China employment lawyersThe issues related to China employee probation are usually more complicated than they first appear and though many of our employer clients and potential clients are telling us “we get it now,” our China employer audits consistently find the opposite to be true.

Let’s consider a hypothetical based on an amalgamation of some document-based HR audits we performed for China employers. Employer and Employee enter into an employment contract that does not specify either a probation period nor a term of employment. The contract provides for a monthly base salary amount. For the first six months of employment, Employer pays Employee an amount less than the base salary amount specified in the contract. Employee later resigns and brings a claim against Employer for the six month difference between her reduced rate and the contract amount. Employer argues it does not need to pay because of a provision in its Employer Rules and Regulations stating that all new employees have a six month probation period during which they receive a reduced salary — it even provides a specific salary amount for the probation period. So the basic issue is whether the employer and the employee agreed on a probation period.

They did not.

There was no explicit agreement between the parties regarding the probation period. Under Chinese law, the probation period is not one of the mandatory items that must be included in an employment contract. This essentially means that an employer that wants a probation period to test out a new employee must clearly describe the probation period in the employee’s employment contract. An employer cannot unilaterally impose a probation period on an employee and that means that an employer that wants to pay a reduced rate to a probationary employee must explicitly provide for that in its employment contract.

Note also that because the cited provision in the employer rules and regulations applies to all new employees it could be deemed illegal and unenforceable for a couple of reasons. First off, it fails to exclude certain categories of employees for whom a probation period is not permitted. For example, Chinese law prohibits an employer from setting a probation period for part-time employees. For that reason, if the employer applies this provision to any of its part-time employees, it is in violation of the law. In addition, the term of the probation period should be proportional to the term of the employment. Specifically, for an employment term of more than three months but less than one year, the probation period cannot be more than one month; for an employment term of one year or more but less than three years, the probation period cannot exceed two months. The employer can only use a six-month probation period for 1) an employment term of three years or more or 2) an open-term employment arrangement. Unless the employer always brings on new employees under either of those circumstances, this provision needs to be revised to accord with the law.

Note another mistake made by the employer in the hypothetical above: it fails to clearly specify a term of employment in the contract. What this usually means is that the employer will be “stuck” with the employee indefinitely as the employee becomes an open-term employee, which basically means there is no definitive end date for the employment relationship.

Our China employment lawyers see problems related to probation periods far too often — well over 50 percent of the time for companies that have or seek to use probation periods. To ensure you as a China employer are in full legal compliance, you should check both your employer rules and regulations and your individual employment contracts. If you find they contain a provision similar to the above, you should update your documents now.

 

China trademark registration

The month of wine-related posts continues!

We started with China, Wine and Tariffs, continued with China Trademarks: Wine Labels in China, and I will now examine the Nice classes to use on wine-related trademarks in China.

This may seem like an obvious question – if you’re selling wine, then you should register in Class 33, which covers alcoholic beverages (except beer). Class 33 only has one subclass, so you don’t even need to worry about filing in multiple subclasses. A single registration for “wine” will also cover aperitifs, bitters, ciders, sake, vodka and whiskey (and everything in between). And if all you want to do is ensure that you can sell your product in China, then you can stop here.

But for most brand owners, it’s not enough just to ensure that you can continue your operations. You also want to prevent trademark squatters from coopting your mark in other ways. In China, the trademark examination system is quite mechanical: all items in a subclass are deemed similar to every other item in the subclass – and only to those items. There are a few exceptions with certain goods and certain subclasses (i.e., goods in a certain subclass that are considered similar to those in another subclass), but those are predefined and laid out in Chinese Trademark Office (CTMO) publications. Everything else is fair game, because it’s not considered “similar” under CTMO practice.

Also, as we have explained previously in China Trademarks: Register in More Classes, Take Down More Counterfeit Goods, CTMO practice allows (if not encourages) trademark applicants to file in classes far beyond the scope of what they actually manufacture or sell. This is a double-edged sword: it allows trademark owners to extend brand protection as broadly as they like (if cost is no object), but on the other hand it also allows trademark squatters the latitude to engage in mischief, like applying for Star Wars brand instant noodles.

So when you’re filing a trademark application, you should think about two sets of classes: (1) which classes you need to protect your own goods/services, and (2) which classes you want to keep out of the hands of third parties.

If you’re a winemaker, you probably don’t care if someone takes the brand name of your wine and uses it on telescopes. But you probably would care if someone used it (for example) on corks (Class 20) or beer (Class 32). I just did a quick search on the CTMO website and yes, Penfolds has registrations in both classes.

What are you doing to protect your wine brand in China?

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 what we usually do is 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. On Fridays, like today.

At least twice a month, one of our China lawyers will get an email from someone (usually an American or an Australian or a Brit) who has lived in China for one to three years and who now wants to attend a law school to eventually become a China lawyer. This person will ask us which law school they should attend to best prepare for a career as a China lawyer. Oftentimes they will tell us about how such and such law school looks good to them because it offers three courses on Chinese law and are we aware of any other law school with more such courses.

My response is always pretty much the same and it goes something like this:

Don’t worry about choosing a law school with Chinese law courses. Very few of your potential employers will ever look at or care much about the courses you took in law school. Generally speaking, if you want to become a China attorney, the three best things you can do are the following:

1. Get into and attend the best law school you can.

2. Get the best grades you possibly can in law school.

3. Work on your Chinese language skills as much as possible. Being able to read and write Mandarin is far more valuable than being able to just speak it.

Got it?

China trademark registration costs $
                                                                  What’s in your bottle?

In my last post, I wrote that I could do a whole month of posts about wine. Here’s another.

The Grape Wall of China blog recently assembled a page full of “[f]ake, funny, old or odd” wine labels. The labels are all entertaining, but as someone who regularly deals with counterfeit merchandise, the fake ones are what really caught my eye. Typically, the bottles of fake wine really do contain wine and not some other liquid. However, the wine inside the bottle does not match the label and it is usually low-end plonk that (literally) would not pass the sniff test.

The webpage focuses on two particular faked brands: the legendary French brand Château Lafite Rothschild and the Australian brand Penfolds. Both of these brands have enjoyed worldwide success and are well-recognized in China, which is undoubtedly why they have been counterfeited so often and in so many ways.

Some of the counterfeits are straight copies and are hard to tell apart from the real thing – like the 10,000 bottles of Chateau Lafite that police found last year in a single house in Wenzhou. Lafite only exports 50,000 bottles to China each year and nobody believed that 20% of the bottles were languishing in a house in Wenzhou. But the wine resale market is mysterious enough, and the fake labels good enough, that at the time the wine was seized, no one could definitively say the seized wine was fake.

Other fakes are more “inspired by,” which makes you wonder how hard these counterfeiters are trying – or how hard they need to try. No one who speaks English would think that a wine called “CHATEAU OFFICIALLAFITE” is legitimate. But if your market is people who don’t speak English and don’t know much about wine but have heard of Château Lafite Rothschild, then the bar is pretty low.

Unlike most consumer products, the world contains thousands of wineries and even more brand names. And for those who don’t particularly follow wine, maybe only a dozen are recognizable as wine brands. For Chinese people, the number is even less. Frankly, I doubt the average person in China could name a single winery, with the possible exception of Chateau Lafite. If they know anything about foreign wine, it’s related to geographic areas or appellations (Napa, Bordeaux, etc.). So one response from a foreign winemaker might be: why bother registering a trademark in China? Unless I’m selling thousands of cases, no one knows the name of my winery anyway so there’s nothing to protect. That may be true, but think about it from the perspective of a counterfeiter. They want the biggest return for the least effort. You’ve already built up some brand equity with your brand and your wine label, and even if only a few people in China might recognize your label, it’s a lot easier for a counterfeit wine seller to register your mark and sell “your” wine in China than it would be for them to create a new brand. And all of a sudden you’ve lost the ability to sell wine in China under your own name, which means you’ll need to rebrand to sell in China.

As usual, it comes down to the same issue in China: if you don’t register your name first, someone else will do it for you. The only reason not to register your wine brand as a trademark in China is if you never intend to sell wine there.

China employment law firm
Change your mindset for China employment contracts.

If you have or are going to have employees in China, you need a China-centric written employment contract with each of your employees. Around once a month, one of our China employment lawyers will get a company asking us to “translate our existing employment agreements into Chinese for our China office.” Our response to this request is always the same: “Sorry, we cannot do that because the end result will not work at all for China. You need a China specific employment agreement and our translating what you are using (in the United States or the UK or Canada or Australia or Spain or France or wherever) is not going to work.” At all.

I want to be very clear: translating a foreign country employment agreement into Chinese for use in China is a flat out dangerous thing to do. Even if your translation is perfect and it captures everything you want it to say (which seldom happens), an employment agreement not written specifically for China will contain provisions that do not comply with China’s employment laws or are unworkable in your specific locale in China. For these same reasons, our unwillingness to “just translate a contract into Chinese” extends to every contract we do. See Translate Your Contract For China? The Answer is No.

The most common example our China employment lawyers see in foreign employment agreements of something that will not work under China’s employment system and that can be harmful is a provision stating that the employment is at-will. Under an employment at-will system, an employer is said to be able to terminate an employee for good reason, bad reason or no reason at all, but in China, terminating a China employee almost always requires specific cause both allowed under China’s national and local employments laws and under your employer rules and regulations. Putting an at-will employment provision in your employment agreements will not help you but it can hurt you by making your China management team believe they can fire their China employees for any or no reason at all. We have seen many wrongful termination actions brought by employees terminated by managers who believed they could do so at-will.

If you now think that merely eliminating any references to at-will employment will solve the translation problem, you’re dreaming. China’s entire employment law system is very different from those in Western countries and this necessitates very different employment contracts across the board.

Take overtime pay as another example. If your China-based manager is working under the standard working hours system (this usually means 8 hours on a work day and 40 hours in a week), you must pay or otherwise compensate him or her for any overtime incurred. See China Employee Working Hours and The Things You Cannot Skip. If your manager has been approved by the government to work flexible hours, you may be able to avoid paying overtime, but not always. The foreign country managerial contracts we see usually contain a provision making clear there will be no overtime. If one of your China managers sues you for unpaid overtime in China, you should expect this provision will be Exhibit 1.

Many foreign companies have their own policies on how much notice their employees must give when resigning and these sort of notice requirements are often put into their employment agreements. China though has its own very strict notice requirements and an employer that seeks to require resignation notice longer than China’s own minimum requirements is just asking for legal trouble.

We have also found that using a non-China centric employment agreement causes companies to lose sight of what most matters for China. Seniority, for example, is a huge issue for China employees as it is tied to other important employee benefits, such as statutory vacation days, and statutory severance. It is therefore important as a China employer that you deal extensively and clearly with this issue in your China employee contracts. But because this issue is usually not covered or covered very differently in foreign employment agreements, your using your foreign employment contract as your template for your China employment contracts will mean you either fail to address this critical issue or you will do so very badly. Either way, this will end up hurting you if/when you are sued.

This is not to say that what you have in your existing employment contracts is wholly worthless in formulating your China employment contracts because it isn’t. My firm’s China employment lawyers will often like to review our clients’ existing employment contracts before we start drafting their employment contracts for China. We though want to see those contracts not because we intend to translate them or even because we intend to use them as a template for the China contracts. Rather, we want to see them just because they often broadly outline what is important to our client in its employer-employee relationships.

In terms of your own thinking though, it is best for you to start from scratch. China employment laws are that different and that local and so what you know from Barcelona or Boston or Brisbane or Berlin may not matter or may just get you in trouble.

China scams. China attorneys. China lawyers.

Recent business confidences surveys conducted in China show a downturn in the Business Confidence Index for small and medium -sized manufacturing companies of all types, falling to its lowest level since the 2008 financial crisis. The decline in business confidence is the result of features built into the Chinese economy.

This declining BCI shows that economic stress on SME manufacturers in China continues to increase. This is a long term trend, and any resolution of the trade war likely will not impact this general trend. As a result, China based non-government economists are predicting a wave of plant closures and bankruptcies that will ripple through the entire PRC SME manufacturing sector over the next year. The large state owned enterprises will not be significantly impacted; the impact will be primarily center on small and medium enterprises. This means bankruptcy and closures both in the private sector and in the provincial and local state owned manufacturing sector.

These closures and bankruptcies do not reflect the condition of the Chinese economy as a whole. The companies that will be swept away are weak and technologically backward entities that would have been eliminated many years ago in a fully market economy. The Chinese system tends to keep these weak players alive far longer than is economically rational. Then the life support is suddenly removed and they all die at once. This sudden rise in business deaths is what is being predicted for the next decade.

The concern for foreign buyers of Chinese product is that an increase in closures and bankruptcies will also mean an increase in scams and frauds. When a factory in China knows it will be shutting down, its owners often work to make a final score. They set up a deal that allows them to bring in as much cash as possible in the short term. The owners then take the cash as a final bonus, shut down the company and then move on. No bankruptcy is involved. They just shut the doors.

In implementing their scam, the factory owners are faced with a problem. If they commit fraud against another Chinese person or entity, they likely will be pursued for retribution. That retribution may be criminal investigation and prosecution through China’s criminal justice system. Or the retribution may be informal action carried out by an effective criminal gang system active in China.

Perpetrating a scam on a Chinese entity involves considerable risk. On the other hand, scams against foreign buyers have hardly any risk at all. When a foreign buyer is cheated, the Chinese police often do nothing at all and there is virtually nothing your Embassy or Consulate can do beyond put the names of the offenders on a list. The Chinese courts can do little to nothing as well and the informal methods of retribution are rarely available to foreign entities. For this reason, when it comes time to do that last big scam or series of scams before shutting down the factory, foreign buyers will always be the preferred target.

The scams at this stage follow a regular pattern. The three primary patterns are as follows:

Model Scam Number One: It is typical for Chinese factories to require buyers make an initial deposit on the date it accepts the buyer’s purchase order (PO). A common structure for China suppliers is 30% down and 70% paid prior to shipment. Using this structure, a factory that knows it will shut down will take the deposit, do no work at all and simply fail to deliver. If the factory does this with enough foreign customers, it can collect a substantial sum for funding its owner’s retirement.

This kind of scam is hard to detect and for that reason is very effective. The problem for the scammer is that in a declining market, the total return for the scammer may be disappointingly small. So to milk more from unsuspecting buyers some factories will go for an even bigger score. They go to their buyers and offer to sell their product at a substantial discount. But the price for this discount is a substantial increase in the order amount and an increase in the deposit from 30% to 50%. The Chinese side says: “It is a great deal for you. Make a full year of orders all at once and you will save big money.” Using this scam, the Chinese factory collects a much larger deposit amount and the owners shut down the factory and disappear.

In China Tariffs and What to do Now, Part 1 we focused on how Chinese factories were offering to illegally transship their products to Malaysia or Thailand or Vietnam or Bangladesh or the Philippines (mostly), thus avoiding U.S. tariffs:

But before I discuss what companies do about their tariff problems, it is far more important I start out discussing what they should NOT do. They should not have their China products shipped to Taiwan or to Malaysia or to Thailand or Vietnam or anywhere else and then have those products shipped to the United States as though they are not from China. Doing this sort of transshipping can and does lead to massive fines and to JAIL TIME. I am not kidding. I am starting out with a post on what not to do because the risks from this one thing far exceed the benefits of the things we will be discussing in our subsequent posts.

And yet, many are telling us that their Chinese factories are suggesting these exact sort of transshipments and giving assurances that they are legal or that nobody ever gets caught, neither of which are remotely true. Step back for just a second and ask yourself why you are even considering taking legal advice about United States customs law from a Chinese factory owner or salesperson who has all the incentive in the world to sell you Chinese products and very little incentive to keep you out of jail. Please, please, please don’t fall for that. Please.

Chinese companies and the U.S. importers of their products often believe they can get around United States tariffs  by transshipping the products to Malaysia, Vietnam, Philippines, Sri Lanka, Thailand, Bangladesh, India, [or some other country] before sending them on to the United States. Their plan is to relabel the products with a new country of origin and then export the products to the US free of China , without US Customs and Border Protection (“CBP”) ever being the wiser.

I bring this up because many of the same factories that are making this transship offer are at the same time offering to discount their prices in return for a large increase in the deposit. This sort of “double” offer to illegally avoid tariffs and raise the down payment amount is a terrific indicator of a brewing scam.

Model Scam Number Two: Chinese factory sells a standard product: usually something like a chemical or a basic raw material or a food product. As with scam number one, it pumps up its orders by offering a substantial discount — sometimes even too good to be true. In exchange for the discount, the factory requires full payment before shipment. Then the factory ships a non-conforming product, collects the payment and disappears.

The below are some examples brought to the attention of our China lawyers by foreign companies that were scammed:

  1. Container of custom cut food product: 25 containers, neatly packed. The first layer of these cartons contain conforming product. The rest of the container is filled with bricks.
  2. Barrels of a granulated chemical (say citric acid). The top two inches in each barrel is conforming product and the rest is filled with sand. Or barrels are for a liquid chemical (say sulphuric acid). The barrels are filled with salt water.
  3. Containers filled with frozen food product, which when thawed, reveal that the food is rotten. In my own experience, this happened with 8 containers of frozen salmon. The decay was so bad that the containers were declared a hazardous waste site and the buyer was required to pay the substantial cost of a hazardous waste clean up.

Model Scam Number Three. The owners of the Chinese factory contact a foreign customer (oftentimes a regular buyer who gets all or most of its product(s) from the dying Chinese factory) and offer to sell their business at a unrealistically low price. In exchange for this low price, the deal must close very fast. This fast close means no time for due diligence and no involvement of experienced and trustworthy China lawyers or consultants.

The foreign buyer pays the purchase price by wire transfer to the Chinese factory. Then the buyer travels to China to inspect its factory and here is what they find:

— The factory building was rented, not owned. The building is stripped. Not only has all the machinery been removed, but even the window glass and plumbing fixtures are gone.

— The bank account has been emptied by the former owners and they have disappeared.

— The landlord shows up and demands a full year’s rent on the factory that has not been paid. 200 hundred workers show up and demand 6 months back salary. The local government shows up and demands one year in back taxes. To make it even “better” the local government colludes with the workers to take the passports of the foreign owners, lock them up in a local hotel, and then announce that they will not be able to leave town until all back payments are made.

The above sort of scams are committed in China all the time. However, their frequency and severity increases whenever there will be a wave of factory closures and bankruptcies. This is what is predicted for the next couple of years for China, so particular care is now required. For some of the things you need to be doing now to reduce your chances of problems stemming from this wave, check out last week’s post, China’s Economic Slowdown and YOUR Business: The Times they are a Changin’.

And be careful out there.

Forming a China WFOE
Forming a China WFOE is not kids play

If I were to list the ten biggest/most common mistakes the China lawyers at my firm see committed by foreign companies doing business in China, not forming a WFOE and forming a WFOE unnecessarily would no doubt both be on that list.

Let me explain….

We have written constantly about the risks of doing business in China without a WFOE. For more on that, check out the following:

Today’s post is going to focus on the mistake of forming a WFOE in China when no such WFOE is actually necessary or advised, an incredibly common and very expensive mistake.

It is expensive and time consuming (usually 3-5 months) for foreign-owned businesses to be formed in China. The following is the most basic list of what you need to do to form a Chinese WFOE and then operate it legally and safely in China:

  • Determine whether your business model is legal for a foreign business in China.
  • Form and register your WFOE in China. This will typically be a WFOE, a Representative Office, or a Joint Venture.
  • Lease property (a prerequisite for the registration process above).
  • Draft an employee manual and execute written employment agreements with all of your employees.
  • Open a bank account with a Chinese bank.
  • Figure out and pay all of your taxes, including company taxes, employee taxes, and social insurance payments for your employees.

It is complicated and expensive to form a WFOE in China and it is complicated and expensive to operate a WFOE in China. Very. To do so in most cities, you need good office space and you need employees and you need to meet with the tax authorities four times a year and you need to calculate and pay all sorts of taxes and….

To make matters even worse, shutting down a WFOE makes forming one seem like a piece of cake. See Closing Down a China WFOE: You Can Run But You Can’t Hide (Part 1) and Closing Down a China WFOE: You Can Run But You Can’t Hide (Part 2). Let’s just say that I once heard a China accountant at a seminar analogize it to a colonoscopy. Not kidding.

Because forming a China WFOE is very expensive, there are scads of companies in every tier 1 or tier 2 China city that exist solely or mostly to form China WFOEs. This means that if you go to one of these companies to form a WFOE the odds of them telling you that you do not need a WFOE are slim to none. The odds of them questioning you on why a WFOE might or might not make sense for you and then analyzing whether it does or does not are about the same.

The result of this is that countless foreign companies go through the pain and expense of forming a WFOE they don’t need, then operating a WFOE they don’t need, and then closing down a WFOE they never needed in the first place. Ugh.

Even worse are the entity formation companies that encourage foreign companies to start with a Representative Office that the foreign company does not need and then a year or two later encourage that foreign company to shut down that Rep Office because a WFOE is now allegedly needed and then charge for shutting down the Representative Office and for forming the new WFOE. This allows the entity formation company to charge for two additional processes that were never needed in the first place — forming and shutting down the Rep Office. Ugh. Note: Rep Offices cannot directly employ anyone nor can they get paid in RMB and just to give you an idea of the utility of China Rep Offices, we have not written about them since 2013!

My law firm and most law firms (both foreign and Chinese) do not play these tricks. What we do before forming any company in China (WFOE or otherwise) is to determine whether any such company makes sense at all. In Forming A China WFOE: The Agony and the Ecstasy, I wrote the following:

At least once a month, one of our China lawyers will get a call from someone asking us to form a “China company” for them before they start doing business in China “next month.” Half the time when we get this sort of call, the better solution is not to form a China entity at all.

That “half the time estimate” is still true but I should also mention that many times when our China lawyers get a call from someone having a problem with their WFOE, additional discussion reveals they should never have formed their WFOE in the first place. Ugh.

Do YOU need a China WFOE? Generally speaking there are two main situations when a China WFOE is legally necessary and a third situation where it can make good sense to have one, even though not legally required.

It is legally necessary to have a China WFOE (or some other legal Chinese entity such as a China Joint Venture) if you will have one or more employees in China. Note that you should assume that anyone you are paying in China as an “independent contractor” is in fact an employee. See Four Common and Dangerous China Employee Hiring Myths, in which Grace Yang, my firm’s lead China employment lawyer, lists “Hiring without a Chinese legal entity (WFOE or Joint Venture) is fine so long as you only bring on independent contractors.” as Myth 1.

It is also legally necessary to have a China WFOE (or some other legal Chinese entity) if you are going to get paid in RMB.

If neither of the above are or will be true for you, you probably do not legally need a WFOE.

There are though many instances where a WFOE is not legally required yet forming and having one still makes sense. If you sell products or services to universities, banks, hospitals, governmental bodies, SOEs or Chinese businesses with any sort of governmental ownership it might make sense for you to have a WFOE, even if you are not legally required to do so. These sorts of businesses are often pressured by the Chinese government to buy from Chinese entities and if you don’t have a WFOE your sales could be way less or non-existent. We also have seen instances where having a WFOE is worth the money and pain because it increases sales by convincing Chinese buyers that you are in China to stay and that there will be someone local to whom they can go if ever they have problems.

But just to complicate things even more, our China lawyers often see instances where a foreign company formed a China WFOE to hire employees in China and/or to get paid in RMB in China and yet would have been better off without having done so. These are cases where the foreign company did not realize that it had better options for accomplishing its China goals without need for a China WFOE. The following are the two most common examples we see of this:

1. Foreign company forms a WFOE in China to sell its widgets. Foreign company hires two employees in Shanghai to do this after having been convinced that it needs a WFOE because it will have employees in China and because it will be getting paid for its widgets in RMB. In Want Your Product In China? Try Using A Local Distributor, an article I wrote for Forbes Magazine, I emphasized the benefits of selling widgets to China through a distributer, rather than going it alone:

When foreign companies want to get their products into China, they often think they only have two choices: go it alone via a China WFOE or form a joint venture with a Chinese company.

Joint ventures are notoriously risky, while a WFOE can take three to five months to form, leaving you with a company in China to operate (that includes bookkeeping, hiring employees, etc.).

But there’s actually an easier option. Companies can enter into a distributorship relationship with a Chinese company (or companies).

Use a Chinese distributor

From a business perspective, taking most products into China (be they industrial or consumer) is a massive task for any foreign company. China is a big and diverse country and it should be viewed as many markets, not just one. Using an experienced Chinese distributor is oftentimes the best way for to sell your product in China.

And from a a strictly legal perspective, distribution (and reseller) relationships between foreign and Chinese companies are fairly straightforward.

Distribution contracts with Chinese companies can have much in common with U.S. distribution agreements, but they also almost always also have stark and important differences.

Licensing your brand name and/or your technology is another excellent (and far less risky) way to profit from China without setting up and operating a WFOE there. See China Technology and Trademark Licensing Agreements: The Extreme Basics.

2. Foreign company forms a WFOE to hire one or two people to handle its China quality control. There are many very good and very inexpensive QC companies in China and oftentimes that is a better way to go. And here’s the thing. Oftentimes if you want a QC person in each of the two or three cities in which you are having your products made, you need to form a separate WFOE (or at least a branch office) to be able to legally hire employees in all of those cities and then deal with China’s highly localized employment laws.

Bottom Line:  Forming and operating a WFOE in China is difficult and expensive and you likely have all sorts of other options. It would behoove you to explore those options before you form your WFOE.

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 what we usually do is 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. On Fridays, like today.

What with all the US-China tensions and trade tariffs, the most common questions our China lawyers are getting these days from clients are whether they should keep having their products made in China and “what should we do about the tariffs?” We will deal with this second question first by simply referring to the following posts we recently wrote on this subject:

As for the second question, we’ll start out by giving the lawyer’s favorite answer: it depends.

For our clients that make clothing or furniture or basic beauty products or basic kitchenware or rubber duckies or the like, we can say that in the last five years well over fifty percent already moved elsewhere, to places like Vietnam, Pakistan, India, Malaysia, Thailand, The Philippines Cambodia, Turkey and even Laos. In the last couple weeks our international lawyers have been checking in with these clients and flat out asking how they are liking their new countries and the word coming back is that they are not without problems but they prefer them to China and they are — for the most part saving money by doing their manufacturing in these places. But what if you are making electronics or auto parts or IoT devices or medical devices or pharmaceuticals or skincare or vitamins or the like? Incredibly few of these companies have moved out of China in the last few years and though many of them are now looking to do so, it does not seem that will or even can occur in the short term as there are very few factories outside China that make these things on a contract basis. We have though had discussions with many companies about setting up their own factories in these countries and the big issue for them — no surprise — is whether their moving will so much cut them off from the components they need to make these products as to cancel out any potential savings. Some of these companies in these industries are looking at Eastern Europe, Spain, Portugal, South Korea, Taiwan and the United States.

Overall though, it seems as though most companies that have moved some or all of their production outside China — usually with a fair amount of trepidation — are surprised at how easy it ended up being and how quickly they have adapted to the change. There have been some though who once outside China found their costs went way up, usually due to supply chain difficulties, and moved back.

That is where the “it depends” part becomes so relevant. Things like doors and door handles and windows seem almost to be the perfect middle ground as some have moved out of China already (mostly for Vietnam and Taiwan) and some are looking at moving out and yet some who moved out have returned and some who looked at moving out have — at least for now — decided to stay.

Interestingly enough, we are hearing increasing talk of foreign companies looking to buy their Chinese factories either to try to reduce costs or because the owner wants to retire and there is fear that the factory will go downhill after that. In doing their cost-benefit analysis nearly all of these companies are accounting for the tariffs as a permanent condition and we think that wise.

On the legal side, moving is relatively easy in that a good manufacturing contract is a good manufacturing contract and it is relatively easy for us to take an existing NNN Agreement or Product Development Agreement or Manufacturing Agreement or Mold Ownership Agreement and modify them to work for another country. It is though very important (with most of the countries listed above) that you secure a trademark for your company name, your brand, your product name and your logo in the new country to which you are moving and it virtually always makes sense to do that as soon as possible.

The above is why our final answer is “it depends.” We will over the next few weeks and months be writing often on what is involved in moving your production from China.

What are you seeing out there?

Asia Manufacturing Lawyers

With the recent onslaught of tariffs, our manufacturing lawyers are increasingly drafting manufacturing contracts for Asian countries beyond China. In the last few weeks alone, we’ve drafted manufacturing contracts for Vietnam, Malaysia, Indonesia, Taiwan, and India.

This recent increase in manufacturing contracts for countries beyond China has only reinforced how the core legal and business issues tied up with such contracts spans the globe. With so many companies (and clients!) looking to move some or all of their manufacturing to countries other than China, we will over the next few months be writing often about the basic concepts underlying good manufacturing contracts, no matter the country.

One of the issues our manufacturing lawyers perpetually face is pricing. How much will the factory charge for the widget and, more importantly, how much will the factory charge for the widgets a month and a year from now. Oh, and what about currency fluctuations?

Many of our clients (especially those recently stung by trade tariffs) are seeking to lock in pricing. This is a tough one. If you are maybe going to buy 1000 widgets at $34 from time to time with no minimum requirements, no legitimate factory anywhere will  lock in its prices for any extended period, if at all. They simply have no incentive to take a risk for an occasional buyer. On the other hand, if you contractually commit to buy five million such widgets, the factory will be a lot more willing to give you a price lock.

The same holds true for currency fluctuations/risk — which really just translates to price in the end. If you are an occasional buyer of 1000 widgets, you likely will not find a factory that will sell you its widgets for $34 for the next five years, no matter how much the Dong/Rupee/Ringgit/Bhat/Rupiah/Riel/RMB changes against the dollar. If you are buying five million widgets, sharing in currency risks very well might be doable.

Yet many foreign companies believe it possible to get a price lock when it really isn’t. Even worse, many foreign companies believe they have a price lock when they really don’t. Most factories throughout Asia are well-versed in how to convince their Western buyers that there is a price lock when there really isn’t. These factories lure buyers with a fake price lock and then when that price lock really matters, they easily and legally back out.

How do these factories accomplish this feat? Simply by refusing to accept a purchase they are under no obligation to accept. The below email from one of my firm’s lawyers regarding negotiations with a Vietnam factory nicely illustrates this sort of legerdemain:

The discussion on price adjustment is meaningless. If the Vietnamese factory is not required to accept all purchase orders with the locked price, it can simply change its price by refusing to accept your PO. It is standard practice in Vietnam (and pretty much everywhere else in Asia and around the world) for the Vietnamese factory to agree to a low price and in return get certain minimum order commitments from you the foreign buyer. Then when its costs rise (or less common, its currency rises) the Vietnamese factory will refuse to accept your purchase orders until you agree to pay a higher price. A price lock is only meaningful if the factory is required to accept your purchase orders with the locked price. In this case, your factory has rejected that approach, which means you will have no price protection. Your factory fully understands this and this is why they revised the contract as it did.

You must now decide whether you want to move forward with this factory without price protection or see if you can get price protection elsewhere. Or you might even want to see whether your agreeing to commit to buying more from this factory will get you a real price lock or not.

Please stay tuned for our next post in this series.

 

China lawyers
Halfway for a China WFOE is not good enough. Photo by Jacqui Sadler

Earlier this week, I wrote about how China’s economic slowdown should impact how you do business in China and even with China. Today I focus on why this slowdown (and if you are an American company, the US-China trade war which is precipitating that slowdown) are why now is not the time for you to be operating quasi-legally in China.

And yet, there seem to be as many companies operating this way in China right now. For nearly a decade now, we have been stressing the need to have a WFOE if you are going to be doing business in China. Along these lines we have stressed again and again how independent contractors are almost never legal in China and how if you have “employees” in China you need a WFOE. For more on this and for how our tone on this has become increasingly strident as the Chinese government has consistently and unrelentingly stepped up both its enforcement of this requirement and the penalties for failing to comply. For more on this, check out the following posts from the following years:

  1. Doing Business in China Without a WFOE: Will the Defendant Please Rise. In this post from August, 2018, we wrote about how our China lawyers are increasingly hearing of foreigners getting arrested and imprisoned for operating in China without a WFOE.
  2. Doing Business in China with Deportation or Worse Hanging Over Your Head. In this post from March, 2017, we wrote about how our China lawyers were increasingly hearing of foreigners (especially Americans) getting deported from China and being cut off from doing business in China for having operated in China without a WFOE.
  3. China’s Tax Authorities Want You. In this Forbes article from May, 2015, I wrote about how our China lawyers were increasingly hearing of foreigners getting hit for massive taxes for having operated in China without a WFOE.

With all the pressure to have a WFOE in China, our China attorneys are now increasingly hearing of foreign companies forming a China WFOE but then continuing to operate illegally in China. This is more common than you would probably think and it also seems more common than ever.

Let me explain.

Forming a WFOE is not the same thing as operating legally in China. In fact, it is so different that around a decade ago my law firm made the decision not to simply form WFOEs for clients and then walk away. At that time we ceased doing what we called pure WFOE formations. Instead, if anyone wanted us to form a WFOE for them, we would do so only if they retained our law firm for what we called a WFOE formation package. Our explanation for this was that operating legally in China with a WFOE requires a lot more than just a WFOE and we did not want to charge clients to form a WFOE only to have them get in trouble with China’s authorities for operating illegally. One of the things we always (as in 100% of the time) require as part of our WFOE formation work is what we call our China employment package, which consists — of among other things — our drafting dual language China-specific employment contracts for all WFOE employees and Employer Rules and Regulations to go with those. See China Employer Rules and Regulations: A Must Have No Matter Your Size.

Unfortunately, many law firms and companies that do WFOE formations are not concerned with launching China WFOEs that operate illegally from day one. I say this because in the last year or so our China lawyers are hearing more and more from foreign companies with WFOEs in China that are operating illegally in China. I find this very distressing because it strikes me as so illogical. Why spend the substantial time and money to form a WFOE if doing so is not going to make you legal in China? Why form a WFOE telling the Chinese government that you are there only to make it so much easier to be discovered for operating illegally.

What are these WFOEs doing illegally? Two main things, both centered around trying to reduce costs by avoiding taxes. One is setting up a WFOE and doing various things to illegally reduce the WFOE’s income taxes. We get maybe one call every six months from someone caught for this and we tell them that the only solution is to try to negotiate down the total figure for back taxes, interest and penalties, and to do that from outside China. The other thing is China WFOEs that hire China “employees” through their foreign company and not through their WFOE. They do this to avoid having to pay the approximately 40% on salaries China employers are to pay in employer taxes and benefits and to avoid having to withhold the approximately 20% they are to withhold on behalf of their employees for their employees’ individual income taxes.

Way back in 2010, we did a post, Operating Illegally In China. Half-Assing It Does Not Help. In that post we explained how operating quasi-legally so greatly increases your risk of getting caught that you would actually be better off operating fully illegally. Back then, the issue was forming a company with a Chinese citizen (which though less common today than back then, is still an issue). Here was our position on that back then (and now too):

Legally, you pretty much cannot go into business with Chinese citizens without a joint venture. China recently started allowing partnerships, but the impact of that is still not clear.

You pretty much have two options:

1. You form a WFOE and you own it. Forming a company in Hong Kong is no different for China purposes than forming one in the United States, so forget about Hong Kong for a moment. [For an update on why having a Hong Kong company does not cut it, check out American Companies in China without a WFOE and the Impact of Donald Trump and US Tariffs and Why Hong Kong is not the Answer.] Forming a WFOE can be very expensive, in large part depending on the Chinese city in which you will be forming it.

2. You let your fiancé, her mother and cousin own the entire business. You do this and you are exposing yourself to losing whatever you put into the business. Twice, I have had men break down and cry right in front of me because they went into business with their fiancée and her family and they put 3-8 years of their lives into the business, only to be completely and unceremoniously booted out once it really started to make the big money. These are just the ones who cried. I can tell you about the guy who invested millions in condos with his fiancée and her mother, only to leave China for a few weeks and return with all of the condos sold and his fiancée and mother in law gone. Vanished.

My emails often lead to pushback, with the person complaining of how China makes things so difficult for the “little guy” and then their explaining how they know of how these things usually turn out for the foreigner, but in their case it will be different because:

a. Their girlfriend/fiancé/wife’s family would never be anything but above board.

b. Their girlfriend/fiancé/wife’s family is so “connected,” it makes sense for them to go into business with them.

They then usually ask us to write up a contract that protects them “as best as possible.” We tell them that we will not do that because those contracts are usually not enforceable in China and we are not in the business of writing contracts we know will not work.

In that same post I wrote about an email to me from my co-blogger, Steve Dickinson, to me, which went as follows:

If these people are going to go illegal in China, they should go 100% illegal. That is, enforcement either through really strong family connections (your father knows her father) or enforcement through gangsters and the like. I know people who have succeeded this way but I don’t know anyone who has succeeded with an illegal contract. This is not because contracts don’t work in China, because you and I have won enough China contract cases to know that they do.

It is because the Chinese judges are totally on to these sorts of arrangements and they know they violate or seek to evade Chinese law. They therefore have and will continue to deem such contracts void. Why do people live in this fantasy world thinking that somehow they are so different or that they have discovered the solution? Why do they think a Chinese court would enforce a contract designed to evade the law?

Take an alternative example. Remember John Smith’s [yes, it is an alias] company we formed in Beijing a few years ago? Not sure if you remember this, but that investment was with his Chinese wife. However, we did that as a very formally organized WFOE and left the wife and her family with the irregular side of the deal. His US company is the only shareholder and he runs the board. His company has had no trouble and he has had no trouble because he is legal and secure. His US LLC [and with it, the China WFOE] were just purchased by _______ [a pretty big name U.S. company]. The reason the purchase was successful is that the whole company was “clean” and therefore it could be purchased by a foreign public company.

I then went on to say that “as lawyers we are never going to tell our client to go full illegal, but in my role as a blogger, I have to think going full illegal would probably make better sense than paying a lawyer to draft a void contract. I think people know this, but their rightful discomfort at operating illegally makes them want to clutch on to something that will allow them to justify (however falsely) their actions.”

We also used to frequently see the same sort of thing by companies seeking to justify operating illegally in China with a Representative Office instead of a far more expensive WFOE. We has this to say about this situation way back in 2010:

Every couple of weeks my firm gets an email or a phone call from a small business that is seeking to justify forming a Rep Office in China instead of a Wholly Foreign Owned Enterprise (WFOE). These small businesses typically go into advocacy mode explaining why their business can and should be a Rep Office in China. They then go on to explain that they simply cannot afford to form a WFOE in China due to the minimum capital requirements, the legal fees, and the taxes.

They then want me to condone their Rep Office plans but I never do.

In fact, the increasing number of these requests has caused me to get even blunter than usual, and my most recent response exemplifies this:

What you are describing doing as part of a Rep Office is definitely not proper for an RO. Not even close.

In terms of minimum capital required, because it is Dongguan, it is likely to be pretty high. Sorry.

You pretty much have two choices. You can operate completely off the grid and risk getting shut down, or you form a WFOE. Probably the worst thing you could do would be to form an RO that operates illegally because that will just draw attention to how you are operating illegally.

I get the sense that the people contacting us on these things are hoping that they somehow have found THE loophole that nobody else has found and that if only they can get the blessings of an attorney for what they are doing, that their operating illegally will somehow not be illegal. I wish I had some magic oil I could sell (for a helluva lot of money) that I could sprinkle on illegal China businesses to make them legal, but I have no such thing.

Those who think they are going “sorta” legal by forming what is clearly an illegal Rep Office in China are very similar to those who think they are “sorta” protecting themselves legally by doing a “sorta” joint venture with their girlfriend. I wrote about those people in a post, entitled, “Operating Illegally In China. Half-Assing It Does Not Help.

I went on to explain how forming a Rep Office that then operates as though it were a WFOE “will just serve to let the Chinese government know where you are and what you are doing and will make it easy for them to realize that what you are doing requires a WFOE.” I then made clear my frustration with these sort of quasi-legal schemes:

What really drives me crazy about all this though is that on at least three occasions, companies for whom we have refused to form Rep Offices have written to tell me that “so and so” entity formation company is willing to form the Rep Office for them, as though this mere fact means my firm was wrong in declining to take money to do something we know will eventually not work.

And though I take no happiness from this, I will note that one of the three companies that went ahead and formed a Rep Office against our advice did contact us about a year later to tell us that the Chinese government was now making them form a WFOE.

It is frustrating to hear about the latest round of foreigners believing that going half-way with their China WFOE is enough, especially as most of these people we are hearing from do not even know they are operating illegally because they were told otherwise by the “experts” they hired. These companies that are hiring and paying their China employees outside their WFOEs seem to believe the following make what they are doing legal, but they don’t:

  1. Setting up a Hong Kong business and paying the employees from that. Wrong. This is no different than paying your China employees from the United States. If you are going to have employees in China you need to pay them through a legal China entity, not from overseas. See Having A Hong Kong Business Does NOT Make You Legal in Mainland China. See also, China Expat Pay: Splitting with Hong Kong is 100% Illegal and 200% Dangerous.
  2. Hiring only expat employees in China. Wrong. Expats working in China need to work for a legal China entity just like everyone else.
  3. Hiring only Hong Kong or Taiwan (or Singapore?) citizens. We have heard this one many times over the years, in large part because citizens from these places often claim to their employers that they can and should be treated differently because they are from these places. Wrong. A China-based employee is a China-based employee and a China-based employee needs to work for a legal Chinese company, be that a WFOE, a Joint Venture or a Chinese domestic company. Yesterday, in China Employment Law Update: China Work Permits no Longer Needed for Taiwan, Hong Kong and Macau Residents, our lead China employment lawyer, Grace Yang, wrote about how citizens of these places no longer need work permits to work legally in China. Just since then our China lawyers have received a couple emails from people who seem to believe this work permit change means people from these regions can legally work in China without being directly employed by a legal China entity. Wrong. This work permit change has no impact on this.

Doing business in China with employees in China? Don’t do it half right because you are only increasing your risk.