange rate and the unofficial or black market exchange rate. The first task for every traveler was to find a black market money-changer to obtain a reasonable rate of exchange. Third, the banks were primitive and positively hostile to foreigners.

On this trip, all this had changed. Everywhere I went accepted payment in local currency (kyat). Though many prices were quoted in dollars, no one insisted on payment in dollars. The new, unified official exchange rate was working, and most people I met were exchanging their currency at the local banks rather than with the black market moneychangers. The moneychangers offered a rate that was only slightly better than the banks, so most tourists (and us) did not want to take the risk. Finally, banks were open, efficient and quite friendly in their money changing operations.

Though these small changes in the treatment of visitors mean little regarding the overall modernization of the banking system, the contrast from the former system was a great surprise to me. In fact, the impact of the changes extends to larger issues. With a stable exchange rate system that seems to be accepted by the business sector, the purchasing of import goods can now be conducted with efficiency in Myanmar. This will have a major impact as Myanmar opens to economic contact with the outside world.

3. Foreign Investment.

As I mentioned in my earlier post, the commitment of the Myanmar government towards foreign investment seems half-hearted at best.  Many obstacles to foreign investment remain:

  • The sudden opening of the economy has lead to a sharp increase in land prices in Yangon. Rumors at the Summit were that 30-year lease rights for prime land in central Yangon had risen to $1000 per square foot. If true, this would make the price of land in Yangon the highest in Asia. There is a general lack of good existing real estate in Yangon: hotels, office space and condominiums are all in short supply. This means that in the near future, the cost of all real estate will rise dramatically, making Yangon and the rest of Myanmar extremely expensive. In terms of land prices, the government seems unwilling to allow for any price reduction that would make investment more attractive to foreign interests. In fact, government officials made it clear at the Summit that they intend to exercise the right to approve all land prices for foreign investment projects. Their goal is to prevent local governments or private persons from offering low land prices as an inducement to foreign investment. This situation makes foreign investment in hotel and office real estate difficult at best. It also makes investment difficult for manufacturers, since the cost of building and renting factory space is prohibitively high. We were in Yangon working with a large manufacturer and when we left, they were still looking for appropriate space.
  • Electricity is extremely expensive and in short supply. Blackouts and brownouts are common. Virtually every major project is required to include a back-up generator as part of the project design. Diesel and electric fuel is also expensive, so operating generators can be a significant cost.
  • The road system is not developed and overland transport remains difficult and expensive. As a result, export oriented manufacturing must be located close to the major ports. For now, this means primarily in the Yangon area. Concentration in Yangon will then further exacerbate the high land prices and energy shortage issues.
  • At the Summit, Myanmar government officials acknowledged these three obstacles, but offered no plan for dealing with them. This then reflects two larger, more fundamental problems with the foreign investment program. First, there is a general lack of planning for the development of the economy and there is therefore no real plan at all for the role of foreign investment in that development. Second, Myanmar government officials know little or nothing about private business. They are therefore unable to design programs that are actually attractive to foreign investors. Government officials actually seemed hostile to the concept of foreign investors actually earning a profit in Myanmar. These officials seemed to equate foreign profits with exploitation of the Myanmar people. Thus, rather than encourage profit, they seem to want to discourage it.  A Myanmar businessperson made clear to us that the government officials have a long way to go before they can be viewed as on the side of foreign investment.
  • Government officials feel that they need to protect the Myanmar people from exploitation by foreigners. They therefore require that all foreign investment decisions be approved by the central government. They are not willing to delegate to local officials or to private individuals. This involvement in every decision by government officials who have no understanding of business is a serious obstacle to foreign investment. For example, government officials proudly stated at the Summit that they will approve projects within two weeks. However, local lawyers informed us that the actual approval time is six months or more. As interest in Myanmar grows, delays are expected to grow worse rather than better.
  • To date, foreign investment in Myanmar has centered on oil and gas, minerals, timber (teak) and power generation (dams and coal fired power plants). The government wants to shift this focus to manufacturing, services and agriculture. However, at the Summit, light manufacturing and services were not even discussed, and the discussion of agriculture merely highlighted how unattractive the investments would be. Myanmar is not going to develop a strong economy by relying exclusively on extraction of its non-renewable natural resources. Though the government officials indicate that they understand this, no programs are yet in place to make investment outside of the traditional areas attractive. In fact, the only discussion was about new measures in oil and gas and minerals that will make future investment in those areas less attractive than they are now. As a result, even the traditional sources of foreign investment may decline rather than increase if the new foreign investment policies are implemented. When confronted with these issues, government officials expressed indifference. Their attitude was essentially that if you do not like our policies, go home.
  • Local lawyers and business people are aware of the obstacles to foreign investment that I note above and they are already working aggressively to design legal structures that will avoid the obvious defects of official government policy. Let me give one example. Under the official policy, a foreign owned company cannot lease a building for longer than one year. For major projects, the foreign owned company is expected to lease raw land and then build the factory, warehouse, hotel or office building at its own expense. To make the situation worse, land cannot be owned but only leased. To obtain the lease, the foreign company has to pay an initial lease fee and then pay annual rent. The lease fee is set at the discretion of the government. To top it all off, the government reserves the right to adjust the rent every five years. To say that these terms are unattractive is an understatement.

Locals understand this. Their solution is to build the factory or warehouse and then rent it to the foreign company on a monthly rental basis. They then roll the rental every month with no set term. The idea is that they will roll in perpetuity. This approach avoids the problems with the government approach. The building can be rented, no premium needs to be paid, and the government does not raise the rent every five years. The problem is that the foreign investor has absolutely no certainty with respect to the lease, since the lease is on a monthly rental basis. The locals’ response to the concerns of such an arrangement are to say, “Of course we would not take advantage of the foreigner by raising rent or by offering the building to a party who is willing to pay more.” Thus, even though local Myanmar business people are working on ways to avoid the worst of the government policies, these ad hoc methods are not likely to be attractive to most larger and more sophisticated foreign investors.

To summarize, my response to the situation in Myanmar is mixed. The political and financial system changes are encouraging. Will the changes continue? Is the government sincere? Who knows? These are all concerns about the future that do not recognize the remarkable changes that have already occurred. I encourage the skeptics to go take a look for themselves. On the other hand, there seems to be little real effort being made towards making foreign investment in Myanmar attractive. Many of our clients are looking to Myanmar as a new base for their export oriented manufacturing operations, but I would expect most of them will be taking their time to go in. The company we went to Myanmar with is in a special situation as it is more focused on being in a large number of countries than it is on low costs.

My view at this time is that Myanmar is only suited to well capitalized investors with a capacity to deal with uncertainty and risk. For those brave souls who do go to Myanmar, a permanent and substantial commitment to personnel on the ground in Myanmar will be required. No Myanmar operation will run itself; substantial supervision by the foreign investor is required. Most important is that the costs of operating in Myanmar must be carefully assessed. Low wages are countered by high land and energy costs.

Though the obstacles to investment in Myanmar are currently high, there is also the prospect of rapid improvement. In this area, the encouraging point is that the local private business people fully understand the need to change and the need to work around governmental dictates. Given the rapid changes taking place in Myanmar, it is entirely possible that the locals will develop attractive alternatives to the current policies. The real question is whether the government will be willing to get out of the way and let business people make their own decisions. We will continue to follow developments in that direction.

Dan’s Addendum: I hate to get all corny here, but Steve has failed to talk about Myanmar as a place to go and so I am going to step in and do a bit of that. This was my first time in Myanmar and I found it absolutely fascinating. There were cool looking religious buildings (mosques, churches, Buddhist temples, Hindi temples, even a synagogue), everywhere).  There is a China-town and an India-town and the people on the street are about as diverse as anywhere.  Yangon is full of big and beautiful (and mostly decrepit) buildings and big and Soviet style (and mostly decrepit) buildings as well.  Though hotter than hell and subject to random torrential downpours (with massive winds at any time), Yangon is a great walking city.  Nobody bothers you on the street and the cars don’t seem to be out to run anyone over.  The food is also really good and varied.  They even have half-way decent domestic beer and wine.  And the Shwedagon Pagoda is downright incredible.  Go there (as a tourist) if you can.

Update: Just read an article reflecting yet another difficult in doing business in Myanmar: the rents. There is such a dearth of office space in Yangon, rates are higher there than in New York.

Client sent this to me the other day because he liked it and I do too. The “this” is a China factory inspections checklist compiled by Carson Block (pre-Muddy Waters), for the Doing Business in China for Dummies book.  The list is online here and it suggests that your on site factory due diligence consist of you taking into account the following:

  • Cleanliness. A sloppy workplace (including workers’ appearances) indicates a sloppy attitude, and most likely sloppy performance.
  • Organization. Be sure to take some time to understand the entire workflow. Does it make sense? Can you see any bottlenecks? If you do not understand something, ask questions. If you cannot ultimately understand why a factory’s workflow is a certain way, it may be a warning signal.
  • Machinery. Get thorough explanations of what the machines do, where they are from, and other detailed questions. Asking detailed questions about the machines will make you seem smarter (thus less gullible). Listening to the answers will in fact make you smarter. Once you have toured several factories, you can make comparisons.
  • Quality Control. The key here is the number and location of QC checkpoints. Figure out how the rejected parts are handled. If you cannot understand that, it is likely that the workers also cannot.
  • Employee Conditions. In China, most laborers live at the factory. Regardless, happy workers make for productive workers. Be sure to visit the employee housing areas to see how they eat, sleep and live when they are not on the floor.
  • Location. The factory should be close to its suppliers – otherwise, there can be supply bottlenecks. It should also be close to a port from which it can ship. Finally, learn about whether there are utility quotas in the area that affect production – this is especially important for electricity.

We are China lawyers, not China factory inspectors and so we do not purport to be expert on China factories, but the list does seem like a good one.  Do you agree? Anything missing?

Ford assembly line, 1913.


Little bit behind on my Economist reading, but just read a seriously thought provoking article, entitled, “The third industrial revolution: The digitisation of manufacturing will transform the way goods are made—and change the politics of jobs too.”  The thesis of the article (and one which I completely buy) is that we are on the cusp of a third industrial revolution. The first industrial revolution “began in Britain in the late 18th century, with the mechanisation of the textile industry.”  The “second industrial revolution came in the early 20th century, when Henry Ford mastered the moving assembly line and ushered in the age of mass production.”  The third revolution “is under way” and that consists of manufacturing “going digital.”

The article then points out that this revolution — like those before it  — will be disruptive:

Like all revolutions, this one will be disruptive. Digital technology has already rocked the media and retailing industries, just as cotton mills crushed hand looms and the Model T put farriers out of work. Many people will look at the factories of the future and shudder. They will not be full of grimy machines manned by men in oily overalls. Many will be squeaky clean—and almost deserted. Some carmakers already produce twice as many vehicles per employee as they did only a decade or so ago. Most jobs will not be on the factory floor but in the offices nearby, which will be full of designers, engineers, IT specialists, logistics experts, marketing staff and other professionals. The manufacturing jobs of the future will require more skills. Many dull, repetitive tasks will become obsolete: you no longer need riveters when a product has no rivets.

Again, I completely agree.  It then talks of how it will not only affect how things are made, it will also affect where things are made:

The revolution will affect not only how things are made, but where. Factories used to move to low-wage countries to curb labour costs. But labour costs are growing less and less important: a $499 first-generation iPad included only about $33 of manufacturing labour, of which the final assembly in China accounted for just $8. Offshore production is increasingly moving back to rich countries not because Chinese wages are rising, but because companies now want to be closer to their customers so that they can respond more quickly to changes in demand. And some products are so sophisticated that it helps to have the people who design them and the people who make them in the same place. The Boston Consulting Group reckons that in areas such as transport, computers, fabricated metals and machinery, 10-30% of the goods that America now imports from China could be made at home by 2020, boosting American output by $20 billion-55 billion a year.

So here are the big questions. Where will China fit in this next revolution?  Will it thrive, flat-line or decline? In some respects, I think China has the potential to thrive as it is amazing at taking advantage of the latest manufacturing technologies. But will it create the newest technologies, and if it does not, will it be able to get access to them either by purchasing/licensing them?  Or will it be able to “steal” them?  Do you even buy into this idea of a third revolution? If you do, when do you think it will occur and when will its results really become known?  And what will it all mean for China and for United States-China relations and trade and relative wealth?

Go with it people. We really want your thoughts.

If you want to discuss this on Linkedin, please join the China Law Blog Group there and have at it.

UPDATE:  If, like me, you cannot get enough of this idea that we are in the midst of a third industrial revolution, I urge you to check out this Economist Magazine video program, entitled, “The End of Cheap China: Innovation in Manufacturing.”  It is not cheap, costing as it does $19.95 for less than twenty minutes, but it is really good and really interesting.  I particularly enjoyed Vivek Wadhwa’s portion “on the Next Cheap China” and Carl Bass on the Future of Tool Democratization/Infinite Computing.  They both talk of how the cost of computer power is approaching zero and how that is going to impact the world economy.  I’m telling you, this is going to change the world and it cannot be ignored.

FURTHER UPDATE:  While going through the TSA security line at SeaTac Airport the other, I heard two people talking about the above.  The person doing most of the talking was saying that he had moved to Houston to work at a 3-D parts printing company. He went on to say that he is an outdoors person and he really misses Seattle, but that he took the job because it is so much the wave of the future.  He then in one sentence did a great job explaining 3-D printing. He said that “unlike carving, where you start with a block and end up with a product, you start with nothing and you just keep layering until you have a product.” Is the fact I heard this just another indication of what is happening out there or is it just the equivalent of when you buy a Honda Accord, you start noticing that everyone else is driving a Honda Accord? Or is it all me just mistakenly hyping something that really isn’t going to make that big a difference?

Probably more than any other agreement, there is a conception out there that it is just fine to use an off the shelf NDA Agreement when dealing with China.


At least as much as with any other sort of agreement, it is critical to tailor your NNN Agreement (we call our NDA Agreements NNN Agreements because they include non-use and non-compete provisions, in addition to non-disclosure provisions) to your specific situation. I thought of that this morning as I watched a number of emails fly back and forth between a couple of my firm’s China lawyers regarding a couple of NNN Agreements we are in the process of drafting.

Together, these two emails do a great job of showing how you need more than just an “off the shelf NDA” and of exactly what typically goes into drafting an NNN Agreement that will be effective for each individual company.

The first email was sent to client A at the commencement of work on its NNN Agreement:

I will be drafting your NNN agreement for China. For the start, please provide me with a one or two paragraph description of what you will be doing in China for which you are seeking protection by this NNN agreement. Note that what what we mean by an NNN agreement is: 1) Non-disclosure, 2) non-use and 3) non-circumvention. For China, 2) and 3) are more important than 1). The danger with Chinese manufacturers is that they will use the idea you provide for their own production and they will then attempt to sell that product to your own customers. These actions are what we seek to prevent via the NNN agreement.

In addition to the descriptive paragraph, please provide answer the following:

  1. Provide the full legal name of your company, including state/province of formation.
  2. Provide the address and related contact information that you will want for the contract.
  3. Provide the name and title of the person from your side who will execute the agreement.
  4. Does your company have a Chinese name? If so, what is it?
  5. Am I correct in thinking that you intend to use our NNN Agreement for discussions in China regarding manufacturing _________”

Please consider the following:

  1. Will you use this NNN Agreement for a single product or for multiple products?
  2. What is the best way to identify the products for which the NNN Agreement will be used? Ideally, we seek a clear, descriptive name that does not require attaching specifications or other proprietary information. Sometimes, even the name is proprietary. So we want to develop a designation that is clear, but that does not reveal more than you want to reveal.
  3. Do you plan to use this agreement with a single potential manufacturer or with multiple manufacturers?
  4. What types of information will you be providing to the Chinese side that you want to see protected by the NNN Agreement? This can range from providing a general concept all the way to providing the full production specifications as the preliminary to a hard price quote.
  5. Will you expect the Chinese side to do any design work during the initial discussion period? If so, please explain.
  6. Is your product protected by trademark, copyright or patent anywhere in the world? If it is, please explain
  7. After you disclose this product in China, are you interested in preventing the Chinese side from contacting any of your existing customers concerning your product or related products?
  8. We normally require that the Chinese manufacturer NOT contact any potential sub-contractors who would work in the production process. Please advise if you believe that this would be a concern in your situation. Note that some Chinese “manufacturers” are not actually manufacturers. They serve only as a middle man for the actual manufacturers. If you will use that kind of company, then they will need to be able to discuss your product with their subcontractors and we will need to allow for this.
  9. Please advise whether you have any specific technology items you desire to have protected in a heightened manner.

The second email was to another client for whom one of our lawyers had just completed an NNN Agreement:

Please find attached an NNN agreement for this project. Please note the following:

  1. We could not find any Chinese language information about the manufacturer. Please therefore have the manufacturer write in the Chinese company name, address and related information by hand in the appropriate places on the agreement.
  2. When executed by the Chinese side, please be sure that they stamp the agreement with their company seal in red. The stamp is important, so do not neglect this step.
  3. This agreement includes two exhibits. One is for listing the relevant products and the second is called a No Contact list. The purpose of the no contact list is to formally list out those customers of your company that you want to prohibit the manufacturer from contacting. If there are no such companies at this time or if you do not want to disclose names, just leave this exhibit blank at this time. You may want to use it later.
  4. It appears that this manufacturer will be working with numerous subcontractors. This is always a difficult issue. The approach here is the standard approach: subcontractors must be approved by you in advance. It is also best for you to require that subcontractor to execute a separate NNN agreement. However, this is often not practical. Our approach is to make the manufacturer liable for bad acts by the subcontractors. Note, however, that a very common way for copying to occur in China is to allow your designs to get into the hands of subcontractors and related parties.
  5. Be sure to make every document you provide to the Chinese side as confidential. In the case of subcontractors, ensure that the specific items that are provided to any individual contractor are carefully identified. The NNN agreement is of little use if you do not take care at the stage where specifications are distributed to the Chinese side.
  6. Note that this NNN agreement is intended to protect you only during the process of obtaining a quote from the manufacturer. For full production, you will need an OEM manufacturing agreement that deals with all the manufacturing issues in a comprehensive fashion.

What do you think?

Enhanced by Zemanta

One of the recurrent (sometimes underlying, sometimes explicit) themes of this blog is that if you combine best legal practices with best operational practices, you’ll do just fine in China.

For the second time in the last few months, this proposition has taken a major hit.

The first time was in “How To Achieve Problem Free China Outsourcing. Or Not,” where we wrote of how we were hearing of formerly good Chinese factories just up and closing and running off with foreign company’s money:

We are always preaching that if you 1) choose a good manufacturer, 2) use a good OEM contract, 3) engage in good quality control monitoring, and register your trademark, the odds are overwhelming that you will do just fine in outsourcing your product from China.

The odds just went down.

In 2009 and 2010 and the first half of 2011, I estimate that I would receive maybe two emails a month from someone who had sent money to a Chinese manufacturer and received no product. And of those emails, I estimate that pretty much all of them involved a relatively unsophisticated buyer who had done none of the three things listed out above.

In the last three months or so, I have received probably 4-5 emails from buyers who have been burned by Chinese manufacturers but have a very different story to tell. These buyers have been burned by Chinese manufacturers with whom they have been dealing successfully for many years.

Now I have to write about a foreign company that appears to have done everything right, and yet still had its IP stolen in China. I learned of this company from an All Roads Lead to China blog post, wrongly titled, “If You Don’t Act Chinese Firms Can Copy, Register, and Profit from your IP.” I say “wrongly titled” because it appears to me that the foreign company did act and yet had its IP stolen anyway.  The All Roads Post highlights a BusinessWeek article, entitled, “China Corporate Espionage Boom Knocks Wind Out of U.S. Companies” comes from BusinessWeek ,which in turn highlights what happened to American company, AMSC.

Let me backtrack a bit first. Both here on this blog and in real life with our clients, we are always saying that companies must do two things to protect their intellectual property/trade secrets from Chinese (and other) companies: protect them legally and protect them operationally. One without the other does not make much sense. For example, we can write the world’s best NNN Agreement, but every time you show your secret design or formula or whatever to a Chinese factory, the odds of it getting stolen increase. If you can get away with showing just a portion of your secret design or formula, the odds decrease. In “How To Protect Your China IP,” we talked of the importance of non-legal methods for protecting IP:

To trust is nice, to control better. Know what is going on with your IP in China at all times and use “several anti-counterfeit technologies.” In other words, do not rely solely on the law to protect your IP in China.

Let’s face it, though a good contract and a good IP registration increase the ability to trust, neither of them equal total control.

That is why we suggest to our clients that they, whenever possible, operate in such a way that even if some of their IP is stolen, all of it cannot be. By way of example, I always refer to a client of ours who has a hardware/software product that cannot function optimally unless both are working together. This company keeps its software on a server at its home office in the United States in such a way that it is virtually impossible to copy. On top of that, even if it were copied, it would rapidly become out of date due to the lack of updating critical data. When I discuss this company, I often describe it as having found the “magic key” and I suggest to our clients that they too try to find their own “magic key.”

But based on what happened to AMSC, even magic keys are not so magic.

AMSC’s China business was not atypical:

AMSC began packaging the electronic components and selling them to China’s small but growing domestic manufacturers, which had plenty of capital and cheap labor to make the turbines’ steel skeletons but lacked the sophisticated gadgetry to run them. The arrangement was working the way it was supposed to: China would turn out the commodity hardware — the turbines — and a U.S. company would retain control of the high-margin intellectual capital-end of the business.

But the steps AMSC took to protect itself went beyond that of most companies:Secure Barriers

Secure Barriers

If McGahn [AMSC’s CEO] was going to bet AMSC’s future on partnerships with Chinese companies, he wanted secure barriers around its intellectual property. He designed AMSC’s China operations — in fact, reorganized much of the company — with that in mind. To hire AMSC’s first 30 employees in China, McGahn interviewed 400 people, handpicking the ones he thought he could trust. When AMSC opened a factory in China’s Jiangsu province to assemble power converters, McGahn made sure firmware and other technology-rich components were built in factories in the U.S. and then shipped to Asia.

Software was sequestered at the company’s research facility in Austria, which has a booming clean energy sector much like Germany’s. The source code to AMSC’s control system software sits on a secure server in Klagenfurt. To protect the code from hackers, the server isn’t accessible from the Internet.

Strategy From Beginning
“The idea of dividing up the intellectual property part of the content and not having them in China was part of the strategy from the beginning,” he said.

McGahn thought he’d planned for every contingency to keep AMSC safe. He also believed the company could find a way to have both partners benefit. He was wrong on both counts.

I have to admit, if a client had told me the above, I would have congratulated them for their good work, and just assumed they were fine. But in AMSC’s case, they weren’t: Han’s company, Sinovel, allegedly paid someone in AMSC’s Austrian office to provide the Chinese company with AMSC’s software code. Armed with this, Sinovel had all that it needed to compete with AMSC and it did.  According to the BusinessWeek article, “what Sinovel realized was that it was cheaper, and easier, to convince a software developer to jump ship” than to create its own product.

In light of the above, All Roads offers the following excellent advice:

In the past, when firms were focused on manufacturing for export, and when the major markets for products made in China were for export, my advice to firms was to make sure that they not only had their legal ducks in a row through patents (home and China), trademarks (home and China), and supplier agreements (with non-compete clauses), but that they aggressively scan the market and visit suppliers to minimize the risks for copied products (made by their suppliers) to end up in the global market.  Attending trade shows, scanning Alibaba, and setting up mock purchase calls.

And that advice goes double now, particularly for firms who think that China offers a market for their goods on ANY level going forward.

I completely agree, but in my most cynical voice possible, I would add, “and good luck with that.”

What do you think?

David Barboza, the New York Times’ crackerjack Shanghai business correspondent, recently did a story on his interview with Dan Breznitz and Michael Murphree, authors of the book, Run of the Red Queen: Government, Innovation, Globalization, and Economic Growth in China. The book (which I have not yet read) is, according to Barboza, about “China’s innovation drive” and it posits that “China should worry less about coming up with breakthrough technologies and focus more on what it already does best: making incremental innovations in everything from manufacturing to logistics.”

I agree.

According to Breznitz and Murphree, China should continue focusing on incremental process and manufacturing innovation, and hold off on trying to compete with the United States and Europe (what about Japan?) on “novel ideas and breakthrough products”:

[]China has shown strength in process innovation and creating new manufacturing systems. Rather than trapping China in low-end manufacturing, they say, these capabilities will power the Chinese economy for years to come and eventually allow China to move up the value chain.

Indeed, they argue that the Chinese government’s push to compete with the United States and Europe on novel ideas and breakthrough products may be wasteful and inefficient, partly because of government interference but also and because China has not yet reached an advanced stage of development.
Breznitz talks of how places today “specialize not in specific industries but specific stages or activities within those industries”:

In different places — Taiwan, the U.S., South Korea — there are different stages of production in each industry. The next logical step in thinking about innovation, since industries are fragmented, is that different places need different systems and different kinds of innovation. China excels in different kinds of process or manufacturing innovation. This includes design for manufacturing, organization of production, sourcing and logistics.

He goes on to say that China is doing a bang-up job of innovating within its manufacturing specialities:

China’s companies are extremely efficient at creating new versions, often simpler, cheaper and more efficient, of technologies and products shortly after they are invented and marketed elsewhere in the world. For instance, I can’t think of any company in the world that can have over 200,000 people in one location producing a wide array of electronic gadgets for multiple companies other than Foxconn in China.

The American military, the best fighting machine in the world, can hardly move 200,000 people into the exact locations it wants them in months, but this company moves engineers and production workers from line to line and product to product with amazing efficiency. This is production innovation. China does innovate.

But when it comes to “novel-product innovation, China is very weak” and this, according to Breznitz is due to China’s governmental system:

There’s no way around it. The central government is the main antagonist in the process. The political economic institutions and system in China make it so entrepreneurs can’t make profit by developing novel innovation. But this same system makes process and second-generation innovation very profitable and successful.

Co-author Murphree then talks of how there is a tendency to “equate innovation with invention” and to believe that without invention, you will “fade.” This belief, in turn, “leads to a tired dichotomy: either China is already innovating, or it’s on borrowed time and will stagnate like other middle income countries.”

In Murphree’s view, innovation is more than just invention. It also includes “the whole array of moving and improving inventions so consumers get better, newer, and cheaper products and services.” Much of “what we think of as innovation is what we notice in the final gizmo, but the innovation is actually in the guts that make the device work.”

Breznitz then cites to the Apple power cord as a great example of China process innovation:

Do you own an Apple computer? There’s a white power supply box on the power cord. That box has been improved with continuous R.&D. so it doesn’t go up in smoke and so it will do what it does ever more efficiently. This is entirely done in China. The company that makes the power supplies is constantly doing research to make them smaller, more efficient, cooler, cheaper, and less energy intensive. This can only be done in China because firms can find high-quality engineers and tell them, ‘You will make power supplies better’ and the engineers will oblige. What are the chances you can hire someone from an elite U.S. university such as Carnegie Mellon to do that? This gives China power in the global production networks.

The authors see China’s model as “not just sustainable,” but as a driver for China increasing its power over the next fifteen years.

It is an excellent article on innovation and since I have discussed just a fraction of it, I urge you to read the whole thing here.

By: Steve Dickinson

On Monday, March 14, The PRC National People’s Congress approved China’s 12th Five Year Plan and the outline of the plan was released to the public yesterday. The full 105-page document can be found (in Chinese) here. I am now reviewing the plan and over the next several weeks I will provide a series of reports on its contents.

I can make some preliminary remarks at this time.

The striking thing about the plan is its lack of originality. In the policy documents that have been promulgated over the past year, the party and the National People’s Congress (NPC) concluded that China must boldly reform its entire economic structure. The idea was to have China move away from a export and infrastructure driven economy to a balanced, consumer demand driven economy. The Communist Party of China (CPC) issued an outline of a bold plan that would bring about this transformation. The conclusion of many Western economists was that 1) the transformation would be essential for the long-term health of the Chinese economy but that 2) the transformation would be extraordinarily difficult. See the recent writings of Michael Pettis on this issue.

Apparently, the NPC also concluded that the consumer driven economy simply would be too difficult to achieve. As a result, the 12th Five Year Plan basically abandons the concept of creating a consumer driven economy and falls back to the standard Chinese economic model of depending on massive infrastructure projects and export driven growth as the primary models. Though some lip service is paid to increasing household consumption, that concept is basically brushed aside in favor of domestic infrastructure spending.

The list of projects is breathtaking. In just a preliminary review, I noted the following:

  • Highways, conventional rail and high speed rail
  • New airports
  • New ports and port upgrades.
  • Oil and gas pipelines
  • Electric transmission lines, especially high voltage lines
  • Coal transport and storage
  • Environmental upgrades of virtually the entire system of coal fired power plants, together with constructing substantial new coal fired power plant capacity
  • Modernizing the entire heavy industry sector: steel, cement and aluminum, in particular
  • Expanding mineral mining, particularly coal
  • Oil and gas field development in Inner Mongolia and Xinjiang
  • Creating an entirely new industrial base, focused on seven strategic industries
  • Urbanizing rural China to allow at least 10,000,000 rural residents per year to move to the cities
  • Investing in massive amounts of new nuclear power and hydropower facilities
  • Major expansion of domestic oil refining capacity and LNG storage and transmission
  • Sewage and waste treatment facilities throughout the entire country
  • New hospitals throughout the country
  • Waterworks focusing on irrigation and water transport from the South to the North
  • Developing coastal marine resources, primarily focusing on maritime infrastructure
  • Developing the Central and Western regions
  • Redeveloping China’s Northeast industrial base
  • New jobs for 45,000,000 workers

Note that this set of projects is not designed to encourage the domestic household economy; all of it is designed to maintain China’s position as an export-oriented manufacturing powerhouse. It seems that the NPC has rejected the idealistic notion of reforming China’s economic structure and instead has adopted the easier plan of simply improving what China has been doing for the past ten years. No major changes here: just upgrades and refinements.

Of course, as is typical, there is no mention of how much this huge list of projects will cost and no mention either of from where the money will come to pay for all of this. If the past is any indication, the projects will feature a mix of direct central government expenditures and bank loans to local governments. The recent huge jump in bank lending supports the notion that the banks will be instrumental in funding this truly massive set of infrastructure projects. There is also no discussion of how this massive spending program will mesh with the China’s current concern with controlling inflation. Nonetheless, the basic plan is clear. Spend, spend, spend on creating manufacturing capacity and then export the surplus in order to pay for it all. 

In other words, we should be expecting more of the same.

What do you think?