China joint venture lawyersOur own China lawyers have written countless articles on China joint ventures (for this blog, for AmCham, for the Wall Street Journal, for Above the Law,  and for many others), so it good when someone we know and respect says the same basic thing about them, which is that you should watch out.

The writer is my friend Randall Lewis, who has headed up Asia legal out of China for both Danone and ConAgra and who truly knows China. Last month Randall wrote about setting up joint ventures in emerging market countries. Randall stated that his article “is intended to be your general “watch-out” guide to avoid basic and simple joint venture mistakes.”

Randall begins his article by commenting on how people are wrong to believe that if they “set up a good platform for a business, agree on ownership percentages and the business plan/finances work. . . . the lawyers will work out the rest.” He then proceeds to list a ton of “common mistakes your commercial folks WILL make when taking your company into a foreign market. He makes clear that his list is “not hypothetical” as he has encountered every situation personally. Guess, what, our China lawyers have encountered every situation personally as well, and multiple times.

But without further ado, here are the more China-relevant mistakes Randall has seen and about which he wants to warn you, with my comments about China joint ventures in italics:

  • Commercial people frequently engage in detailed discussions with potential partners before discussing options, strategic structures and legal issues with their own legal counsel. This leads to promises being made and structures being agreed to that are completely against your own best interest and which benefit only your JV partner. Once these “agreements” have been made, it is difficult to change once you bring in legal counsel. In short, a wise approach is to consult legal counsel BEFORE you have discussions on structure, methods of investment, holding companies, corporate governance structures or just about anything outside of pure commercial matters and general alignment. Definitely true for China as well. 
  • Never take legal advice from your potential JV partner. This happens more often than you know. Your commercial people will start a discussion and the “local” will advise your team on what they can and can’t do in their country. This advice is more likely than not, 100% incorrect or misleading for a good reason; it is being given to take advantage of your company and to secure a structure not in your best interest. I wrote about this in China Joint Ventures, The Tide is Out: We have seen US companies that have put tens of millions of dollars into a Chinese joint venture, using no legal counsel at all, using the legal counsel of their joint venture partner, or using a local Chinese lawyer who has no experience with foreign joint ventures and no real incentive to protect the foreign company. 
  • If someone says; “we don’t need to involve the lawyers yet” or “we don’t need to have your legal counsel in the room for this discussion” or “we prefer to let the lawyers work out the contracts after we agree on XYZ,” stop immediately and ask yourself if that makes any sense.  Usually, excluding lawyers is not for cost savings or to do you a favor in terms of simplifying your discussions; it is, simply enough, to pull the wool over your eyes. True for China. 
  • If someone says “ we have someone that will act as our CEO/GM and CFO/finance people” be wary that you have enough control over key functions so that you don’t end up a financial investor in a JV vs a real partner. Keep in mind that if someone is appointed to an executive function by your partner, that person is more likely than not, viewing your partner as their “employer” vs the joint venture entity or your company. Their interest will be completely aligned with your partner and not to your company. 100% true for China as well. The key is control and one of the biggest mistakes we see is Western companies wrongly assuming that because they own 51% or more of the joint venture, they control it. See Avoiding Mistakes in China Joint Ventures.
  • When your partner says to you they will build your factory and secure all the licenses and permits for your new business, use caution! If you are in a JV and your partner is engaging in illegal behavior that violates the UK Bribery Act, FCPA or other local equivalent you may find yourself on the hook for all of your partner’s activities! In short, you need to be able to manage and control your partners activities beyond just signing a contract that obligates them to comply with your FCPA and UK Bribery Act obligations. Many times a JV partner will sign anything and proceed to do whatever they desire because they don’t understand the obligations, nor do they care or “that is not how they do things in their country”.  Way too many companies enter into contracts thinking they can trust their partner to follow the rules (hey, you have a contract) and then they get burned. This happens in China all the time.
  • Don’t be impressed by your partner’s government connections and think this is of great benefit to your new potential JV.  It is 99% possible, those connections will be used to benefit your partner in the future and to your detriment. I have seen more than my fair share of commercial people get overly excited about a “connected” potential partner only to find out a few years down the road that those connections are being used privately to do things and take actions the partner is not contractually or legally able to do. Definitely true of China.
  • Don’t be led to believe that if you have a controlling position at a Board level you are in control of your JV in many countries. For example, in China (and other locations), the right to control the Board does not give you effective control of the company. For actual control you need to control the appointment of the General Manager and ultimately the company “chop” or seal (which allows the possessor the power to make binding contracts on behalf of the joint venture company and to deal with the company’s banks and other key service providers).  In addition, your access to financial information and the ability to audit will not necessarily be assured unless you control the CFO position. Securing this finance position will also assure early warning of problems with the business and potential fraud. Agreed. See Avoiding Mistakes in China Joint Ventures.
  • Don’t let your partner convince your team that setting up a JV on a 50/50 basis with no mechanism to resolve a deadlock is a good idea.  I have seen more than my fair share of JVs that have 50/50 shareholding and no deadlock mechanism leading to a complete breakdown of the JV business.  This usually only benefits your local partner that had this as their goal from the beginning. Once the JV is successful (or they have what they need from the partnership) they manufacture a way to push you out so they either buy your interest (in a manner outlined by a local court) or exit to run a new business that looks identical to your own. We see one of these pretty much every year involving China joint ventures and they are never a good situation. 

Randall ends his article by calling for companies looking at doing a joint venture to “slow down, use caution, exercise common sense and surround yourself with advisors that challenge your assumptions and criticize your deal.” I can agree with that also.

China employee probation
China employee probation: like a maze.

Employee probation periods has to be one of the most misunderstood issues in China employment law. Westerners just assume their probationary employees are at will employees who can be fired at any time, for good reason or for no reason at all. Wrong. The probation period is PART of the normal employment term and therefore pretty much all protections afforded to regular employees also apply to employees on probation as well. This period should really not even be called “probation” because it really isn’t. It was five and ten years ago, but no longer and your failure to realize this will be at your peril. Trust me.

Our China employment lawyers often are faced with situations like this: Employer hires an employee on January 1st with a two-month probation period. Employer then contacts us in late February to say it will be terminating the employee before the employee’s probation period runs out so it can avoid paying statutory severance. The employer’s reason for the termination is that the employee is “just not all that good” and they believe they “can do better.” The employee neither failed to follow employer directions nor did he or she fail to possess the qualifications required for his or her position. In other words, the employer has NO legal basis for terminating the employee. So with the probation period now coming to an end, can the employer go ahead with its planned unilateral termination without having to pay severance? Probably not.

The employer is shocked when we tell them that if they go ahead with the unilateral termination, they will be at risk of being sued for an unlawful termination. China is not an employment-at-will jurisdiction and the probation period is not an exception to this general rule. An employee termination during the probation period requires a legally permissible ground and except for the limited number of grounds permitted under the law, an employee on probation cannot be unilaterally terminated. If this sounds familiar, it should. Because if you replace the italicized parts with “during the employment term” you get the most fundamental rule of China’s employment law: a China employee cannot be unilaterally terminated without cause.

So under what grounds can an employer terminate an employee on probation?

Article 39 of the PRC Labor Contract Law provides that an employee on probation may be terminated with no severance for one of the following six reasons:

  1. The employee is proven to have failed to satisfy the conditions of employment during the probation period;
  2. The employee materially breaches labor disciplines or the employer’s rules and regulations;
  3. The employee commits a serious dereliction of duty or practices graft, causing substantial damage to the employer;
  4. The employee has established an employment relationship with another employer which materially affects the completion of her tasks with the employer, or she refuses to terminate such employment relationship with the other employer, after she is required to do so by the employer;
  5. The employee uses deception or coercion, or takes advantage of the employer’s difficulties to cause the employer to conclude the contract, or to make an amendment thereto, that is contrary to that party’s true intent;
  6. The employee has criminal liability imposed in accordance with the law.

Under Articles 40(1) and 40(2) of the Labor Contract Law, an employee on probation may also be terminated if:

  1. He or she has fallen ill or sustained a non-work related injury and, at the end of the medical treatment period, can neither engage in the original work nor in other work arranged by the employer;
  2. He or she is incompetent and remains incompetent after training or assignment to another post.

That’s IT. No law allows an employer to terminate an employee on probation for whatever reason the employer wishes (or for no reason at all) simply because the employee is on probation.

In addition, Article 21 of China’s Labor Contract Law clearly states that when an employer terminates an employee during the probation period, the employer must provide the employee with reason(s) for such termination. It is critical that the employer convincingly document its terminations in writing — in Chinese. If the documentation setting forth the grounds for termination is not convincing, you will be giving your terminated employee incentive to challenge the termination and a good chance of prevailing against you in a labor arbitration proceeding. This is especially true when the employer is a WFOE because let’s face it, China is always going to favor a Chinese employee over a foreign-owned entity.

The most common ground for terminating an employee on probation is the first ground under Article 39; the employer can prove the employee on probation does not satisfy the conditions of employment. Note the wording though in Article 39. The employer must be able to prove that its employee failed to satisfy the employer’s conditions of employment. For the employer to be able to prove this, it must have specified such conditions/requirements in writing and it must communicate those conditions to the employee beforehand. Though some courts will consider the general requirements in an employee’s specific industry as conditions of employment, most courts will not. What this means is that the smart employer has a clear writing setting out its probationary employee’s conditions of employment and if a termination becomes necessary, another clear writing documenting exactly how the employee failed to meet those conditions.

What then is the difference between a probation period and a normal employment term? Not much, actually. If an employer can prove any of the above grounds for termination exits, it can terminate the employee during the probation period without having to pay severance. Or the employer can wait until the end of its initial fixed term and not renew the contract but pay severance to the employee.

What then should you as an employer in China do? The best way to proceed is usually to specify the employment requirements in your employment contracts or in a separate agreement/document (in Chinese!) and preserve good evidence of how your employee fails to meet those requirements. If you as an employer want to be able to fully take advantage of the probation period, you should set out the conditions of employment in writing and provide those to the employee for review and sign off before the employment relationship commences. And then, as discussed above, if you find yourself wanting to terminate that probationary employee, you should give the employee a reason beyond telling them that “you are fired because you are still on probation.”

Few WFOEs seem to understand these rules and even fewer seem to get them right. Many try to manage their China-based employees from afar in a foreign (especially U.S.) style that does not work for China, without China-centric employment contracts or China-centric employer rules and regulations. These WFOE employers consistently fail to maintain records of employee behaviors/performances in a way they can later use in their favor in an employment dispute.

China employment cases are rife with examples of foreign employers that lost and lost big because they did not understand employee probation periods. Chinese employees know this and they are quick to sue when terminated during their probation period.

In a fairly recent case in Shanghai (which is actually more pro-employer than most cities in China), a foreign employer sought to have the court overturn a labor arbitration ruling finding the employee had been wrongfully terminated during the probation period. The employer argued that the employee was emotional at work, had on many occasions read magazines unrelated to work, and did not possess the professional skills expected for the job. The employer also argued the employee failed to pass his evaluations during the probation period. The Second Intermediate People’s Court rejected the employer’s arguments, noting that the employer failed to put forth any real evidence to prove an evaluation of this employee had actually occurred and it ordered the employer to pay damages to its former employee for unlawful termination of the employment contract.

Because employers in China must prove the grounds of termination even during a probation period and because there is no legal basis for unilateral termination the safest way for an employer to terminate its probationary employees is via a mutual termination agreement. This usually involves the employer giving the terminated employee a small severance payment in exchange for the employee’s voluntary departure. This mutual termination agreement should be in Chinese and it should include provisions making clear that the terminated employee is releasing the employer from any future claims. If the employee refuses to agree to such an agreement (this almost never happens), the employer essentially has the following two courses of action:

  1. Inform the employee that he or she is being terminated, and then sit back and wait for a potential labor arbitration, or
  2. Continue to employ the employee throughout the employment specified in the employee’s contract.

Can you extend the probation period? As is true of so much of China employment law, that depends on the locale. But this is not something you want to get wrong because in some locales, extending the probation period is just about the worst thing you can do. And keep in mind that even if your extending the probation period is legal, you as the employer still must prove cause for any eventual unilateral termination.

Bottom line: China probationary periods are neither what they used to be nor what they seem to be.  If you are unsure whether you are using your China employee probation periods correctly, now is the time to find out.

China contract lawyersIn my first post in this series (here), I described the five basic attitudes Chinese companies have regarding advanced equipment being sold into China.  In part 2 (here), I set out two of five tactics high value equipment sellers should follow when selling advanced (and therefore expensive) equipment into China: One, do not discount, and two, get paid before you deliver your equipment to your China buyer.

In this, part 3, I wrap up this series by setting forth the remaining three tactics equipment sellers should employ when selling their equipment to Chinese companies.

3. Do not deliver the equipment until first verifying that the conditions for its installation have been met. Remember that the Chinese side believes your equipment works based on an almost “magic” formula and your rules on how to set up for its installation and the specifications for its use are just a subterfuge you use to “hide the magic.” The detailed set up work is therefore unnecessary. Meeting the specifications is not necessary. So the Chinese side will not do the proper set up and they will ignore the specifications. But then when your equipment does not work as it was supposed to, the Chinese side will blame you for its failures.

The following are two (of many) true stories that illustrate how this typically goes down:

  • A heavy equipment manufacturing company delivers iron pipe casting equipment. The conditions of sale provide that the floor of the casting room must be perfectly level. When the equipment is delivered, the casting room has an uneven dirt floor. The casting machine does not work and the Chinese side does not pay a single penny on the contract. The Chinese bank that guaranteed the payment sides with the Chinese buyer. Why create a level, clean concrete floor for a dirty machine used for metal castings, one of the China company’s engineers asked at one point.
  • A water power equipment manufacturing company delivers a new hydropower generation set of equipment. The specifications provide that the current flow can never exceed 6 knots. When the equipment is delivered, the Chinese side installs it in an unapproved location where it is well known the current exceeds 8.5 knots. Within one year, the entire facility is destroyed. The Chinese side defaults on the last payment and the reputation of the foreign company is destroyed. The foreign company lost money on the project and never did another sale in China.

Foreign equipment sellers cannot rely just on clear contractual specifications and then relying on the specifications when there is a problem. The foreign seller should itself ensure the conditions are met before it delivers the equipment. And if the conditions are not met, the foreign seller should not deliver. If there is a cost in confirming your Chinese buyer has met the specifications (and there usually will be), you should build that cost into the cost for your product. Remember: the failure of the installation is always your fault and the Chinese side will always find a way to make you pay for that failure. We have said this before and it made people mad, but some of our most experienced and sophisticated and successful China essentially charge a premium to Chinese buyers simply to cover themselves in advance against these sorts of problems.

4. Build required training and after sales maintenance and support into the price of the equipment. No matter how much your potential Chinese buyer tries to get you to decouple the pricing for maintenance and support (and then eliminate it entirely) do not make these optional add-ons that are billed for an additional fee. If you make these optional and charge extra for them, the Chinese side will almost always choose not to pay. So you have to force them to accept training and support as part of your sales price.

Why do the Chinese refuse to pay? Your trying to require them to pay for after sales maintenance is just you admitting that your product is somehow defective and why should they buy a defective product. If properly manufactured your equipment should work forever, with no service or maintenance required and your trying to make the Chinese side pay for training and service as an add-on is you unfairly seeking to increase the price of a product that is already unfairly expensive.

There is one exception related to training. If the Chinese side is planning to clone your equipment, they will seek extensive training in how the equipment operates. Their goal though is not training; their goal is to somehow obtain the formula that will allow them to clone your machine. For this reason, you should carefully control your training with Chinese companies.

During training, the Chinese side will ask for more information and more training time than is necessary. They will also insist on visiting the U.S. manufacturing facility and they will expect to spend substantial time in that facility. For this reason, all training obligations must be carefully defined to prevent your costs from skyrocketing out of control. You should carefully limit time, location and access to information. One good way to control this is to require the Chinese pay by the hour for all training provided in excess of the basic training included in the purchase price.

Many foreign equipment suppliers say they will provide whatever training proves “reasonably” necessary. This sort of an approach is nearly always a mistake because neither Chinese companies nor Chinese courts truly understand or employ the concept of reasonable. You therefore should state state with precision the training you will be providing, where you be providing it, who will be providing it, and for how many hours you will be providing it. The same rules apply to provision for after sales support. Chinese companies tend to abuse after sales support obligations. So those obligations should also be spelled out clearly in your contracts as well. Again, I base this not on any “feelings” I have about China, but based on my having represented countless foreign equipment sellers on countless China equipment transactions and on what I have heard from other equipment companies and from other China lawyers who represent them.

5. Protect your IP through with a China-centric contract. Protecting the intellectual property you have in the advanced equipment you sell into China should be a core goal in all of your sales. Understand the basic approach from the Chinese side: your product is too expensive and b) any form of IP protection is just a unfair device you are using to force them to pay the unfair price of the machine. So the goal of the typical Chinese company is to purchase one or two items at a bargain price and then clone them in China at a “fair” price.

The obvious way to protect the intellectual property in your advanced equipment is to register your patents in China. But for various reasons (including time bars) this is often not possible. Where there is no patent registration (and oftentimes even when there is), your best solution is to incorporate basic IP protections into your sales agreement. This is essential for China.

To accomplish this, either your sales contract or a collateral agreement must provide for the buyer agreeing to the following:

  • Buyer will not reverse engineer or manufacture a copy/clone of the product or engage any affiliate or third party to do the same. A complex legal definition is not required. A blunt, simple statement (in Chinese) is what is required.
  • Define confidential information information (such as the information you provide in training and support) and require no confidential information can be used by your buyer or by any affiliate or by any third party to infringe on your product.
  • Provide for monetary damages if these restrictions are violated. Injunctions rarely work in China, so contract damages are required.
  • Impose these restrictions with a written agreement enforceable by litigation in China. This is a key requirement. Your English language sales agreement that is enforceable in the New York or in London or in Geneva is not going to be helpful in protecting your IP and if it makes sense for you to use that sort of agreement on the sell side (and sometimes it does), you should have a separate IP protection agreement in Chinese, subject to Chinese law and enforceable by litigation in China.

My first post in this threeChina manufacturing lawyers part series focused on a post entitled The 7 Major Risks You Run With Your China Manufacturers, by China manufacturing expert Renaud Anjouran. In that post, Renaud outlined the business risks foreign companies face when having Chinese factories manufacture their products. I noted how Renaud’s list nicely accords with what our China lawyers tell our clients who retain my law firm to draft their Chinese manufacturing contracts. See China Manufacturing Agreements: Binding Contract or Contract Terms. I noted how our manufacturing clients usually want to focus on a) intellectual property protection/prevention of counterfeiting, ownership of molds and tooling and after sales warranty service. In other words, the sorts of things legal agreements are really good at resolving. But oftentimes, core business issues like price, quantity, delivery date, quality and resolution of quality issues, subcontracting and shipping are of at least equal importance.

My second post focused on the first four items on Renaud’s China product outsourcing list. In this, my last post in this three-part series on China manufacturing, I focus on the last three items from Renaud’s list.

Risk Five: Subcontracting. Subcontracting of production presents a number of risks often not clearly understood by foreign buyers. Renaud identifies the first and most common risk. The foreign buyer goes to substantial effort to verify that the Chinese factory it has chosen is capable of meeting its quality standards. If the factory then subcontracts the foreign buyer’s product manufacturing to another factory, all of the buyer’s verification work becomes meaningless. This then leads to other issues: How will inspections take place? How will quality control standards be enforced? How will worker safety or worker age rules be enforced? How will anti-bribery and related rules be enforced? Working to the next level, manufacturing by a third party where there is no contractual relationship means that confidential information agreements are automatically breached, and this is a primary way intellectual property gets lost in China. Finally, molds and tooling are often moved to the subcontractor, resulting in loss of control and the inability to retrieve these items when required.

There are three reasons Chinese factories typically subcontract. First, the “factory” is a front for a trading company that actually does no actual manufacturing on its own. This type of trading company will subcontract all of the manufacturing and will limit its involvement to supervising (usually very poorly) the manufacturing process. Second, the factory may be capable of doing the basic manufacturing process, but it requires subcontracting assistance on key elements of the production process. For example, it is normal for Chinese factories to subcontract mold making and electroplating of key components. Finally, the factory may decide that the foreign buyer’s purchases are too small to justify the effort of setting up production and it will subcontract to a factory with the time and the interest. Such a factory is almost guaranteed to be of lower quality, leading to the problems Renaud describes in his post.

Since subcontracting is always an issue when manufacturing in China, it is necessary to confront the issue directly in a formal agreement. The standard approach is to provide that subcontracting is prohibited without notice to and consent by the foreign buyer. The foreign buyer should condition its consent on inspecting the subcontractor and getting the subcontractor to execute a separate manufacturing contract with the same key terms as the foreign buyer has with its original manufacturer.

Though this approach is best, many Chinese factories insist on an absolute right to subcontract. In that situation, if the foreign buyer agrees, then the normal contract provision is to require (a) the Chinese factory at least identify its subcontractor(s) (b) the subcontractor grant the foreign buyer access to its premises for inspection and c) the Chinese factory agree to be directly liable for any violations committed by the subcontractor. Some Chinese factories will not agree to these conditions. When that happens, our China lawyers recommend the foreign buyer refuse to purchase its products from that factory.

Renaud identifies a more difficult problem: undisclosed subcontracting. This situation is unfortunately quite common. It arises most often during the busy season when a factory simply cannot keep up with the orders it has accepted. The best way to prevent this from taking place, the foreign buyer must regularly inspect the factory operations to ensure that the factory is really doing the work on the premises. Since the high season is the most likely time subcontracting will occur, this is the time when appropriate, unannounced inspections should occur. It is also crucial to enter into a formal agreement that prohibits undisclosed subcontracting as described above.

Way back in 2009, in The Six (Not Five) Keys To China Quality, we wrote about the tremendous value of putting a no-subcontracting provision in your China manufacturing agreements:

We typically put a provision in our OEM agreements (which we nearly always do in Chinese for better enforcement in China against the manufacturer) mandating that the Chinese manufacturer cannot subcontract out the manufacturing. We have been doing this for years and, as far as we know, no manufacturer has ever violated this provision. I know many of you are dubious of this record, but hear me out. Let’s say the Chinese manufacturer has 30 customers for whom it manufacturers product. Let’s say only four of those customers have a no subcontracting provision (my guess is this number is more like to be two, but for the sake of argument, let’s go with four here). The China OEM manufacturer gets really busy and has to subcontract out some of its manufacturing. It can subcontract out the product manufacturing of any of its 30 customers, so why wouldn’t it choose to subcontract out the product for the 26 customers who have no contract provision prohibiting subcontracting? I call this the bike lock theory of Chinese law because the no-subcontract provision operates like a good bike lock. The thief can still steal your bike, but why would he when there are so many easier targets out there?

In our experience, these no-subcontracting provisions work shockingly well.

Risk Six: Failure to Deal with Defective Product. The problem of defective products raises several issues. First, it is critical to identify a factory that will attain and maintain a reasonable defect rate. If the defect rate during production is over an “epidemic percentage” level, it is almost certain success will not be achieved. As Renaud illustrates in his post, the defects in Chinese factories are often at the cosmetic level. The base product is acceptable, but the finish is defective or scratched; fingerprints show up on glass in an enclosed case; greasy footprints are found on well sewn, elegant handbags.

There are two issues relating to dealing with such defects. The first is how to locate the defect. It is best to locate the defect during the production process. Second best is to locate the defect before shipping. Third best is to locate the defect after your receipt of the product. The worst case is to learn of the defect after delivery to the down stream customer.

As Renaud notes, once defects are found, the parties must have in place a formal plan that clearly deals with what will be done with the defective product. It is critical not to allow the defective product to enter into the retail market. Many Chinese factories will sell defective product “out the back door.” When this product gets into the market, the damage to your reputation can be substantial.

But what should be done with defective product? We usually provide that the defective product must be destroyed. However, this is not always the best alternative. In some cases, the defective product can be repaired or otherwise reworked. This is a common approach for complex and expensive cast metal parts for large equipment. In other cases, the defective product can be disassembled so that valuable components, such as precious metals, can be recovered.

Once you resolve how to handle defective products you receive from your China factory, your next issue is how to get reimbursed for the defects. The Chinese side will usually propose that the value of the defective product be applied as a credit against your future purchases. This is a bad system because the foreign buyer can only obtain credit if it makes another purchase. This forces the buyer into a relationship with a factory that makes defective product. Even worse, the amount paid to the factory is going down for each new purchase, which means the factory has even less incentive to do a good job.

The practical solution is for you to inspect your product before making any payments for its manufacture and reducing the invoice price to account for any short delivery resulting from removal of defective product from any given shipment. If the defect level reaches an epidemic failure rate (this rate must be determined on a product by product basis), your manufacturing contract should provide for you to be able to impose additional penalties. Foreign buyers that delay dealing with quality issues until after they have made full payment for their product are virtually never able to successfully resolve their China product defect issues.

The above discussion shows that a detailed, formal system for dealing with quality control and handling of defects is required and the only way to do this is with a formal, written manufacturing agreement. The common one line statement that the Chinese factory will warrant the quality of its products will never work. Manufacturing in China will ALWAYS result in defects. A workable plan for dealing with those defects is therefore not optional. It is required.

Renaud’s post raises an even more important issue. In some cases, the defect level from the factory will be high and will remain high. In that situation, where a defect rate is over 20%, it is normally impossible to develop a workable solution with the factory. The solution here is to monitor the process from the very beginning. In China, factories do not do better work over time. Their performance almost always only gets worse over time. As soon as an excessive defect rate is identified, you should take immediate action. Usually that immediate action means cutting your losses and moving to a new factory. A good manufacturing agreement will make this transition as easy as possible.

Risk 7. Logistics Cost Increases Due to Factory Error. As Renaud notes, you need to beware of increased shipping costs due to your factory making an error in the size of container required to ship your product. This issue arises from a common mistake make by foreign buyers. Inexperienced foreign buyers often do not understand that in international transactions, “logistics” is an integral factor for success. Shipping costs, shipping timing, method of shipment (air/ground/ocean), port of delivery and a host of other factors can have substantially impact the marketability/pricing of your product.

This then leads to the standard mistake. The foreign buyer looks for the lowest China Price. So the China manufacturer provides a product price that does not include the shipping cost: free carrier or the (erroneous) FOB price. Under these terms, it is the foreign buyer’s responsibility to make arrangements for shipping. The illusory concept is that the foreign buyer will then negotiate the lowest shipping rate, making for an even higher profit.

In fact, however, foreign buyers are normally unable to effectively manage shipping in China. So even though they specify free carrier terms, they in fact end up needing to rely on their Chinese factory to make all the arrangements for shipping. But under this scenario, the foreign buyer has taken on all liability for mistakes and yet it has no effective control to prevent those mistakes. This then is a perfect setting for the kind of disaster that Renaud describes.

From a legal perspective, resolution of this problem is simple. The foreign buyer’s contract with its China factory should reverse impose all of the responsibility and liability for shipping on the China factory. This is done with a manufacturing contract that provides for the product price to include shipping fees. The standard CIF (cost insurance freight) shipping term will achieve this goal. Use of CIF terms does not mean that your China factory will not make mistakes, but it does mean that your factory (not you) will be liable for those mistakes. Your China manufacturing agreement should also include a provision that requires your factory ship by air freight if delivery of your product will be delayed beyond a certain number of days. The only way to ensure that your China factory treats your key business issues as important is for your manufacturing agreement to impose an immediate penalty on your factory that does not require a cross border lawsuit to enforce.

 

China AttorneysBecause of this blog, our China lawyers get a fairly steady stream of China law questions from readers, mostly via emails but occasionally via blog comments as well. If we were to conduct research on all the questions we get asked and then comprehensively answer them, we would become overwhelmed. So what we usually do is provide a super fast general answer and, when it is easy to do so, a link or two to a blog post that may provide some additional guidance. We figure we might as well post some of these on here as well. On Fridays, like today.

Our China attorneys are often asked some version of the following question:

Why are you so concerned about getting the name of the Chinese party on my contract exactly right?

Answer: Because if it is wrong, the Chinese company may at some point argue (perhaps even successfully) that it is not bound by the contract.

We get this question especially often when our clients are dealing with China’s biggest companies like Baidu, Alibaba or JD.com on the other side. Our clients will ask us to draft a contract with Baidu, for example, but Baidu is really more of a brand name than a company. We then have to push our client to get from their Chinese counterparty (at whatever company it is with which they are actually dealing) the Chinese characters for the specific Baidu entity with which they will be contracting.

China Lawyers

Because of this blog, our China lawyers get a fairly steady stream of China law questions from readers, mostly via emails but occasionally via blog comments as well. If we were to conduct research on all the questions we get asked and then comprehensively answer them, we would become overwhelmed. So what we usually do is provide a super fast general answer and, when it is easy to do so, a link or two to a blog post that may provide some additional guidance. We figure we might as well post some of these on here as well. On Fridays, like today.

I had no idea what question to use for today but the following email (modified slightly to delete anything that might enable tracking) from this morning solved that problem for me:

I am _________ from _______, consulting company located in Spain. First of all, thank you for the informative blog posts. They have been very helpful.

My client company is a high-tech manufacturer (digital __________) and tries to expand the market to China.

Is it possible for you to recommend me some China distributors who supply to Department Stores and Home Convenient Stores?

Best Regards.

My response to these emails is usually somewhat along the following lines:

I’m sorry but because we represent a number of similar companies who have paid us tens of thousands of dollars over the years I just can’t. I do not think it would be fair for me to take what we have learned from getting paid to represent these companies and then turn around and give that information for free to one of their competitors. I hope and trust you will understand.

There you have it. Your thoughts?

China ScamWe long ago instituted the rule that if we got three blog comments and/or emails on a subject in a week, we would write about it. We have received three emails and one comment from people about to get scammed by a classic (but obviously resurgent) China scam. The below blog comment came in today:

So pleased to have found this blog. I have been contacted recently by this company from Kunming asking that I fly to Kunming to sign the Official contract. They were proposing that we organise a 20 day tour of France for 89 retired military veterans. We had provisionally booked the hotels and reserved the coaches so had spent quite a lot of man hours on the project.

After sending me the official contract they then asked me to pay my own expenses to China in order to meet them to sign the official contract in person before they would release 30% deposit into our bank account.

This does not normally happen in our Industry so a Chinese colleague phoned the companies that were on the contract and nobody from either the Kunming Tourist Board or the Government Department for retired veterans new who the man was that had signed the contract.

So that’s when I did a bit more research and found this Blog. Halleluya, great to get closure.

BEWARE OF “CON-MING”

This scam has been around forever and yet Western companies are still falling for it. It though seems to be rapidly accelerating of late, which is absolutely par for the course whenever China’s economy starts slowly, which it has been of late.

The scam consists of the Chinese company (actually, in every instance when our firm has done any investigation at all we immediately learned that there is actually no real company there) luring in the Western company with promises of big money for services (or sometimes products) to be supplied by the Western company. There is just one small hitch: the Western company must go to China (near as I can remember, it’s always some third or fourth tier city in China, never Beijing or Shanghai or Shenzhen, or even Tianjin or Qingdao) to sign the contract.

Why must the Western company go to China to sign a contract when China deals constantly get done without an in-person signing ceremony? The following are the reasons typically provided:

  1. Chinese custom. It would be rude if you don’t come. Note that of the thousands of contracts in which my firm’s China lawyers have been involved, less than ten percent have involved an in-person signing.
  2. We need to do this in front of Chinese government officials, for one reason or another. Note that I can recall only two instances where our contracts were signed in front of government officials and those didn’t need to be. They just were because the transactions were so large and so vital to the local economy and doing so was a way of improving government relations going forward.
  3. The contracts need to be notarized by a Chinese notary and for that they need to be signed in front of a Chinese notary. Complete lie.

Why does the Chinese company want the Western company to go to China? How does the Chinese company possible benefit from this? Based on the Western companies that report back to us after they have been scammed, the following are the most common:

  1. Western company personnel will be put up in a local hotel for 4-5 days and the bill will be maybe ten times what it should have been. The hotel and the scammers then split the take. This is not to mention the multiple celebratory banquets that also are grossly over-billed.
  2. The fake notary charges a percentage of the deal, typically USD$8,000 to $15,000. The Western company believes it must pay this for the deal to go through.
  3. The Western company is subtly told that for the deal to go through, government officials must be paid and it is legal for a foreign company to pay them. Complete lie. If these were really government officials and you do really pay them, you are risking jail time in both China and most likely in your home country as well.
  4. Some third party is necessary for the deal for some reason and the Western company must pay that third party. Really?

For more on this particular scam, check out the following:

How do you prevent this scam from happening to you? Easy. You conduct basic due diligence on the Chinese company before you get on the airplane. Long before. The first thing you do is determine whether your China counter-party even exists as a registered China company or not. And when you discover that it doesn’t, you end all communications.

You have been warned. Again.

China Manufacturing ContractsThis is the third in my series on China manufacturing contracts. Part one was on the three main types of China manufacturing arrangements we are seeing these days: Original Equipment Manufacturing (OEM), Contract Manufacturing (CM) and Original Development Manufacturing (ODM). Part two focused on ODM contracts, which ten years ago were relatively uncommon (back then many of our clients were making clothing or toys or very basic electronics), but now make up well over fifty percent of the manufacturing contracts seen by our China lawyers — largely complicated hardware, internet of things (IoT) devices, and industrial equipment.

This post focuses on the intellectual property (IP) issues surrounding who owns what in a ODM arrangement and on the need for that ownership to be clear before any relationship between the foreign (usually American, European, or Australian) buyer and the Chinese factory company begins. I concluded

The technical question of percentage ownership is critically important for our clients because it determines the answer to a second, oftentimes even more important question: if you as the foreign buyer decide to or need to move your product production to a different factory, can you do it? Yes or no? If you own 100% of the IP, you can move. And if you have a contract that makes this clear and penalizes your existing factory for not allowing you to do so smoothly, you almost certainly will be able to do so without incident. However, if your China factory owns some or all of the IP, then you will not be able to switch your production to a new factory without some sort of license or permission from the factory. This is an issue that you need to resolve at the outset and you should not assume that you already know what the factory will say. Often, the response of the China factory is quite surprising to the foreign buyer.

In our recent experience, the most common position taken by Chinese factories is as follows:

  1. The foreign customer owns the exterior design (design patent) for the product. The customer owns its trademarks and logos.
  1. The Chinese factory owns the core intellectual property for the product.
  1. The Chinese factory agrees to manufacture the product for the customer on an exclusive basis. However, the manufacturer is free to continue to make use of its core intellectual property, including any “new work” developed as part of the product design process, in manufacturing for itself and in manufacturing products for other customers. This includes the Chinese factory manufacturing products that will directly compete with the foreign buyer’s product. The only limitation on the Chinese factory is that it cannot employ its IP to manufacture a product that uses the exterior design, trademark or logo of the foreign customer.
  1. The foreign customer cannot take the product and have it made by any other factory. That is, the customer is stuck with the Chinese factory, no matter what happens.

Assume the factory takes the “you cannot go anywhere else” approach. Then you will have to consider critical issues that will arise at the production stage. Specifically, you will need to consider what will happen in the following common situations:

  1. The Chinese factory raises its price to an unacceptable level.
  1. The Chinese factory cannot meet your quantity or time of delivery requirements.
  1. The quality of the product is not acceptable. There are consistently too many defects.
  1. The Chinese factory just decides to stop manufacturing for you. This can be because it simply decides to quit, or this can be because it decides to manufacture a similar product for themselves or for a larger company that can generate larger and more consistent orders.

All the above happens all the time when working with Chinese factories in China in the OEM and CM settings. In those settings, the remedy is to move to a different factory. The alternative to move is the primary threat that keeps the Chinese factory under control. Now consider the situation where you cannot move your production to a different Chinese factory. This obviously puts you in a very difficult situation. You are at the mercy of the factory. This is a situation you must avoid. For more on why it is so important to avoid this sort of situation, check out, China and The Internet of Things and How to Destroy Your Own Company, where we talk about companies that have come to our law firm too late.

The standard international standard for dealing with these intellectual property manufacturing issues is as follows:

  1. The factory is required to make the product for you for so long as you are interested in the product. If the factory determines on its own to quit making the product for you, then the factory must provide you with a royalty free license to the technology solely for the purpose of your being able to manufacture the product in a different factory. If the factory wants to avoid this result, its solution is simple: it must continue to manufacture the product for the foreign buyer.
  1. The factory is locked into a specific price for a specific period. Assuming that the production arrangement will be long term, it is probable there will be valid reasons for raising or lowering the price. For example, exchange rate fluctuation can be a good reason to go in either direction with the price. To provide for reasonable price changes, your contract should provide for a mechanism for annual price adjustments. This mechanism can range from a simple index to the CPI to a complex formula that takes into account multiple factors.
  1. There are two primary mechanisms for dealing with the quantity/time issue. The first is to develop a production schedule that binds both parties. The second is to provide for the situation when the factory is unable to meet the foreign buyer’s requirements by contractually requiring the factory to license production at an alternative location, but only in the amounts required to meet the excess requirements.
  1. Your manufacturing contract should provide for the situation where the factory consistently violates quality standards by giving you — the foreign buyer — the right to terminate the manufacturing contract for breach. The foreign buyer may have other reasons to terminate the contract for breach by the factory. Your contract should state that if it is terminated because of a breach by the factory, the factory automatically licenses you to manufacture your product in a different factory. Some Chinese factories will claim this rule allows for breach in bad faith simply for the purpose of moving to a new factory. If this is a genuine concern, the agreement should provide for a method of arbitration focused solely on this issue.

Though the above provisions are both fair and standard in the international business of custom design and manufacturing, we find that many Chinese manufacturers either refuse to discuss these matters or refuse to accept a reasonable solution. The Chinese factory knows that its customer will be stuck and stuck is exactly where it wants its foreign buyer to be. Being stuck with a factory what behaves unreasonably is a very unpleasant experience. You should consider carefully whether you want to proceed in that kind of situation.

You do not want to be ambushed by these critical issues after you have spent considerable time and money in developing a product with a factory that will then hold you hostage at the production stage. See China and The Internet of Things and How to Destroy Your Own Company for a taste of what this can look like.

You need to get clear on these design and manufacturing and pricing and production and intellectual property issues from the start; that means you need an ODM agreement that sets forth how they will be resolved.

China lawyers
Because of this blog, our China lawyers get a fairly steady stream of China law questions from readers, mostly via emails but occasionally via blog comments as well. If we were to conduct research on all the questions we get asked and then comprehensively answer them, we would become overwhelmed. So what we usually do is provide a super fast general answer and, when it is easy to do so, a link or two to a blog post that may provide some additional guidance. We figure we might as well post some of these on here as well. On Fridays, like today.

Today’s question comes from a reader who sent me a link to a Wall Street Journal article, entitled,
China’s Tech Rules Make It Hard for U.S. Firms to Take Control along with the following core question/comment:

You are always talking on your blog about how foreign companies are better going it alone in China and not entering into joint ventures and not entering into VIE contract arrangements. Do you think HP, Microsoft, Qualcomm and Cisco don’t know any better?

I think HP, Microsoft, Qualcomm and Cisco know exactly what they are doing and we have never said that foreign companies should never enter joint ventures with Chinese companies. My sense/guess is that HP, Microsoft, Qualcomm and Cisco have conducted thorough cost-benefit reviews of these deals and determined the rewards outweigh the risks. Our position on joint ventures are something to be wary of and to be avoided if possible. But we fully realize that there are times where the best way (and even sometimes the only way) forward in China is via a joint venture or some other sort of tied-in relationship with a Chinese entity.

Negotiating with Chinese companies
Negotiating with a Chinese company? Think Game of Thrones.

If you have been reading the business news on China, two things ought to have jumped out at you. One, Chinese companies are looking to buy technology innovation. And, two, Chinese companies have a very annoying habit of backing out of their deals. For a news piece on the former, I give you this May 31 Wall Street Journal article: China’s Xiaomi to Buy 1,500 Patents From Microsoft, subtitled, “deal reflects smartphone maker’s efforts to acquire the intellectual property it needs to broaden its reach.” For the later, I give you this June 1 Wall Street Journal article: China’s Latest Export: Broken Deals.

For the last year or so, our China lawyers have been seeing the same thing. On both counts.

Let’s talk about innovation first. Can China innovate? That question has been asked countless times in the last ten or so years and this blog and our China attorneys have asked that question many times as well. Some of us have even been on seminar panels discussing that issue. But I have stopped asking that question ever since a friend of mine pointed out to me that it is no longer the salient innovation question to be asking about China. I his view (and mine now), the better question is a slightly broader one. The better question is whether China can secure innovation either by generating its own or by buying it. Truth be told, many in China, including at the highest levels of the government, have given up on China becoming a top-tier innovator and have therefore turned their attention to China becoming a top tier innovation acquirer. Add in the fears of a declining Yuan and you have all you need for a golden age (or period anyway) of China innovation acquisitions. And that is exactly what is happening and exactly what our China team has been seeing. Chinese companies are looking to acquire innovation/technology/IP any way they can, including by licensing, by purchasing (either the technology itself or the entire company) or by joint ventures.

Now let’s talk about why so many of these technology deals do not come to fruition and that naturally will lead us to why negotiating these deals is so incredibly difficult and why we subtitled this post “Buckle Up For Some Seriously Tough Negotiating.” The Chinese government is telling Chinese companies to acquire technologies and Chinese companies badly want to acquire technologies, but this does not mean they are not having a really really difficult time securing those technologies the way a company from, let’s say Spain or Germany, might go about acquiring such technologies.

Here is how our firm did a technology licensing deal for a Spanish company recently. This Spanish company wanted to buy a U.S. company with a cutting edge technology. The Spanish company spoke with the U.S. company and they negotiated a purchase price and generally discussed other key terms.  The Spanish company then did its due diligence on the U.S. company and that due diligence uncovered a few warts and raised a few issues. So the Spanish and the American company sat down again and negotiated on some of the new issues and renegotiated on some of the old issues, and within a week or so the deal was again ready to move forward. The whole process from start to finish took 3-4 months.

Here is what typically happens when we represent an American company seeking to do a technology deal with a Chinese company:

  1. The American company and the Chinese company reach what sounds like a perfectly reasonable deal.
  2. We draft up the perfectly reasonable deal and the Chinese company then completely changes it.
  3. Our American company tells the Chinese company that it cannot do the new deal the Chinese company has just proposed.
  4. The Chinese company comes up with some really bizarre explanation for why the new deal it is proposing is absolutely essential and explains why the deal our client thought it had can never work.
  5. We then spend weeks explaining why the old deal is just fine, while the Chinese company alternately acts like it will do the old deal with just a few small changes or hints very strongly to our client that it should take the new deal or the Chinese company will just walk away.

I could go on and on, but you get the point. The point is that Chinese companies like to draw in American and European companies with what looks like a really good deal and then go back on that deal. Chinese companies negotiate like this because they realize that once an American company commits to a deal, it wants to close the deal. Once five people in an American company have told their fellow employees that “we have a deal with XYZ Chinese company,” those five employees do not want to have to keep negotiating that deal for another 5-6 months or just walk away from it. Chinese companies know all this and they seek to wear down the other side, plain and simple.

Chinese companies will change the deal not just monetarily, but in even bigger ways as well. Have a deal where you don’t turn over anything about your technology unless and until you get a large upfront payment? Prepare for an explanation from the Chinese company weeks into the deal why that is no longer possible. Have a deal where the Chinese company is supposed to get your three year old technology? Prepare for an explanation months into the deal as to why you now need to replace that with your newest technology, and all at the same price. Again, I could go on and on.

So how should an American or a European company handle this sort of negotiating. By remaining firm and resolute. Not kidding. In subsequent posts, we will go into greater depth on how to negotiate with Chinese companies. So stay tuned….