China technology IPThe standard story is that the Chinese government has decided to “corner” the world market for electric vehicles. The most expensive and important component for an electric vehicle (“EV”) is the battery pack. So the the logic goes that the first step in this plan is for Chinese companies to dominate production of EV batteries.

The recent Shenzhen stock exchange IPO of Ningde, Fujian based Contemporary Amperex Technology Ltd (CATL) has been seen as a key phase of this process. According to the press reports, CATL raised USD $830 million in its IPO completed on June 10. Though far less than the $2.0 billion CATL had originally planned to raise, this is nonetheless a substantial sum.

CATL plans to use the proceeds from its IPO to buildd new production capacity for 24Gwh of batteries focused on the EV market. CATL plans for its Ningde facility to become the largest EV battery maker in the world, with a final projected capacity of 50 Gwh scheduled to come on line by 2020. This can be compared with the Tesla Nevada Gigafactory 1 which is projected for 34Gwh capacity.

Though this is a considerable achievement for a company located in the isolated country town of Ningde, its significance is not as reported. The real issue here is not the Chinese government’s decision to promote high volume manufacturing of a basic industrial product. The issue is rather with the technology behind the product and the control of that technology. Production within China may become controlled by Chinese owned companies, just the way so many other basic industrial commodities are under such control today. But it is unlikely China will develop new EV technology through indigenous innovation. That is where the real challenge rests.

Consider the basic issues:

  1. CATL’s advantage rests almost entirely on China’s preferential policies. First, the Chinese government is providing substantial subsidies to EVs for domestic transport. Second, the Chinese government has set the rules so that only EVs using product from Chinese battery makers (CATL and BYD) qualify for these subsidies. This is not a market phenomenon, it is simply an artifact of Chinese government subsidies. This means CATL is entirely dependent on the subsidy program. If the subsidies end, the CATL market advantage disappears
  2. Production of EV batteries in China is largely irrelevant to U.S. EV manufacturers. Batteries are heavy and dangerous and so battery manufacturers seek to locate as close to vehicle manufacturers as possible because long distance shipping is not practical. China is currently the largest market in the world for EVs so the big battery manufacturers are moving as much production capacity to China as possible. Panasonic, LG Chem and Samsung are major players that have invested heavily in China production. Even Tesla has announced plans for a battery gigafactory in China. But the key is that the production for those factories is limited to China EVs. Regardless of the capacity built in China, it will have little impact on the market for EV batteries in the United States or in Europe.
  3. What CATL is doing is just old fashioned Chinese industrial policy. It is manufacturing a product that has mostly become a commodity. Its strategy is to make an “adequate” product in high volume, competing almost solely on price. In 2017, CATL reduced its product price by 30%. As it expands production, further price reductions are expected. Usually this policy leads to overproduction and value/market destruction and this could happen in China as CATL and BYD and others engage in a race to the bottom. However, unlike what Chinese industry has done in steel and electronics, this race to the bottom will not have a major impact on world markets because the product cannot be readily exported. The situation is more like that of cement in China: the destructive industrial policy has no impact on the rest of the world because the product cannot be exported.

The real issue here is that CATL is investing huge sums in manufacturing a product with a less than rosy future. CATL makes old generation versions of lithium cobalt oxide batteries. Though lithium is readily available, cobalt is rare and expensive. More importantly, it is well known in the EV world that lithium cobalt batteries do not have the energy density to compete with petroleum based engine systems and other battery types are already being developed to replace lithium cobalt. Though lithium remains a constant, other metals such as manganese, nickel and even iron are being developed as alternatives to cobalt.

Though CATL appears to have a large R&D department, it does not seem to engage in its own cutting edge research related to developing the new generation of EV batteries. R&D for CATL is confined to two areas: a) additional cost cutting and b) assimilating existing battery technology developed outside China. As CATL continues cutting its prices, its ability to do cutting edge research and development will likely be further constrained.

So what’s the real take away here? CATL and other Chinese EV battery makers do not need help on the investment and production side. They have that covered. But they need access to evolving battery technologies to achieve increased energy density, reduced material costs, reduced weight and increased safety. In other words, we should expect them to fall back on another standard Chinese industrial policy strategy: assimilation of foreign developed technology.

What I expect to see in the next decade of electric vehicles in China is an avid interest in foreign technology in all related fields, centering on power supply (batteries/rechargers) and on vehicle technology. Chinese companies will use all the standard techniques that we have discussed on this blog to try to acquire foreign technologies that are already rampant in the auto tech and other high tech industries: The question is not so much what the Chinese companies will attempt to achieve; the question is whether foreign developers of these critical technologies will give them away or demand adequate compensation.

For more on the “giving away” intellectual property to China versus getting adequately compensated for it, check out the following:

And for more on China IP issues directly related to the automative industry, check out China IP Challenges for Automotive Suppliers.

China WFOEOur China lawyers are constantly helping foreign companies set up companies in China — usually wholly foreign owned enterprises or WFOEs. When a client’s WFOE is approved or a freshly minted WFOE gets in touch with us requesting guidance on China’s employment law, we usually send out the following WFOE Employment Letter:

Now that your WFOE is up and running, our China employment lawyers will assist you in making sure your WFOE is protected on the employment front. Towards that end, the first thing we will do is provide you with employee agreements for your use with all your China employees as part of what we call our Initial Employment Package, which consists of the following for each employee:

  1. An Employment Contract;
  2. A set of Employer Rules and Regulations;
  3. A Trade Secrecy and IP Protection Agreement; and
  4. A Sign Off Agreement (acknowledging each employee’s receipt of the Employer Rules and Regulations).

Having the above for your employees is crucial to operating as a WFOE in China with employees. In addition to the above mandatory documents, we also draft the following optional agreements for eligible employees:

  1. Non-compete Agreement; and/or
  2. Education/training Reimbursement Agreement.

During the process of drafting the Initial Employment Package, we will also work with you on any additional employee-related procedures you might need in China. For example, a common employment law issue we see with new WFOEs (and sometimes established WFOEs as well) is related to employees who work under an alternate working hours system such as the Flexible Working Hours system. In most locales, an employee cannot be designated to work under such a system until its employer has obtained government approval for the WFOE, which usually requires we work closely with the local labor authorities.

After you approve the employment documents we create for you, we will let you know what you need to do to maintain those documents. Ideally, the WFOE’s legal representative would sign all employment documents with WFOE employees, and the second-best option would be for the WFOE’s general manager to sign.

It is important the WFOE affix its official chop on all relevant employment documents. Besides stamping the company seal on the documents, you can also fan out the pages and stamp your company seal across all pages to make them look even more formal.

You should also make sure all your employees sign and date the documents appropriately. It is best to have both parties (the WFOE and each employee) execute the documents on the same day, before or on the employee’s first day at the WFOE.

You should provide one copy of the fully executed employment documents to each employee for their own records and you should hold onto at least one original copy of each fully executed document. Most places in China require you retain the employment contract for a minimum of two years after an employee’s departure, but we generally advise you hold onto the originals of all employee-related documents for as long as possible.

Please let us know right away if you encounter any issues in the signing process.

We recommend you check in with us as around one year from now for an assessment of your China employee situation. This quick audit normally involves our reviewing your employment-related documents, checking for any possible non-compliance against all national and local employer laws, speaking with your HR people and/or management regarding any imminent or potential employee problems (this includes you thinking about terminating an employee) and resolving any employment matters. Spotting employee issues and taking appropriate actions early can significantly reduce your headaches and costs. China’s employee termination laws are extremely strict and your costs to make sure an employee termination is handled correctly will be considerably less than your costs to defend against a wrongful termination lawsuit.

We also recommend a subsequent employer audit about three years from now. Among other things, because most WFOE employees start with a three-year employment term it is advisable to spend some time considering whether to extend the employee’s contract before the initial employment term is up. Because terminating a China employee is generally so difficult, you want to be sure not to retain an employee for a second employment term unless you are certain you wish to continue employing that person. Failing to properly terminate (or otherwise renew) an employee before his or her initial term has expired may convert that employee to a lifetime employee who you must retain until he or she reaches the mandatory retirement age. If you use a shorter initial employment term for an employee, we suggest you come to us at least one month before that employee’s employment term expires.

China’s employment laws are complicated and localized and they can change quickly. You should therefore have your employment situation checked regularly to confirm you remain in compliance with all applicable employment laws. I mention the hyper local nature of employment laws because it is not uncommon for companies to get into trouble when they hire employees in a new locale in China without effective employee documents for that specific locale.

Please do not hesitate to contact us should you have any questions or concerns now or along the way.

China film quotasSince 1994, China has had a quota on the number of foreign films that could be shown in Chinese theaters on a revenue sharing basis (i.e., with the Chinese distributor remitting some percentage of the revenues to the foreign film’s producer). The quota started at 10 per year in 1994, was increased to 20 films per year in 2002, and then was increased again to 34 films per year in 2012 with the proviso that at least 14 of the films be in either 3D or IMAX format.

The exact revenue sharing model has varied, but the current rule, as outlined in the 2012 US and China Memorandum of Understanding (which was a settlement after the US had prevailed in a WTO complaint), allows the foreign film producer to keep 25% of all domestic revenues, without any withholdings or deduction. That percentage has been more aspirational than actualized; money from China is often both too little and too late.

Hollywood has been negotiating a new deal with China for more than a year (the 2012 memorandum expired in 2017), in hopes of raising the quota, increasing the percentage on revenue shares, and gaining more control (or at least transparency) with respect to distribution logistics such as release schedules and blackout dates. But the on-again, off-again US-China trade war has thrown those negotiations for a loop and effectively given China the ability to take whatever position it likes, from slapping a huge tariff on all US films to conceding on all of Hollywood’s deal points. But China is in no hurry to agree to anything. Why should it be? They’re fine with the status quo.

Meanwhile, an alternative to the quota import system has emerged that may render the whole discussion moot. For years, in parallel with the quota-based foreign films, China has also allowed the importation of “buyout” foreign films: films bought for a flat amount, with no required profit sharing. But in recent years, as the Chinese box office has become ever more profitable, the competition for buyout films has gotten increasingly fierce, with many distributors offering better terms, i.e., profit sharing. The most famous example of profit sharing on a buyout film came in January 2017 with Resident Evil: The Final Chapter, which became a smash hit in China to the surprise of all parties involved. Once the film passed RMB 500 million in domestic revenue (which happened on opening weekend), the film producer started getting a piece of the revenue.

As Resident Evil goes, so goes the world. Indeed, strict buyout films are now more the exception than the rule, and the revenue-sharing provisions are getting better and better. The US negotiators must be wondering why they are spending so much time negotiating an agreement for terms that are not appreciably better than what foreign filmmakers are already getting on the open market.

Except it’s not really an open market; China’s theatrical distribution system is dominated by two huge players, China Film Co. and Huaxia, both of which are state-owned. Even the buyout films have to go through those distributors to play in theaters, because foreign companies are legally prohibited from distributing films in China. If there is a convergence between the revenue-sharing terms of buyout films and quota films, it’s only because the Chinese authorities want that to happen (or at least are allowing it to happen).

It’s anyone’s guess how long buyout films will be allowed in on similar terms as the quota films or what the Chinese authorities really think about buyout films. Maybe they’re letting all of this play out to see what happens. Maybe they’re just roiling the waters between the MPAA (which represents the Hollywood studios, who provide most all of the quota films) and the IFTA (which represents non-studio producers, who provide many of the non-quota films). Either way, if you’re an independent producer, it’s a good time to be selling to China.

United States tariff exception
Happier times….

Well, that escalated quickly!

The U.S.-China trade war is back on.

President Trump last week announced that the U.S. will impose 25% tariffs on about $50 billion worth of Chinese imports, ostensibly to punish China for its “systematic theft” of U.S. intellectual property and/or to reduce America’s trade deficit with China. China immediately fired back by announcing it would  impose 25% tariffs on about $50 billion worth of U.S exports to China in two stages.

Here are the two lists of Chinese products the U.S. has targeted, primarily machinery and industrial parts from industries such as aerospace, robotics, automotive, industrial machinery, and information and communications technology. These 1,102 product lines theoretically benefit from the Chinese government’s “Made In China 2025” industrial plan to become a global leader in certain new and advanced technology industries.

China also issued two lists targeting U.S. products ranging from salmon to soybeans, Harley Davidsons to electric cars, orange juice to whiskey. China’s first list targets 545 product categories covering about $34 billion in U.S. exports to China and its second list targets another 114 product categories covering about $16 billion. Many of the U.S. products selected for extra tariffs are from Trump-voting red states that have benefitted from huge volumes of agricultural exports to China.

July 6 is currently the deadline for when China and the U.S. will start imposing the proposed tariffs on the first list of imported products. Given President Trump’s track record of flip-flopping on China trade issues, it is not entirely clear whether these tariffs on Chinese imports will actually be imposed.

So, what can and should U.S. companies do if they are caught in the cross-fire of this escalating trade war, either because they import goods from China that will be subject to U.S. tariffs or because they exporting U.S. goods to China that will be subject to Chinese tariffs?

For the U.S. tariffs, U.S. companies likely will be able to request that specific products be excluded from the tariffs on Chinese products. This process likely will be similar to the exclusion request process used for the recently imposed “national security” tariffs on steel (25% tariffs) and aluminum (10% tariffs). In the past few months, the U.S. Department of Commerce has been flooded with nearly 20,000 requests to have products excluded from these tariffs. Separate requests must be submitted for each product a company wants excluded.

An exclusion request typically includes the following:

  1. Identify the product you want excluded. The U.S. list of targeted products is identified by the Harmonized Tariff Schedule (HTS) number that is used to declare the product when imported into the United States. A company needs to identify the commercial name of the product, the HTS number for the product, and any other industry designation of the product under a recognized standard or certification (for example: ASTM, DIN).
  2. A description of the product based on physical characteristics (for example: chemical composition, metallurgical properties, dimensions) so your product can be distinguished from other products that would still be covered by the tariffs. A significant concern in considering exclusion requests is whether granting a specific exclusion request will create a loophole many other products can also use.
  3. The basis for requesting an exclusion. Is the steel/aluminum/other product unavailable from a domestic U.S. supplier and thus imports are needed to fill a demand no U.S. supplier can fill. Are there certain qualification requirements only the import supplier can satisfy? Have you been put on allocation by domestic suppliers?
  4. The names and locations of any producers of the product in the United States and in foreign countries.
  5. Total U.S. consumption of the product by quantity and value for each year for the past three to five years (2013 – 2017) and projected annual consumption for the next few years (2018- 2020), with an explanation of the basis for the projection.
  6. Total U.S. production of the product (or possible substitutes) for each of the past three to five years.
  7. Discussion of why the U.S. products (or substitute products) cannot be used in place of the imported products.
  8. A good story why your company deserves the exclusion it is requesting. This typically includes the history of your company (e.g., fifth generation family-owned), the products produced by your company, the strategic significance of your company’s products, the number of workers in your company, and your company’s annual sales.

On the Chinese side, U.S companies exporting to China likely will have a similar process to try to get a special waiver to get their products excluded from the Chinese tariffs listed U.S. imports into China. The Chinese exclusion process will likely not be as formalized as the U.S. process but it likely will require a Chinese company to submit the exclusion request and to provide the above listed items to explain why the U.S. products deserve to be exempted from the tariffs.

A U.S. exclusion process will likely proceed fairly slowly because there are so many exclusion requests already in the pipeline for the steel and aluminum tariffs, though a successful exclusion request likely will result in a refund of any tariffs paid. Waiting for a tariff refund is not the best thing in the world, but requesting such a refund will be the best path for many.

 

International Trade Lawyers False Claims Act
The False Claims Act can be radioactive

I and the other international trade lawyers at my firm will sometimes get asked by US importers about their obligations to make sure that the product they get from overseas truly comes from the country listed on the shipping documents. The short answer is that US importers are required to make sure the products they import are truly from the country listed on the import documents and a failure to fulfill this duty can lead to jail time, especially under the Trump administration.

The examples below are illustrative.

  • A US importer receives an e-mail from a Chinese chemical producer/exporter seeking to get the American company to buy the Chinese company’s chemical products, which are covered by a US antidumping (“AD”) order. The Chinese producer tells the US importer not to worry about the AD duties because the Chinese company will ship the product through Taiwan and list them as Taiwan products. The importer should decline this offer because if it imports this product knowing it is from China and not Taiwan, it will be criminally liable under U.S. customs law and subject to potentially massive damages under the U.S. False Claims Act. 
  • A US importer suspects its Vietnamese “producer” is not actually making anything, but rather simply transshipping product that comes from the Chinese company that owns it. The company visits the Vietnam facility and it does not appear anything is actually being produced there. The US importer then decides to be the consignee of the products and not the importer of record because US antidumping laws make the importer of record liable for AD duties and not the consignee. The Vietnamese government later closes down the Vietnamese facility for transshipping Chinese products and that leads the US government to prosecute the US consignee company for conspiracy to defraud the US government to avoid AD duties. The owner of the US consignee company is found guilty and sent to prison.

Transshipment is a crime and Chinese companies and their US importers can have very different interests when it comes to importing product into the United States. The Chinese company wants to ship product to the US above all else and the US importer should above all else want to avoid Customs trouble and avoid liability and stay out of jail.

The US government is very serious about hunting down and prosecuting those who transship and, not surprisingly, the Trump Administration has made known its desire to vigorously transshipment claims.

What few realize is that there is a way for companies and individuals to profit from the transshipping of others. Title 31 of the United States Code, Section 3729 (G) (commonly known as the False Claims Act) provides that any person or company that “knowingly makes, uses, or causes to be made or used, a false record or statement material to an obligation to pay or transmit money or property to the Government, or knowingly conceals or knowingly and improperly avoids or decreases an obligation to pay or transmit money or property to the Government” faces triple damages and an $11,000 penalty per claim.

Now here is where it gets interesting and where any of you readers can profit. Section 3730 of the False Claims Act provides a private right of action that allows anyone to sue on behalf of the US government for anyone else’s violation of section 3729. This private party merely need file a complaint and written disclosure of material evidence and information under seal in the Federal District Court to show that certain US importers and foreign producers/exporters committed fraud on the US government by transshipping products covered by antidumping and other trade orders so as to avoid the duties. This complaint and the evidence supporting the complaint are not served on the defendants. They are instead served on the US government, which has 60 days to decide whether or not to intervene in the case.

If the government decides to intervene and prosecute the action, the private party is entitled to 15 to 25 percent of any recovery.  If the government decides not to prosecute the case and the private party goes forward, the private party is entitled to 25 to 30 percent of any recovery.

The remedy in a False Claims Act case is triple damages and in many AD and countervailing duty (“CVD”) cases, especially against China, the missing AD or CVD duties can be well over 100 to 300% on imports over the last 5 to 6 years. By way of example, if total annual imports from the transshipment country are over $15 million, the total damages could be close to $200 million, with the party that spurred on the claim getting 30 to 40 million dollars of the government’s recovery.

If you are doing business with a person or company using transshipments to minimize US customs duties, you could be in very big trouble and you should contact a lawyer immediately. If you are aware of such transshipments by a company with which you are not doing business, you should consider contacting a lawyer to determine whether you might profit from your information.

China employment lawyerHardly a day goes by without one of our China employment lawyers getting an email or a phone call asking whether we can help them with such and such employment law matter with their existing or (usually) their ex-employer. Many times they will briefly describe their situation and conclude their email with something like, “do I have a case.”  Our employment attorneys nearly always respond with something like the following:

We do not know and for us to know we would first need to run a conflict check to make sure we do not represent your employer. Most importantly, we also will need to review your employment contract and we probably will also need to briefly research China’s national employment laws and the local employment laws in your area as well.

And guess what? Much of the time when we do review these contracts they are just terrible for the expat employee. Like really really terrible. We then have to tell the expat that there is little to nothing we can do beyond trying to make their transition to any new job as smooth as possible.

Even though we are pretty certain we know what their answer will be before we ask it, we then ask whether any attorney reviewed their employment contract for them before they signed it. We ask this NOT to emphasize the need to use a China employment lawyer before signing a China employment contract, but on the off chance that their contract was actually reviewed by a lawyer who might be willing to pay the employee some money for having done such a poor job on the contract. So far, no such luck as the response has always been either “no” or “no, it just never occurred to me that might be necessary” or “there was no point because it was just a form contract anyway.” Ugh.

If you are an expat working in China or seeking a job in China or even just renewing your contract with your current employer and it is for a substantial job with a substantial salary, you should have an experienced China employment lawyer review your China employment contract before you sign it. This is especially true if you will be working for a Chinese domestic company. This is also true even if you are given a “form” contract. Many companies use some sort of template or form document for their employees but this does not in any way mean you should not have a qualified lawyer review what you will be signing. Just because the employer uses a template does not mean you will be protected nor does it mean you cannot or should not negotiate the changes you need in it.

In fact, the window after you are offered the job and before you sign the employment contract to take the job is usually the best time to go “back and forth” with your employer to make sure the terms and conditions in your proposed employment contract are as favorable to you as possible. Once you sign your employment contract and begin working, that window has closed and your employer has very little incentive to revise or add anything to your contract.

Your proposed employment contract should be reviewed to make sure it protects you and includes everything you need or want to be included. To the extent there are ambiguous terms, take the time to seek clarification. And make sure that what you have been promised orally or in some other writing that is not in your employment contract goes in your employment contract. Do not be pressured into signing an employment contract by an arbitrary deadline. If they want you on their team, they can and they will wait a couple of extra days for you to get your employment contract right.

Even on those provisions you cannot change, a good attorney review will give you actionable information for the future. What provisions in your employment contract are illegal and therefore not enforceable against you? What provisions are unfavorable or unfair to you? What matters important to you are missing? Answers to questions like these will give you clarity and help you decide whether to take the job or not. They also will let you know what you can and cannot do if you do take the job.

But in our experience, employers are nearly always willing to make concessions to get the expat on board as an employee. Employers are often reluctant to make changes to their form contracts but far more willing to add things to it. For example, if a bonus is created just for your position, you should make sure this bonus is mentioned in your employment contract and that it specifies how much and when and under what conditions you will receive it. Far too often expats are offered a guaranteed bonus that is not mentioned anywhere in their contract.

On a related note, “yin-yang” contracts are never a good idea for either the employer or the employee. These are contracts where the employer offers the expat an employment contract the expat knows is a fake. The real deal between the employer and the expat employee is in a different document or not in writing at all. These yin-yang contracts are illegal and usually done to skirt taxes and they pretty much invariably lead to trouble. Just don’t do it.

Bottom Line: Expats looking to work in China should have their employment contracts reviewed by a China employment lawyer before they sign it, not after. This is way cheaper and way better in the long run. Trust us on this.

 

 

China high techWell yeah.

I mean this title does sound pretty obvious doesn’t it?

But this was definitely not always the case. Way back in early  2006, I can remember tentatively writing a post with the same title as this one — China is Booming: Go There for Growth and getting emails and calls from people saying that China would never be more than a low cost manufacturing center and from reporters all but demanding what information I had to support my bold claim.

And I can remember not having much hard information at all. For at that time, pretty much all of the work my firm’s China lawyers were doing was for companies doing business with China for its low costs. Few believed anyone other than a Coca Cola or a McDonalds could profit from China and it was believed that profits for even the largest companies would take years if not decades to realize.

Fast forward to today where our legal work is roughly evenly divided into the following thirds:

1.  Helping foreign companies with the legal issues that stem from China manufacturing. And even the legal side of that has changed dramatically. See China Manufacturing: Cha-Cha-Changing….

2. Helping foreign companies profit from doing business in China. That still involves a lot of WFOE formations and Joint Venture, but starting only a few years ago, it now involves at least as many licensing and distribution and e-commerce deals.

3. Helping foreign and Chinese companies navigate deals in foreign countries.

And in all three areas, our work increasingly involves the highest of high tech: biotechnology, autonomous driving, fintech, artificial intelligence, blockchain, cryptocurrencies, battery tech, and the Internet of Things, none of which were on most people’s radar back in 2006. Heck, back then, viewing China as anything more than a cheap place to make socks or rubber duckies was truly not all that common.

Things change and things have changed. What are you seeing out there?

China joint venture schemesThis is part 3 in our series of posts detailing the current methods Chinese companies use to get a “free look” at the intellectual property and trade secrets of foreign companies. In part 1 of this series, we looked at how Chinese companies use their purported interest in investing into a foreign company to convince the foreign company to give the Chinese company access to the foreign company’s IP. In part 2, we explained how Chinese companies use Memoranda of Understanding (MOUs) to get free looks at foreign technology. And in this part 3, we explain how Chinese companies use Joint Ventures (real, fake and non-existent) to get at foreign technology without paying for it.

Chinese companies dangle the formation of a joint venture as a means to view (and then use) foreign company intellectual property. Just to be clear, I am not saying all China joint venture proposals are made solely to get a free look at foreign technology. As dubious as our China lawyers are about most (but not all) China joint ventures, plenty of them are legitimately proposed and formed. Here I am not so much talking about real joint ventures as I am about proposing a joint venture with no real intent to form one and doing that to get at your IP.

The Chinese side wanting a free look at your IP will normally propose forming a joint venture in China for developing and marketing a product. In these cases, however, even if a well formed Chinese joint venture would be commercially reasonable, this is not the case when a free look joint venture scheme is being employed. Normally, the type of joint venture proposed by the Chinese side is not permissible or practical under Chinese law and business conditions. In these situations, it is normally best to accomplish the commercial objectives of the U.S. side through a well drafted license agreement rather than by creating a JV company.

As a quick aside, if you want to learn more about China joint ventures, I suggest you read China Joint Ventures: The 101 and China Joint Ventures: Testing the Dream.

The basic issues related to Chinese companies using a Chinese joint venture to garner a free look at your IP are as follows:

1. Forming a JV means forming a separate legal entity pursuant to the PRC Sino-Foreign Joint Venture law. This means establishing a separate company with a separate address, separate facilities and separate officers, directors and employees. It is rare that the Chinese side really intends to do this.

2. When the entity is formed, the stock must be issued to both investors. All of the stock must be issued to the foreign side on the date the JV entity is formed; here can be no waiting for issuance of the stock. Issuance of the stock cannot be triggered by some event such as authentication of the technology or government approvals.

3. The Chinese side normally will offer the foreign company share ownership in the Joint Venture in exchange for the foreign company licensing the foreign technology to the joint venture and for general cooperation in the future. The Chinese side does not require the foreign side to contribute cash or to contribute the technology to the JV company. The proposal is that the U.S. side will get “something for nothing.” It will get ownership in the China Joint Venture without having to pay anything for it, beyond licensing its technology to the Joint Venture and getting licensing fees for that. Of course, no successful business gives something for nothing. In China, however, this would also not be legally permissible.

China does not allow “sweat equity” or equity issued based on some separate benefit conferred on the Chinese entity (say, preferred investment in a foreign company). Stock must be issued for cash or for a hard asset like equipment. A license to technology does not qualify as equity in a China joint venture. For technology, the investment only counts if the technology is formally contributed to the JV entity as an asset. Since a license is revokable, a license is not treated as an asset under China Joint Venture law. Even where technology is contributed as an asset, the value of the technology must be independently appraised and normally the contribution of IP by the U.S. side is limited to a maximum of 15% of the foreign company’s total investment in the Joint Venture.

This means the Chinese company that is offering the above “something for nothing” terms is doing so as a ploy to convince the foreign side to drop its guard and reveal confidential technical and business information. The argument by the Chinese side to facilitate this intellectual property look-see is: “We will be partners soon, so why hide anything from us.” But since the terms of the JV are not legally permissible you really won’t be partners soon and the result of this ruse is either that the JV never forms and the Chinese side blames this on the government (always beware of force majeure clauses in Chinese contracts) or the JV is legally formed but never actually does any business.

4. It takes at least three months to form a JV company and it often takes six months or more. Forming a Joint Venture in China is expensive and time consuming and this timing and expense should be taken into account in the business plan. And as noted above, it is entirely possible the Chinese government will not approve the formation of your JV company, especially if — as described above — the equity structure is not allowed. Often, however, the Chinese side will draw the joint venture formation process out for a year or more. During this entire period, the Chinese side is working to extract confidential information from the foreign side. One standard trick at this stage is for the Chinese side to say that it is bringing other “big player” investors into the JV company and these new investors are skeptical and need to see proof of the technology before they will invest. Of course, these big players will assist in taking the JV public in China, resulting in a major returns for the foreign side. So in a case where the foreign side is not required even to pay for its shares in the JV, this becomes “something for nothing” squared. Like all good con games, this one too plays on greed.

5. If the Chinese side scheme involves actually forming a Joint Venture, rest assured that you will own less than 51% of it. And with your less than 51% JV ownership, you will have no control over the JV and no meaningful rights of any kind. Many (most?) foreign investors believe that their ownership in a Chinese JV entity will allow them to exercise at least some control over the operations of the entity, but exactly the opposite is true. China has no effective minority shareholder protections. The management of the JV will simply ignore the “rights” of any minority investor, including the “rights” of the foreign investor. So, in the end, the foreign investor in a Chinese JV has less power and control than a foreign party that simply licenses its technology to the Chinese side.

6. Nearly all commercial reasons for doing a JV in a technology development and sale project can be duplicated with more certainty via licensing. For example, a license can be drafted where the JV entity pays a royalty that provides exactly the same economic benefit as a percentage ownership in the JV entity. If the foreign side truly believes in the prospect of a PRC IPO (even though these are incredibly rare), the license agreement can be drafted to provide for the Chinese company licensee to pay a royalty in the event of a sale of the Chinese entity that will provide the exact same financial return to the foreign licensor that it would have gotten had it had an equity interest in the Chinese entity. For more on China technology licensing agreements, check out China Technology and Trademark Licensing Agreements: The Extreme BasicsChina Technology Licensing Agreements: The Questions We Ask, and China Licensing Agreements – Look Before You Leap,

7. The control benefits of a license can be considerable. As noted above, if the foreign entity is a less than 51% owner in a JV company, the foreign entity basically has no remedy at all if the Chinese side does not perform. There may be remedies on paper, but Chinese company law is defective in this area and minority shareholders pretty much have no effective rights. On the other hand, a well-drafted license gives the licensor very powerful rights. If the Chinese side does not perform, the licensor can both terminate the license and sue the Chinese side for damages. This is exactly why Chinese entities prefer the JV approach and why they avoid licenses.

Bottom Line: In considering cooperation with a Chinese company, a standard technology transfer agreement/license is nearly always better than forming a PRC joint venture entity.

China business basics

Every so often, one of our China lawyers will get an email from a blog reader asking for a recommendation of THE book to read to “better understand China” or “to get a better handle on China.” These requests often come 2-3 weeks before the person is heading off to China for the first time and they oftentimes mention wanting something that will give them a quick overview.

Amazingly enough, there are a plenty of really good, really short books that qualify, including the following three:

  1. Modern China: A Very Short Introduction,  By Rana Mitter. 168 pages. 2016. Oxford Univeristy Press. Mitter is a Professor of the History and Politics of Modern China and Director of the University China Centre at the University of Oxford, authored this book and it is an excellent short history on China. It does a great job of conveying an overall sense of China in an amazingly short time.
  2. The One Hour China Book (2017 Edition): Two Peking University Professors Explain All of China Business in Six Short Stories.  By Jeffrey Towson and Jonathan Woetzel. 152 pages. 2014. This book truly does take about an hour and in that time you will gain a pretty respectable sense of what is going on business-wise in China.
  3. China in the 21st Century: What Everyone Needs to Know. 192 pages. Jeffrey N. Wasserstrom and Maura Cunningham. Wasserstrom is a Professor of History at the University of California, Irvine and the Editor of the Journal of Asian Studies. Cunningham is the Diigital Media Manager of the Association for Asian Studies. This book is meant to be basic and it is, but it is a good a first book as can be found and it is not in any way simplistic.

Any (and all) of these three books would make for excellent reading on an airplane flight for those heading to China for the first time. The One Hour China Book is best if you are going to China for business, but it would be good to supplement that book with one or both of the other two. If you are going to China as a tourist or to teach English or to study, I recommend reading both Modern China and China in the 21st Century.

Any others?

China movie contracts
Photo by George Baird

Over the past couple weeks, the Chinese Internet has been abuzz with chatter about how Chinese movie stars allegedly underreport income via a dual-contract system in which only one contract is disclosed to the tax authorities.

The ruckus started when television personality Cui Yongyuan uploaded a redacted actor employment contract apparently for Chinese A-list actress Fan Bingbing’s work on the upcoming Bruce Willis film Unbreakable Spirit. (Initial reports stated, incorrectly, that the contract was for Fan’s work on the upcoming Feng Xiaogang film Cell Phone 2.)

Cui complained that Fan was massively overpaid – nearly $1.6M for only four days’ work – and her contract was bad for the Chinese film industry. The contract also detailed some of Fan’s allegedly egocentric contractual demands: screenplay rewrites, her own hairstylist and voice artist, luxury car service, a $200+ daily food allowance, and a requirement that the studio also hire her personal makeup artist at more than $12,000/month. Here in the United States, The Smoking Gun and other websites have posted so many celebrity contracts that we are inured to such terms, but Chinese netizens went berserk. Some penned impassioned defenses of Fan; others bemoaned the country’s skewed priorities.

Cui was just getting started. The next day he published a second redacted contract, this one for $7.8M, and intimated that the two contracts were so-called “yin-yang contracts” for Fan Bingbing: a form of tax evasion under which the smaller contract is reported to the tax authorities as income, and the other is unreported and therefore tax-free income.

At this point the Chinese tax authorities got involved and announced they would be investigating various Chinese film companies and also Fan Bingbing’s own production company. Shares in most of China’s major film companies promptly took a dive, presumably on the assumption that accounting flim-flam was rampant.

Meanwhile, the supposed evidence of Fan’s financial misdeeds unraveled nearly from the beginning. Cui conceded that the second contract had no connection to Fan Bingbing and in fact he had no evidence of any tax evasion on her part. Fan has vehemently denied the allegations of a second contract, and has threatened to sue Cui for damage to her reputation. It’s enough to make your head spin.

Actor compensation is an increasingly touchy subject in China, as the government more control over the film industry while also wanting to exert “soft power” through its cultural exports. With the possible exception of Olympic champions, movie stars probably represent China’s most bankable and least controversial form of soft power. But if the stars shine too brightly (or get paid too much), then the optics start to look bad, especially internally. For this reason, last fall the China Alliance of Radio Film and Television passed guidelines (almost certainly at the behest of the Chinese government) seeking to limit actors’ pay in two ways: capping acting fees at 40% of a project’s budget, and capping any one actor’s fee at 70% of the casting budget.

At this point the only thing that seems (relatively) clear is that Fan Bingbing received $1.6M for four days’ work on Unbreakable Spirit. But let’s imagine for a moment that Fan did receive a separate, larger payment via a second contract. There’s no proof this occurred, but even if it did there’s nothing illegal about it, unless the recipient never reported it. Indeed, all of the criticisms leveled against Fan thus far are similarly uncompelling. Consider:

  1. Fan is being paid too much for her acting services. It’s not difficult to muster a convincing argument that as a policy matter celebrities should not be paid more than, say, teachers or scientists. But the producers of Unbreakable Spirit are the ones who have to pay Fan, not the public, and they have obviously made the calculation that Fan is worth it. She is one of the most popular actresses in China, and they’re not running a charity. Why shouldn’t Fan get as much money as possible for her role? Fame (and the attendant paychecks) can be fleeting, and it’s hard to begrudge anyone who demands to be paid what the market says they’re worth. Especially a female actor, in this age of #metoo. If Unbreakable Spirit were an American film no one would think twice about Fan’s compensation.
  2. The contract is with Fan’s company, not her personally. The vast majority of actors in Hollywood are hired through their own companies, usually LLCs called loanout companies. The main reasons for this are to limit liability and to gain preferential tax treatment. The situation in China is similar. Nothing illegal about it.
  3. Fan (might have) signed two contracts for the same film. Fan has her own production company and it’s quite common for big stars to work as actual or de facto producers on a film. That is: they use their fame, connections, and/or money to help get the film financed, made, and distributed. If someone not  an actor did that, they’d be paid as a producer. Nothing illegal or even unusual about having a second contract for different services.
  4. If she signed two contracts, Fan was paid much more for producing than for acting. Actors take lower fees all the time for various reasons. Maybe they love the movie and take less just to get the movie made. Maybe they believe in the movie and will take less upfront for a piece of the profits (or even revenues, as pioneered by Jack Nicholson in 1989’s Batman). Maybe they’re also directing and producing the film and effectively want to invest their sweat equity in the film. It’s also possible Chinese filmmakers may also be trying to avoid the 2017 rule limiting actor compensation. Such a workaround is arguably a gray area but seems difficult to police, especially with talent that legitimately provides more than just acting services. Who should decide the actual value of their acting services?
  5. Fan’s contract requests are outrageous. By Hollywood standards, Fan’s requests for Unbreakable Spirit are neither outrageous nor particularly diva-like; I’ve received bigger, less rational asks from actors who are much less famous. It’s almost expected for an actor (or their agent) to push the envelope and see how much they can get, not least because it establishes a benchmark for the actor’s next picture. And sometimes a seemingly outrageous request has a legitimate purpose, as most famously embodied by Van Halen’s prohibition of brown M&Ms.

Even if Fan Bingbing hasn’t done a single thing wrong (which is very possible), it wouldn’t be surprising to learn that tax evasion is rampant in the film business. Tax evasion is like a national sport in China. Mainland factories regularly misreport income by having payments go to a Hong Kong or Taiwanese holding company. So-called “independent contractors” in China rarely report their income because they and their foreign employer are both operating illegally. And the billion-dollar daigou business is profitable largely through tax and customs fraud.

But if Chinese celebrities are committing tax evasion through two contracts, it’s because they’re not reporting income, not because there’s anything wrong with the two-contract model.