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 or phone calls 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 we usually provide a quick general answer and, when it is easy to do so, a link or two to a blog post that provides some additional guidance. We figure we might as well post some of these on here as well, which we generally do on Fridays, like today.

One of the questions our international manufacturing lawyers are constantly asked is where other than in China “should we make X  product and can you give us the names of some factories that make X product in any of those countries.” Our answer to that question is usually as follows, we have seen some companies that make similar products go to X, Y and Z countries, but just because they are going to those countries does not necessarily mean that you should or even can. Truth is that the country and the factory you choose needs to be the one that makes your product at the price point and at the quality that makes sense for your business and there is usually no way to determine what country or what factory within any country that will be. Jeans are a great example as we are seeing many companies move their jeans production out of China. SeeJeans Sourcing Landscape Sees Major Changes as China Fade Continues,  which describes what is happening with worldwide jeans production as follows:

Imports of the category from China dropped 10.44 percent in the six months through June to a value of $369.97 million. This brought China’s market share of the category–97 percent of which are denim jeans–down to 22.82 percent, a 5.11 percent decline for the year ended June 30.

All of the other Top 5 suppliers posted gains in the amount of denim they shipped to the U.S., with each growing their market share. Mexico, the No. 2 denim supplier to the U.S., inched up on China to hold a 22.16 percent market share. Jeans imports from Mexico rose 14.44 percent to $410.07 million, leading a Western Hemisphere increase of 12.03 percent to $509.74 million, which also included a 28.02 percent gain by Nicaragua to $55.19 million, and a 12.06 percent advance by Guatemala to $16.22 million.

Among the major Asian apparel suppliers, Vietnam and Pakistan are the big winners so far this year, while Cambodia and Indonesia lost ground, and Bangladesh maintained the status quo.

Jeans imports from Vietnam jumped 29.36 percent to a value of $142.36 million. The country’s market share rose 36.39 percent to 8.38 percent for the 12 months, as makers look to capitalize on its apparel manufacturing expertise.

Pakistan, which benefits from also being a major supplier of denim fabric, saw its first-half imports to the U.S. rise 15.49 percent to $119.72 million. The country’s market share increased 16.27 percent to 6.69 percent.

On the downslide, jeans imports from Cambodia fell 8.47 percent to a value of $45.89 million and Indonesia’s shipments were down 2.54 percent to $35.57 million. Denim apparel imports from Bangladesh rose just 1.13 percent in the period to $247.5 million, although its market share grew 4.96 percent to 14.5 percent.

In other words, for jeans,  the production leaving China has been replaced by countries literally all over the map, usually depending on each company’s familiarity with a particular country and their price and quality requirements. Our international manufacturing lawyers see the above sort of pattern (really non-pattern) with many sorts of products. But then there are some products where just about everyone leaving China is heading to one or two other countries. Smaller backpacks, for instance, we see going almost exclusively to Vietnam. Wood toys, we see going mostly to Thailand and India and Indonesia. Auto parts to Mexico and Thailand.  Electronics to Taiwan, Korea, the Phillipines, Thailand, Vietnam and Indonesia. See The US-China Future: Meet Vietnam, Thailand, Mexico, Malaysia, Turkey, and the Philippines.  Oh, and then there are those companies that try and try to move their manufacturing out of China, but end up not moving a single widget. For them, China is the new China. Which always begs the question, Has Sourcing Product From China Become TOO Risky?

In other words, it really just depends.

China litigation arbitration lawyers

As China’s relationship with the outside world continues to deteriorate (especially with the United States and to a lesser extent with Europe) the number of lawsuits and potential lawsuits between Chinese and foreign companies is on the upswing. There is an old saying about how lawyers do best in times of great change and that is doubly true of attorneys that focus on litigation and arbitration and it is even more true during down times. When companies are thriving, lawsuits are viewed as more of a distraction. When companies are doing poorly, lawsuits become a way to secure profits  Law firms with China practices are gearing up for increased international litigation and arbitration involving Chinese companies and our international litigation and dispute resolution lawyers are already seeing an uptick in such cases.

What though is the best way to you pursue a legal claim against a PRC company that owes you money or has wronged you in some other way?

Since Mainland Chinese courts do not enforce U.S. judgments, it is usually (but not always) a waste of time and money to bring a lawsuit in a U.S. court against a Chinese company that does not have assets in either the United States or in a country that enforces U.S. judgments. See China Enforces United States Judgment: This Changes Pretty Much Nothing.  You should, however, be sure to  research where the “Chinese” company is actually based because Mainland China, Hong Kong, Taiwan, and Macao are different jurisdictions entirely and each of these jurisdictions have their own laws about enforcing a United States judgment.

 

Arbitration versus Litigation 

Whenever someone approaches my law firm wanting to sue someone or being threatened with a lawsuit or having already been sued, the first thing our dispute resolutions ask is whether there is a contract. The reason for this is not so much to determine the merits of the lawsuit, but to see whether there is an agreement out there mandating in what sort of forum disputes between the parties must be resolved. Generally speaking, if there is a contractual agreement to arbitrate, you must arbitrate. And, generally speaking, without an arbitration agreement, your dispute must be resolved in some court somewhere.

 

Jurisdiction

Jurisdiction will usually be one of the first issues you will want to resolve when formulating your litigation strategy against a Chinese company. Suing a Chinese company in the United States requires the typical contact inquiry that comes with suing any foreign company. See Asahi Metal Industry Co. v. Superior Court of California, Solano Cty., 480 U.S. 102 (1987); Glencore Grain Rotterdam B.V. v. Shivnath Rai Harnarain Co., 284 F.3d 1114 (9th Cir. 2002).

An American company usually faces no jurisdictional bar to suing a Chinese company in Mainland China. Articles 3 and 237 of the PRC’s Civil Procedure Law grant Chinese courts jurisdiction over international cases involving foreign plaintiffs against Chinese companies. Though suing in China is usually possible, it should not be done without a good understanding of what that actually entails.

If a U.S. court has jurisdiction over a Chinese company, suing that Chinese company in a U.S. court typically will differ from suing a domestic company on service of process, discovery, litigation strategy, and the above-mentioned enforcement of judgment.

 

Service of Process

China is party to the Hague Convention on Service Abroad of Judicial and Extrajudicial Documents in Civil and Commercial Matters. This means service on the Chinese company of whatever complaint you file against it in a U.S. court must comply with this Service Convention. Service under the Hague Convention is effected through the designated Chinese Central Authority in Beijing, which is the Bureau of International Judicial Assistance, Ministry of Justice of the People’s Republic of China.

A U.S. company suing a Chinese company in a U.S. court must submit the following to China’s Ministry of Justice:

  • The original English version of the documents to be served. The summons must have the issuing court’s seal.
  • The Chinese translation of all documents to be served. Because the USM-94 will not be served, that form does not need to be translated.
  • A photocopy of all the above documents.

China’s Ministry of Justice will then send your service of process documents to the appropriate local court to effect service. In our experience, Chinese courts can be painfully slow and even random in sending out service. And if the Chinese company you are seeking to sue is a powerful local entity, service likely will be even slower. We have found that service moves along a lot faster when one of our lawyers fluent in Chinese repeatedly calls and emails both the Chinese court itself and China’s Ministry of Justice. These days, you should figure on your Hague Service of Process on a Chinese company taking about a year, maybe longer, and assumes you did absolutely everything 100% correctly from beginning to end. One of the trickiest things about effecting proper service on a Chinese company is that if you do something wrong somewhere along the service route, it is not uncommon for Chinese court or Ministry of Justice officials to wait 6-10 months to tell you that they will not be serving your papers and you need to start all over with your service request. To put it another way, it is critical you do everything correctly.

China formally objected to service by mail under Article 10(a) of the Hague Convention on Service and U.S. courts have held that objection valid. See DeJames v. Magnificence Carriers, Inc., 654 F.2d 280 (3d Cir. 1981), cert. den., 454 U.S. 1085; Dr. Ing H.C. F. Porsche A.G. v. Superior Court, 123 Cal. App. 3d 755 (1981).

We will in subsequent posts discuss how to conduct discovery against a Chinese company you have sued in a U.S. Court, the litigation and arbitration strategies to deploy when suing a Chinese company, and arbitrating against Chinese companies and suing them in China.

 

China Movie and Entertainment Law
                                                                                                                                                       Image via www.vpnsrus.com

Over the past few days, reports have emerged of a proposal to open China’s market to foreign streaming services. According to Tech Node, Beijing News reported that China would “allow foreign firms to provide … streaming services … by the end of the year”. This would be a radical departure from current policy and quite surprising in light of present US-China relations. Rumors along these lines have been circulating in Beijing (where I live and work) for the past six months or so and it at first looked like a real breakthrough had finally occurred.

On closer examination, though, all that happened was that the Beijing Municipal Government had issued a release mentioning a plan to allow foreign investment into VPN services as part of some sort of limited pilot scheme. In the Chinese news article descriptions of the plan, such services as “AV product distribution” were taken to mean online streaming by a number of news outlets. Described as a three-year “action plan for open reform” of the Internet, the plan was reported to promote “open reform” and “open foreign investment conditions” for the Internet by “breaking through existing policies”. It’s not clear how this would make sense given that VPNs allow access to foreign websites and services that are blocked in China, but that’s another story.

As an indication of some change in atmospherics, the apparent position of the Beijing Municipal Government may be good news for US streaming service companies. It’s difficult to say because details are hard to come by — despite claims that the plan had been published we have been unable to locate a copy. Certainly, pilot schemes in limited areas are frequently used in China to gauge the viability and impact of reform before a commitment is made at the national level.

For now, let’s be clear that foreign investment in VOD services and TV channels remains prohibited in China. This is because these activities are in the prohibited section of China’s “Negative List”. The Negative List is maintained by the Ministry of Commerce and the National Development & Reform Commission in connection with the “Catalogue of Industries for Guiding Foreign Investment”. Other foreign activities in the prohibited section of the negative list include those carried on by TV production companies, movie production companies and movie distribution companies.

The Negative List also includes a section listing activities in which foreign investment is restricted but not prohibited. Foreign investment in restricted activities is possible but it must usually occur via a joint venture in which the foreign party takes a minority position. For example, though foreign investment in production companies is prohibited, investment in production is, at least as far as the negative list is concerned, permitted via a joint venture.

You can see, then, a foreign streaming service could not take an interest in a China VOD platform without a major change to China’s Negative List. The relevant activity would need to move from the prohibited to the restricted or encouraged sections.  In the alternative, an express exception would be required under some other law or, perhaps, as part of a resolution of the present trade war between the US and China.

international manufacturing lawyers

 

Sorry, But Overseas Factory Problems are Likely YOUR Fault 

The genesis for this post is an excellent post written by Renaud Anjoran and a series of Linkedin comments on that post. The post is on Renauds Quality Inspection Blog and it’s called 28 Common Problems Chinese Suppliers Cause Importers.  Renaud is the long-term owner of a Shenzhen-based QC+ firm (Sofeast) with whom our international manufacturing lawyers have had the pleasure of working on many China manufacturing projects. If you do manufacturing in China (or even elsewhere), you  really should be reading Renaud’s blog.

As per its title, Renaud’s 28 Common Problems post lists out 28 common problems foreign buyers face with their Chinese suppliers. And like so many of the posts Renaud writes, I found myself (last night) nodding my head the whole time while I read it. I then thought it would be helpful to share Renaud’s post on Linkedin so I did, here, with the following blurb: “Not just Chinese suppliers, but suppliers in most other countries are consistently guilty of these 28 things as well. A very helpful piece for anyone manufacturing overseas.”

I woke up this morning to see that Richard Brubaker, another long-time China hand, who too knows China as well as anyone,  Left the following comment:  “After 20+ years of this conversation, and dozens of book available at any airport in Asia, I think it’s time to reframe this as the 28 ways your process failed you.” Renaud responded to this by saying “absolutely” and I responded to it by saying I 100% agreed.  The sad truth is that at least 90 percent of the time, the so-called problem with Chinese or any overseas product supplier lies with the foreign buyer not having taken the right steps to protect itself. In other words, all three of us are essentially blaming “the victim.”

Overseas Manufacturing Problems are on the Increase (Again)

With foreign buyers fleeing China, many factories in China are getting scared and desperate, and their common remedies for that are to cut corners on quality and to take their foreign buyer’s IP and compete with them. We had this to say about the increase in trademark thefts in China Trademark Theft. It’s Baaaaaack in a Big Way:

But starting about a year or so ago, our China trademark lawyers started getting a ton of China trademark theft calls, and the number of those calls has been accelerating ever since. Why has the tide on trademark “theft” come in again? Two reasons. One, there is hardly a soul in China who does not know how to get around the prohibition on an agent registering the trademark that rightfully should go to the foreign company for whom it is acting as an agent. If your manufacturer in Shenzhen wants to secure “your” trademark in China it will not go off and register it under its name, as it knows that cannot work. So instead of registering the trademark under its own Shenzhen company name, it will ask a cousin or a nephew in Xi’an to register it under its company name, making it nearly impossible for you to invalidate the trademark. Two, many (most) Chinese factories are hurting and they desperately want to improve their profit margins. What better way to do so than to sell a product under a prestigious or well-known American brand name — or even just any American brand name? See Your China Factory as your Toughest Competitor.

In China Factory Disputes: The 101, we had this to say about the increase in product quality and other Chinese factory problems:

Many China factories are in deep trouble due to declining sales stemming from the US-China Cold War. I base this not just on the economic statistics everyone is seeing but also on the fact that our China lawyers are getting a steady stream of emails from foreign companies reporting the usual range of problems whenever China’s factories start suffering.

Our international manufacturing lawyers have been getting a ton of emails from foreign buyers that are being pursued by their Chinese factories for refusing to pay for defective products. Typically the foreign company is trying to achieve some sort of compromise while the Chinese factory is insisting on full payment.

There are a lot of huge risks for foreign companies in these situations, and the typical first question we ask a company in this situation is how easily can they just up and move their manufacturing outside China. If they say they can, then we start working with them to achieve that as quickly as possible. If they cannot, we start talking about the sorts of defenses they need to start building.

We then went on in that post to explain what to do if you find yourself in a dispute with your Chinese factory.

With all the problems with China these days, one of the easiest things you can do to avoid or resolve a China factory dispute is to move your manufacturing out of China. See Moving Your Manufacturing Out of China: The Initial Decisions and How to Move Your Manufacturing from China AND Protect Your IP. The risks of manufacturing in China are shooting through the roof these days, and those risks are even higher if you are in a dispute with your Chinese factory. See Has Sourcing Product From China Become TOO Risky?   But those risks are also typically at their highest at the beginning of any new relationship with a factory, whether that factory is in China or in Thailand, MexicoVietnam or wherever. And in the end, it is really up to you to reduce your risks.

How to Avoid your Overseas Manufacturing Problems

The first thing you need to do to reduce the likelihood of having problems with your overseas product suppliers is to recognize that these problems are mostly on you. I am NOT saying that if something goes wrong your overseas manufacturer will not be at fault as well — because it probably will be — but I am saying that most of the time when a foreign buyer comes to one of my firm’s international dispute resolution lawyers with an overseas manufacturing problem, we find all sorts of things the foreign buyer could and should have done differently that would have avoided the problem or reduced its damage.

We wrote extensively on this in China Factory Problems: Always YOUR Fault?:

The title is somewhat of a stab at humor. It stems from my blaming most (but certainly not all) China factory problems on the foreign buyer. We have written countless times of what is required to secure good product from Chinese factories.

*      *      *      *

We have also written how our China lawyers constantly get calls or emails from American and European companies that have received bad product from their Chinese factory suppliers and how there is nothing we can do for them. We wrote about this just last week in How To Get Bad Product From China With No Legal Recourse. To a certain extent, we like being able to blame the victim in these situations because that way we as lawyers can comfortably sit back and tell ourselves that had they only contacted us BEFORE they started having problems, we could have prevented all of their problems.

Everything written above about China holds true with equal force about your manufacturing pretty much everywhere outside of China, as well.

But what exactly can and should you do to protect yourself when manufacturing overseas? The below six basic things are key.

  1. Use a Good Company.  Sounds rather basic, but we constantly see this rule violated. If you do nothing else that we suggest in this post, do this one thing because it matters as much as all the other factors put together.
  2. Use Good Manufacturing Agreements. Good contracts ensure that your overseas manufacturer knows what is required of it and what will happen to it if it does not meet those requirements. For what constitutes a good Overseas Manufacturing Agreements go here. For what constitutes a good overseas Mold Protection/Mold Ownership Agreement, go here.  For what constitutes a good overseas NNN Agreement, go here.  For what constitutes a good overseas Product Development Agreement, go here. Most overseas manufacturing contracts we see are worthless because they are usually written by someone who either does not know manufacturing or does not know international law, or both.
  3. Use Detailed Documents.  Overseas factories that engage in contract manufacturing tend to do exactly what you tell them to do. This means you need to clearly convey what it is that you want them to do, and that means your instructions and specifications should be detailed and in their language. See China OEM Agreements. Why Ours Are In Chinese. Flat Out. Be overly specific.
  4. Visit the Factory. Either your own people or a third party QC company should pay regular visits to your factory. Doing this allows you to make sure your factory understands what you want and lets them know that you are serious about making sure you get it.  It also humanizes you and tells them that you really do care and are not just putting things down on paper to look good to your own buyers or to abide by some regulation somewhere. Trust me when I say that this one should not be underrated.
  5. Inspect Your Products. Perform regular product inspections appropriate to the product you are having made.
  6. Register Your IP. If you have IP worth protecting (and pretty much all of you do), make sure you do everything you can within reason to protect it wherever you are manufacturing your products and wherever you sell your products. This means trademarks, patents and/or copyrights.
If you do all of the above your odds of avoiding overseas manufacturing problems go way down. If you don’t do the above, expect to see people blaming you for your problems on Linkedin and elsewhere. Your thoughts? 

International manufacturing lawyers

Control Your Molds

Far too many companies that have their products made overseas wrongly assume they will own the molds and the accompanying IP used to make their products. If you do not pay for your molds upfront and have a contract that both works for the country in which your molds are being made and used and that makes clear the molds and their accompanying IP actually belong to you, they probably do not. If you do not have such a contract, there is a good chance you will find yourself unable to switch product suppliers even if your product supplier raises prices through the roof and produces terrible products. Without the right protections in place, you will be stuck. In this post, we explain why this is the case and what you can and should do to prevent this.

Companies that engage in outsource manufacturing need to retain control over their molds at all costs. To accomplish this for our clients, our international manufacturing lawyers focus on two issues when drafting mold provisions that are part of a larger contract (such as a manufacturing agreement or a product development agreement) or that stand alone as part of a mold ownership contract.

First, we want to make clear that our client owns the molds, period. The overseas factory (be it in Taiwan, Thailand, Mexico, Spain, Poland, China or wherever)  can use the molds only for producing our client’s product and not for producing product for any other party. Second, we want it clear that when our client chooses to move its production to a different factory, it will have the right to take its molds and transport them to the new manufacturing location. Negotiation of these terms is usually quite difficult since the manufacturer has a strong incentive to hold molds “hostage” to prevent their foreign buyer from moving its manufacturing to a new factory. The only way to succeed is with a stand alone mold ownership agreement or mold ownership provisions inserted into a written manufacturing or product development agreement.

Second, we want to ensure our client owns all of the IP inherent in the molds. In some products, the form embodied in the mold is in fact the entire value of the product. Take for example a complex part used to manufacture  a turbine or a jet engine. After all the engineering and testing is complete, all that remains is a single part produced by casting into one or more molds. In this situation, the molds embody the entire intellectual property in that part and so the party that owns or controls the intellectual property in the molds essentially controls the product. More importantly, if no party owns any IP in the molds, the molds are effectively open source. And if no one owns any IP in the molds or the product, your manufacturer is free to make your product.

As manufacturing overseas has become more complex, molds for products have become correspondingly more complex, as well. In many cases, the mold embodies most or all of the intellectual property in the product. The following two examples highlight this. First, in some products, the interior mechanism is based entirely on open source hardware. The external enclosure surrounding the mechanism is therefore the primary protectable IP for the product. The IP resides entirely in the molds used to manufacture the product case. The”look and feel” of the enclosure then becomes the identity of the product, and if that “look and feel” is not protected, the foreign company that designed the enclosure owns nothing at all in the IP of the product. Without the IP in the molds protected, your overseas factory can freely copy your product.

Mold Fabrication Shops

Factories that engage in contract manufacturing have figured all of this out, making protecting molds difficult. In figuring out what to put into our clients’ contractual mold provisions, our international manufacturing attorneys can no longer focus just on ownership of the molds; we also must focus on ownership of the intellectual property in the molds, as well. The new mold IP issues frequently arise in two settings: (a) third party mold fabrication shops and (b) the outsource factories themselves.

The issues that typically arise with mold fabrication shops arise because of a change in procedure that no one has really noticed. It is standard procedure to provide that the contract manufacturing factory making your product is responsible for fabricating the molds for the product as well. In the old days, the same factory almost always made the molds and the product. However, it has now become more common for the factory to outsource mold fabrication to a third party. In many cases, even the design of the molds is outsourced to that third party.

What this means is that a mold agreement with your factory that has been drafted to control the ownership of the molds and to control the IP in the product is compromised or eliminated when the specifications and the responsibility for fabrication gets sent off to a third party mold manufacturer. Given the economics of mold fabrication, it is not common for your mold fabricator to use your mold design for its own purposes but it is common for them to sell copies of your molds to factories interested in cloning your product.

This type of cloning is of course a thriving business in China and in most other countries known for their contract manufacturing. Foreign designers often wonder how a terrific copy of their product got to market before they themselves have even gone into full scale production. This usually happens because many mold manufacturers conduct a thriving trade in selling the “latest” molds. The factory you use to manufacture your product actually has an incentive to keep the mold for its own use since once it gets out into the world the molds will be used by your factory’s competitors. When this happens, the factory making your product will be damaged in much the same way as you will be.

Though losing one’s molds via a third party mold fabrication shop is an enormous risk, few foreign designers are aware of this risk and even fewer know what needs to go into their contracts to prevent this intentional leakage. The foreign designer rarely even knows the identity of its mold fabricator. They mostly just assume it is the factory that will be making their product. All this leaves a gigantic hole in their IP protection that can and should be closed by using a relatively simple set of contracts.

Consider also the issue of patent protection. To acquire a patent anywhere in the world you must show that you invented the item. In a case where the design of the mold has been outsourced to a third party mold fabrication  shop, who actually invented the item can become unclear. Is it the foreign designer who developed the basic idea? Is it the product factory that did some preliminary drawings? Or is it the mold fabricator that did the detailed drawings and produced the final working model? Or is it all three, each entitled to an uncertain percentage of the patent? Our international litigation attorneys have handled too many cases where this issue was not clear.  With this sort of tripartite structure, the usual answer is that no one owns any IP in the molds: no patents, no trade secrets. This often means no one owns any IP in the product itself either. This then leads to disaster in commercializing the product.

The Factory that Makes Your Products

The fundamental issue with your own factory is the same as with your mold fabrication shop: who will own the IP in the resulting design? For the product, the question is who owns the design for the product. For the molds, the question is who owns the design in the molds. Where the molds are the product, this becomes a core issue that cannot be ignored.

Our international dispute resolution lawyers usually see the following three basic problems after a series of molds has been made for a product that has become commercially successful:

  1. The product manufacturer announces a substantial increase in the price of the product. This is often a surprise to the foreign buyer, who had expected the per unit price of the product to go down as production increased.
  2. The product manufacturer is not able to keep up with increased production requirements. This is often a surprise to the foreign buyer, who had been assured by the manufacturer that it had ample capacity for any scale of orders.
  3. The stress of increased production demand causes the quality level from the manufacturer to decline to unacceptable levels. This is often a surprise to the foreign buyer, who had expected quality to improve over time.

In response to any of the above three issues, the foreign buyer gives notice to its manufacturer that it intends to move production to a different manufacturer. In the past, the issues that arose at this stage mostly focused on ownership of the physical molds, an issue that can usually be resolved with a relatively simple mold ownership agreement. To the extent that a mold ownership agreement resolves the issues, this is old news.

However, in the past few years we have seen  factories make arguments (like those below) that render the situation far more complex:

  1. The factory says: “It is true you paid the fabrication fee for the molds. But that fee only covered the material costs and the time involved. However, in addition to that, we at the factory spent a lot of time and money doing the CAD drawings and related specifications required to fabricate the molds, and we also spent additional engineering time in integrating the molds into our production process. Before you can take the molds, you have to compensate us for those costs. We won’t charge you a markup but you must pay us for our out of pocket costs.” Then the factory provides an unreasonably high invoice for those costs, and if you do not pay it will hold your molds hostage. This has become almost standard practice in outsource manufacturing. It is therefore essential for foreign designers to make clear in a written contract that all amounts it pays for molds include both design and fabrication costs and no additional payments will be required when the foreign buyer seeks to take possession of the molds.
  2. The factory says: “It is true you own the molds and you can take them whenever you want. However, we did all the design work on those molds so we own the design embodied by the molds. We will give you a license to use the molds for production in another factory. However, that license is limited. You have no right to copy the molds. We, on the other hand, have the right to copy the molds and use them for our own production and to sell copies of the molds to third party factories for their own production. The only thing you own is the physical object. You do not own anything else.”
  3. In the more extreme case, the factory says: “We did all the design work for the molds, so we own that design and we already registered a design patent in the molds. Since we did all the work, we are the inventor for patent purposes. It does not matter that you paid us for the molds. We still remain the inventor, and our design patent protects us. You can have the physical molds, but if you want to use those molds for production at a different factory, you must pay us a royalty fee.” This royalty is then quoted at a price so high that you cannot economically have your product produced at a third party facility.

Products Held Hostage 

The more honest factories make the situation clear during the negotiation process. The foreign buyer pays for fabricating the mold, but that payment does not convey any ownership interest in the molds to the foreign buyer. The factory does the design work and the factory owns the molds. The  factory will agree to use the molds only for producing the product for the foreign buyer; however, the foreign buyer has no right to move the molds to any other factory. Some factories will say that you are free to make new molds at your new factory, but some will assert ownership to the mold design and not allow you to have copies made at the new factory. In other words, the factory is clear from the beginning that intends to hold the foreign buyer hostage by guaranteeing it cannot use another manufacturer for its product. With tariffs and duties leading companies to try to  move their production more than ever, our international manufacturing lawyers are getting more calls from companies legally blocked from moving their production, even in the face of crippling price increases. We have many strategies for helping such companies, but none are nearly as good nor nearly as cheap as preventing this problem from occurring in the first place by using good contracts.

Conclusion

The above is where outsource manufacturing is going, and foreign product designers need to deal with it. NOW. The foreign designer needs to ascertain whether its product and/or mold manufacturers will enter into written contracts that provide the foreign designer with the IP protection it needs. And if the manufacturers will not sign such a contract, the foreign designer then must decide whether manufacturing its new and innovative product in a setting where it will be hostage to its factory or whether it can or should try to find another manufacturer. The best move is usually to move on.

What are you seeing out there?

China bank fraud

U.S. companies’ relationships with their Chinese business partners have been strained in the past year, and that has only accelerated the past few months, as we have noted in prior blog posts (see The US-China Trade War: What’s Next?, When Will the US-China Trade War End? It’s the New Normal, and The US-China Trade War: Next Week’s Shanghai Meeting is a Tiny Glimmer of Hope). We expect trade disputes and general business disputes between Chinese and non-Chinese companies to increase significantly over the next many months (and years), and some of those disputes will center on China’s opaque banking system. Bank and wire fraud is endemic to the worldwide electronic banking systems because our increasingly online interactions and troves of data lend themselves to a culture of fraud. This fraud occurs in the U.S., in China, and in most, if not all, countries throughout the world.

Even more than usual we are being asked by foreign companies (mostly American and European) to review Chinese bank records to determine the likelihood that someone or some entity had committed fraud. Companies do not usually ask us to do this sort of review unless they have good reason to believe a fraud has been committed, and nearly every time we do such a review, we find good evidence of fraud. Based on the reviews we have done, we want to provide you with some pointers that may be helpful when reviewing your own Chinese bank records, wire or other transfer receipts, or when you are expecting money to hit your Chinese or U.S. bank account with a payment from China that “definitely should have been here by now.”

First, it is extremely difficult to get copies of Chinese bank records. For bank accounts other than those you or your company own, it is almost impossible to get bank records without initiating a lawsuit in China. If you have been able to get your hands on some records, you are doing pretty well vis-à-vis other foreign companies.

Second, the bank’s location will matter in its ability or willingness to provide records to you. Hong Kong is, as of this blog post, still a semiautonomous city that benefits from a “one China, two systems” (一国两制) economic policy, and barring extraordinary actions by China, it should remain so through for at least the next year.  Many mainland banks have branches in Hong Kong and other major cities like Singapore, London, and New York, so you may be able to acquire bank records from those non-mainland locations.

Third, identify patterns and deviations from those patterns. If you are tracking regular payments, look at the frequency, the payor, the payee, the account numbers, the amounts, and any other category of information that appears with regularity. Do not rely only on the account number or the name of the account holder. Every piece of data should sync up perfectly. As I discussed in my prior blog post (Cryptocurrency in China: A Primer), Chinese individuals and companies have devised many ways to get currency out of China. Those same skills can be used to move money within China or to create the illusion that money has been moved one way when in fact it was cashed out of the account. Ask the banks involved for a copy of their standard transfer receipts so that you can compare the records you have to those standard documents. Banks involved in international wire transfers use standard forms, as well, and if the documents you received do not resemble those standard forms, you will want to dig deeper.

Fourth, trust but verify (because everyone likes easy money). In reviewing your transaction records, assume that at least one actor who handled the chain of money from A to Z had something to gain and acted to their benefit. Research and verify the names and addresses of the companies — in Chinese to ensure they match with the official Chinese company record. Look at the names of individuals and ensure they are consistent and the payments were made to or by the individuals who should be receiving or transferring the funds. See should employees really be getting paid that much? The top 10 Chinese surnames are Wang, Li, Zhang, Liu, Chen, Yang, Huang, Zhao, Wu, and Zhou, and that means there are many individuals with the same, similar-looking, and similar-sounding names. Look at the full Chinese name of the individual (in Chinese) and not whatever is on the English language document. If you see anything amiss, do not assume it is an honest mistake. Flag it in your review and come back to it later.

Fifth, official-looking documents and stamps (seals/chops) can be falsified. Documents that include official-looking (and legally required) stamps and appear to indicate official acceptance of a funds transfer request may show that the request was honored by the bank. Or they may merely show that the “unique” stamp used by the Chinese bank or company was stolen or copied. Chinese companies continue to use these low-tech official stamps, but “official” is not synonymous with “secure.”

Sixth, a request for payment is not proof that a wire transfer or other transfer was made. This point should really be first and last on our list. This is standard fraud: produce a funds transfer request or a deposit or withdrawal slip but do not provide any proof of a successful wire transfer or other deposit or withdrawal. In China as in pretty much every country in the world, it is law and standard banking practice to provide proof of receipt of funds transfer and not merely the proof of request for funds transfer. Each request should be matched exactly by a transfer receipt.

Seventh, look for transactions in cash. Even though China uses cash more than the U.S., deposits or withdrawals of large sums of cash should raise red flags. If the entities and individuals involved generally use cash, then that is less concerning than large cash transactions suddenly appearing where fully electronic payments previously dominated the ledger.

Eighth, look for payments in foreign currencies (non-yuan/RMB) to or from Chinese companies or Chinese nationals. If the payment was supposed to go to a Chinese national or come from a Chinese national, it is highly unusual that the payment would be in a foreign currency. If the company is a Chinese company doing business internationally, it will naturally have one or more foreign currency accounts. But it is very unusual that a Chinese company would use foreign currency to pay its domestic obligations to other Chinese companies or to its Chinese employees.

Ninth, Chinese companies have bank account numbers. Let me explain this obvious point. In reviewing Chinese financial records recently, we often see bank transfer slips that do not include the company’s account number at all – only the company’s social credit number, which can be found in a Chinese company public records search. All other types of records included the bank accounts for the supposed recipients. This gets back to point #3 above about identifying patterns, recognizing what “normal” looks like, and then flagging those transactions that deviate from the standard.

Tenth, look at the whole picture. Any one of the above factors may only cause you to raise an eyebrow. Many of the above factors indicate a high likelihood of fraud, especially if you are the one waiting for funds that were supposedly sent many days or weeks previously but have mysteriously gone missing. If you can get your hands on some records, you should be able to determine whether the transaction records reveal fraud.

Expect that financial fraud will increase in frequency and that reviewing a bundle of transaction records will be integral to cross-border disputes with Chinese companies as the U.S., China, and the global economy continue to bend under the weight of global trade barriers.

international law

This is the fourteenth episode in our ongoing Saturday series on eight+ things to read about China and a lot more. We constantly get emails from readers asking what to read on China and all sorts of things related and even barely related to China and this series is intended to constantly and consistently answer these questions.

As we said in our initial post on this, our plan is to list out eight (or so) articles we benefitted from reading and think you our readers would also benefit from reading, along with a very brief explanation as to why the particular article was included. More specifically:

The articles will likely include many on China and on Asia and a few on international trade, international politics, Spain and Latin America, economics and really just anything else we believe might benefit our readers or even that we just want people to read. We do not plan to choose articles that push our or any other political agenda or any other agenda for that matter, but having said that, we are not objective and our views may creep through. Our goal though is to focus on articles that are important or helpful or — most importantly — that make you think. Our posting of an article will NOT mean we agree with all of it or even any of it. Most of the articles will be from the week preceding the post but we will also sometimes throw in older articles (classics if you will) as well.

Please do not hesitate to comment at the end of this or any other post. We cannot tell you how much we appreciate your comments, good, bad and indifferent.

Here we go, in absolutely no particular order.

1.  Hong Kong critical to China but uncertainty reigns. Deutsche Welle. Is Hong Kong finishedBecause there are so many questions swirling about Hong Kong. Will China send in the troops? as an international business center? And so on and so on…. See also, the BBC’s Hong Kong protests: “We don’t want to leave but may have no choice’ and Atlantic’s Hong Kong Shows the Flaws in China’s Zero-Sum Worldview.

2. Teen goes viral for tweeting from LG smart fridge after mom confiscates all electronics. CBS News.  Because teens are obsessed with social media, but you knew that.

3. Dogfishing: When online daters pose with adorable pets that aren’t theirs. Washington Post. Because who doesn’t love the word dogfishing?

4. American Factory Shows What Happens When One Multibillion Dollar Chinese Company Opens Shop In An Ohio Town. Because it does not pay to believe in economic saviors.

5. Class dismissed: Surge in arrests of foreign teachers in China. Reuters. Because China is no place for English teachers. See also Do NOT Teach English in China. 

6. The rural America death spiral. Axios. Because this is happening. Because America’s the urban-rural divide just keeps growing. Because this is not just a U.S. issue, it is an issue for many (most?) countries.

7. Simone Biles Is First-Ever Woman to Land Triple Double in Competition on Floor. Sports Illustrated. Because only very rarely does an athlete come along and essentially redefine her or his sport by taking it to another level. Because Simone Biles has done that with gymnastics.

8. Which Countries Have the Most Wealth Per Capita. Visual Capitalist. Because the charts are uber-fascinating. Because the United States comes in third if you base it on the mean, but 18th, if you base it on the median — behind countries like Spain, Italy, Ireland, and Taiwan. In other words, the U.S. has plenty of rich people, but also a ton of poor people. Truly stark. Because Wow.

9. Ditch your air conditioning. You’ll be fine. Guardian. Because global warming is real. See also, Salon’s In the future, only the rich will be able to escape the unbearable heat from climate change. In Iraq, it’s already happening.

10. China’s mysterious ‘Bian Kong’ system that can bar anyone from entering or leaving the country. South China Morning Post. Because this may be the future for many countries.

 

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 or phone calls 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 we usually provide a quick general answer and, when it is easy to do so, a link or two to a blog post that provides some additional guidance. We figure we might as well post some of these on here as well, which we generally do on Fridays, like today.

Every day our international manufacturing lawyers see increasing evidence of how China’s role as factory to the world is changing. Most directly, we see it in the emails we get from companies looking to manufacture their products overseas. Three years ago, around 90 percent of those emails mentioned only China. These days, a good 25 percent or so do not mention China at all and of those that do mention China, around a third of those mention China as an option, along with one or more other countries. More subtly, we see it in the increasing number of emails we are getting related to molds and tooling.

How do emails regarding molds and tooling reflect China’s declining manufacturing role? A company that plans to stay with its China factory for the next decade is going to be a lot less concerned with what happens to its molds and tooling than a company that recognizes it might be leaving its China factory for a Thai or Vietnames or Indonesian or Mexican factory within the year. A company that thinks it may be moving its manufacturing to another country relatively soon is going to be concerned about its ability to take its already paid for molds and tooling with them. So yes, we are getting a greatly increased number of questions these days regarding how to protect your molds. The following email exchange are summarizes typical emails our international manufacturing lawyers are getting these days.

Client. Our Chinese and Thai manufacturers have all agreed to sign the NNN Agreements you drafted for us without issue. Thanks for those. One of the Chinese manufacturers has agreed to create samples of the _________ product and we will be paying $2200 to have them make the molds for that. Remember that as soon as the Thai factory is able to increase its capacity (which we expect to happen with the next year) there is a good chance we will be moving all production to there. Do you recommend we have your firm draft an agreement making clear we will own that mold before we pay the Chinese manufacturer any money for it?

Lawyer. It depends. The NNN Agreement you have with  your Chinese manafacturer prevents it from using your molds to compete with you so you do not need a mold agreement for that. So the question then becomes only whether it makes sense for you to have a mold agreement making clear that the mold you will be buying belongs to you. The quick answer is no because our fee for that agreement will end up being way too close to $2200 for it to make economic sense. There is no point in paying X dollars to protect something worth X dollars. But the answer is yes if it would be a complete disaster for you if when you want to move to a new factory the Chinese manufacturer holds onto your molds. Based on what we know about what you are doing and how quickly things are moving for you, I doubt that would be the case, but I feel like I need to at least throw that out there. So almost certainly the answer is no, but if you tell me that you made a typo and the molds are really worth $200,000, then let me know and I’ll scream at you to have us draft something before you pay that kind of money.

For more on how to protect your molds and tooling when manufacturing in China, check out China Mold Ownership/Mold Protection Agreements.

How to get your product through U.S. CustomsIf you are importing products into the United States you need to do your homework to make sure your incoming shipments comply with U.S. Customs laws and regulations. Compliance with U.S. Customs laws and regulations is critical to avoid your shipments being detained or seized, and/or penalties assessed. Common issues importers of products  typically face include the following:

  • Not determining proper classification and duty rate for products. If you plan to import and sell on a Delivered Duty Paid basis, you should consider customs duties in your costs and that means you should know all of your applicable duty rates before you import.  Also certain products are subject to high antidumping or countervailing duties in addition to regular customs duties, which may be as high as 300%.
  • Failing to mark the product with the country of origin of manufacture. Generally goods of foreign origin for import into the U.S. or immediate containers of the goods must be marked legibly and in a conspicuous location with the country of origin in English. Failure to do so accurately can result in civil and even possibly criminal penalties.
  • Not properly marking wood packing material. All wood packing material for products imported into the U.S. must be properly treated and marked prior to shipping. Failure to meet the treatment and marking requirements may cause shipments to be delayed and penalties issued.
  • Failing to provide complete commercial invoices. Customs regulations provide that specific data must be included on the commercial invoice for U.S. Customs purposes, including a detailed description of the merchandise, and correct value information. Omission of this information may result in improper declaration to U.S. Customs at the time of import and expose you to penalties.
  • Failing to meet other U.S. Government agency requirements. Goods imported for sale in the U.S. must satisfy the same legal requirements as those goods manufactured in the United States. U.S. Customs enforces the laws of other agencies in the U.S., including, the Food and Drug Administration, the Consumer Product Safety Commission (CPSC), and the Environmental Protection Agency, in addition to others. Therefore, if toys, for example, are exported to the U.S., detailed CPSC requirements, including for testing, must be met prior to export.
  • Distribution of many trademarked and copyrighted items. Items which are trademarked and copyrighted are restricted by contractual agreements that give exclusive rights to specific companies to distribute the product in the U.S. Imports of improperly trademarked or copyrighted items can be seized at the U.S. border and can subject you as the importer to penalties.

Taking the time to identify the required U.S. Customs laws and regulations for the products to be shipped to the U.S. will help you maintain seamless delivery of your merchandise to U.S. customers and avoid civil and criminal penalty exposure.

China contract damages
  Joost Bakker

This must be China contract damages week. I say that because in cleaning up months of emails I came across three interesting emails on contract damages (similar to  liquidated damages under common law). Before I discuss those three emails, I will explain what contract damages are and why they are so important in just about all China contracts.

Contract damages refers to a contract provision setting out the damages for breach. The typical contract might have a provision saying if Party X breaches this contract, Party Y is entitled to $100,000 in contract damages. Some contracts we write will have more than one contract damages provision. For instance, we might write a distribution agreement that provides for $300,000 in contract damages for a distributor breaching the contract by stealing our client’s IP and another contract damages provision providing for 1% a month in contract damages for late payments.

Contract damages are an amazing and oftentimes essential element of a good China-specific contract.

In the standard commercial contracts, our China lawyers usually include a specific damage amount for certain (but not all) violations of the contract terms. We alway say that coming up with the right amount and the right combination of contract damages is an almost magical combination of experience and art, not a science. We vary the amount of contract damages each time, based on a combination of the amount at stake in the contract, the likely amount of damages if there is a breach, the location of the court in which disputes will be resolved, the moral culpability of the breach, the industry, the financial wherewithal of the Chinese party, the power/prestige of the Chinese company, and sometimes even the country in which our own client is based. The only constant is that we try to make the amount as high as we can, while at the same time erring on the side of keeping it low enough so that it will actually work to scare the Chinese company into not breaching the contract.

Our China lawyers need to ensure that the Chinese judge will not view this provision as a penalty, but rather an honest assessment of what real damages might result from the breach. Perhaps most importantly, this amount needs to be high enough to deter the Chinese counter-party from breaching the contract, yet also low enough so that it will actually sign the contract and so that a Chinese court will enforce it. Chinese courts will often simply invalidate or just ignore a contract damages provision if they deem it to be too high. Far too often foreign companies and their lawyers will put use such a high amount in their contract damages provision that the Chinese company will readily sign the contract, knowing it will never be enforced. They are trying to cover themselves for any potential lost profits they might lose from a breach, but in doing so they shoot themselves in the foot because no Chinese court will enforce it and knowing this, their Chinese company has no fear in breaching.

But done right, contract damages can be a near miraculous thing and our China attorneys love them for the simple reason that they work. Putting the right contract damages provision in your China contract does the following important things:

  1. Increases the likelihood your Chinese counter-party will not breach your contract.
  2. Increases the likelihood you will be able to avoid litigation if your Chinese counter-party breaches your contract.
  3. Increases the likelihood you will prevail quickly in litigation if you do end up needing to sue your Chinese counter-party.

Chinese contract law clearly provides for “contract damages” and Chinese judges tend to like them. Though contract damages are both permitted and encouraged, they cannot be used as a penalty and Chinese courts therefore usually will allow a defendant to argue that the contract damages are too high and the court should therefore ignore them and award a lower amount. The court is then free to accept this argument and award the lower amount.

Amazingly enough, the plaintiff also has the right to argue for an amount higher than the contract damage amount. That means that well-crafted contract damages can be used as a damages floor, but not a ceiling. Though this idea of allowing defendants to argue for less than the amount of contract damages set forth in a contract while also allowing a plaintiff to argue for more does obscure the concept of contract damage amounts, our China lawyers still nearly always include contract damages in the China contracts we draft. We do that for the following three reasons:

  1. We want a specific number for when we contact the breaching party to try to settle and having contract damages gives us a specific damage amount to discuss.
  2. We want a specific number for when we go to the court when suing for a breach of contract. This is particularly important for those situations where the amount of damages is not clear.
  3. Most importantly, we want a specific number to use for a prejudgement attachment of assets. One of the best ways to stop a Chinese company from infringing on your intellectual property rights (IPR) is with prejudgment attachment. But to to get that you need a reasonable standard for the amount of damage that will quickly set the amount to be attached. Contract damages provides that reasonable standard. Chinese companies know how easy it is to attach/seize their assets based on a contract damages provision and they fear this. This in turn makes them far less likely to breach a contract with a well-crafted contract damages provision.

Securing injunctive relief is difficult in China and  have an agreed contract damage amount in cases where the actual amount of damages is difficult/impossible to calculate. In these cases where there is no clear monetary damage (the classic common law injunctive relief situation), PRC courts generally have NOT allowed defendants to argue that no relief should be awarded when there is a contract damages provision.

Now about those three emails. The first was from one of our China manufacturing lawyers to a client regarding the amount of contract damages we had chosen to put into an NNN Agreement. I see this sort of email all the time and it was in response to a client complaining that the amount we had chosen as contract damages were too low:

I do not advise we increase the amount of contract damages we have written into your NNN Agreement. Note that this $350,000 per each event and note that it is intended to represent a fair estimate of your losses from each breaching event. When the amount of contract damages is too high, the Chinese side is unlikely to sign the agreement because it will think you are being unreasonable and or demonstrating your inexperience with how to conduct business in China. Equally importantly, a Chinese Court is unlikely to enforce a much higher amount because it will view it as not having a sufficient relation to the actual damages.
That said, there is nothing “magical” about the $350,000 we chose here for the contract damages amount. We came to this figure using various different factors we ordinarily use for calculating the best amount of contract damages for any specific contract. If you still believe our number is too low, let’s talk more about what your losses are likely to be and see whether we can come to a number we both like.
The second email also was from one of our China IP lawyers to a client involving an IP licensing agreement. In this matter, the Chinese side had stricken our contract damages provision entirely and our client was asking how to respond to that:
As for paragraph 8.2, the sentences they [the Chinese company on the other side of the deal] are seeking to remove are one of the core provisions of this licensing agreement because they provide for contract damages in a specific monetary amount for every act of breach. This sum certain amount (called contract damages) provides the Chinese court with the basis for a prejudgment seizure of the Chinese company’s assets (but it does not limit the court’s power to decide the amount of damages). In short, these sentences give your agreement real teeth and I would not accept the proposed change and would push back hard on this. The Chinese company knows this provision is powerful and will make its breaching your contract more risky to it and for that reason it does not like it. This is somewhat of a red flag regarding the Chinese company’s intentions and so we probably will want to draw a clear line on this issue.

The third email was from me to a company that wanted our China litigation/arbitration team to take its case and the contract damages part of this email went like this:

I also do not like the contract damages provision in your contract. It’s for $25 million dollars on a 2.5 million dollar deal and near as I can tell from what I have read and from what you told me when you spoke, your damages here are well under a 2 million dollars on a really good day and I do not see how anyone could ever have viewed them as being higher than this when the contract was signed. To be blunt with you, I do not even see how you get to $2 million dollars in damages under your analysis and under a U.S. damages analysis I have a hard time getting past $1 million in damages and I am skeptical a Chinese court would see even $750,000 in damages here. Your too-high contract damages provision is going to hobble us from the get-go. It is too high for us to use to try to freeze the Chinese company’s assets so we probably should just forget about that. Even worse, and based on what the Chinese company has told you and on how it is acting, it has zero fear of this happening and in fact, it plans to use this provision to paint you as the horrible exploitive Westerner (the potential client was from the Europe) trying to take advantage of a Chinese company. Not sure how far that will actually get this Chinese company, but it probably will to eat up more time.
So again, I really wish you had used a lawyer who knew what it was doing with Chinese contracts because if you had, you would be in a much better position right now and we might have been interested in taking on this case. But this, coupled with all the other flaws we see in your contract have convinced us that we are not the right law firm for this case. But just to be clear, I am NOT telling you that you have no case and I am NOT telling you not to pursue this case. What I am telling you is that we simply would not feel comfortable taking your money to handle this case nor are we interested in taking it on a contingency fee basis. I therefore urge you to find another attorney/law firm for this litigation and I truly wish both you and your company nothing but the best going forward. This Chinese company did not treat you fairly and I would hate to see it get away with that.
Bottom Line:  Contract damages can be a great thing in a China contract, but only if done right.