China and Hong Kong legal systems
For commercial law purposes, think of Hong Kong as a different jurisdiction from the Mainland

In an effort to reduce the challenge of manufacturing in Mainland China, many foreign companies decide not to go direct. They instead make use of intermediary companies that act as the sellers in the transaction. These intermediaries deal with the buyer, but the messy business of manufacturing is done in the PRC. These intermediary companies are often located in Hong Kong. We have seen that most foreign buyers do not understand the risks involved in dealing with Hong Kong companies and this too often causes them to unknowingly take on significant risks. One of those significant risks arises in the area of intellectual property protection.

From the standpoint of legal jurisdiction, Hong Kong and the PRC are two entirely different countries. The most important result of this legal distinction is that foreign investment in the PRC by Hong Kong companies and individuals is restricted in the same way it is restricted for American and European and Australian companies. This means Hong Kong companies cannot operate directly in the PRC. To operate legally in the PRC, a Hong Kong company must form a WFOE or an Equity Joint Venture, in the same way as for any other foreign entity. See How to Form a WFOE in China, Part 3: What’s Hong Kong Got to Do With It?

What does this mean in the manufacturing setting? The foreign buyer enters that enters into a contract with a Hong Kong company is (999 times out of 1000) not entering into a contract with the actual manufacturer because the actual manufacturer is a company located in the PRC. The actual manufacturer is a legal entity entirely separate from the Hong Kong company. To make this clear, in the manufacturing contracts drafted by the China lawyers at my firm, we call the Hong Kong company the “Seller” and the PRC manufacturer the “Factory.”

Now consider what all of this means from the standpoint of intellectual property protection. The foreign buyer provides its proprietary design to the Hong Kong seller. Complicated molds embodying the proprietary design are fabricated. Extensive engineering and production design work is conducted to develop a working product prototype. But, none of this work is done by the Hong Kong-based Seller because all of this work is being done by the factory in the PRC. This work is almost always being done by entities unknown to the buyer and with which the buyer has no contractual relationship. The molds and tooling and product prototypes are physically located in the PRC.

The result is that the buyer has given away its most valuable intellectual property to persons and entities it both does not know and cannot control. So what happens if something goes wrong? What happens if the buyer wants access to the molds to transfer production to another factory. What happens if the buyer learns the molds are being used to make “knock off” products? What happens if the buyer learns the product prototype is being used in the PRC to manufacture a competing product? These are not trivial questions as these things happen every single day in the PRC. The answer is that the buyer has no recourse at all in the PRC. The only legal action the buyer can take is against the Seller in Hong Kong. In the intellectual property area, this means the only thing the buyer can do is to sue for damages. The buyer can take no direct action against the infringer nor does it usually have any good legal basis to prevent the infringement happening in the PRC.

Now add to this that in most cases (at least most instances — by far — where companies have retained my law firm to investigate the above sort of situations), the Hong Kong Seller has no real assets. The Seller is no more than a small office with a phone and computer and sometimes a small sales staff. All the productive assets are located in the PRC, in the hands of companies and individuals with no direct legal relationship to the Hong Kong entity. Cash received by the Hong Kong entity is regularly swept into separate accounts with no direct relationship to the Hong Kong entity. In litigation terms, the Hong Kong entity is judgement proof.

What this all means is that the foreign buyer has essentially given away its intellectual property. The intellectual property is in the hands of a company in China and nothing can be done in China if the intellectual property is misused in some way. For physical items like molds, tooling, and prototypes, the items are gone forever. The PRC entity may refuse to return the items. The PRC entity may pass the items on to its subcontractors, who then further pass the items on to a subcontractor or family friend. In the end, it is not unusual to find that no one knows the ultimate fate of the items. But what is known is that the items are located in the PRC and the buyer has no legal recourse in the PRC. The buyer has nothing more than a claim for monetary damages against a Hong Kong entity likely to be judgment proof.

A foreign buyer that fully understands the risks may make the business decision to incur the risk. However, in our own work in Asia, we pretty much never encounter U.S. or European buyers that understand the situation. Most simply assume that when they contract with a Hong Kong entity, their legal situation is no different than if they were contracting with a PRC entity. They have already decided to incur the risk of manufacturing in the PRC and they see working with a Hong Kong entity as a way to reduce that risk, not increase it. They assume the Hong Kong entity will be easier to communicate with and that because Hong Kong’s legal system is better, they and their IP will be better protected this way.

But in reality, the foreign buyer has not reduced its risk. It has instead dramatically increased it. If the increase in risk is intended, that is part of the commercial calculation. But when the increase in risk is based on a fundamentally incorrect understanding of the law and the facts, it is nothing more than a mistake.

For more on why it is important to distinguish Mainland China from Hong Kong, check out the following:

Negotiating China contracts
Negotiating contracts with Chinese companies

When negotiating a contract with a Chinese party, firm deadlines are essential, but also dangerous. They are dangerous because many (most?) Chinese companies have mastered the technique of manipulating deadlines to their advantage.

There are many reasons to set a deadline for concluding a contract with a Chinese party. In any deal where the Chinese side will be required to make a payment, such as the purchase of an offshore asset, the Chinese side will tend to delay making a final decision. Setting a tight contract deadline controls this tendency. On the other hand, when the money is flowing in the other direction, the Chinese side will often impose an artificial deadline unrelated to the deal. In my experience, the most common is for the Chinese company to assert that the deal must be done on a specific date because a public signing ceremony has already been scheduled.

If you are negotiating with a Chinese company that has set a deadline for completion, you need to be prepared to deal with what is now the fairly standard Chinese program for manipulating contract deadlines. Without regard to who set the deadline and without regard to why the deadline has been set, you must be willing to simply walk away from the deal if all of the terms and all of the drafting is not complete on the deadline date. If you are not willing to simply walk, then you will be manipulated by the Chinese side.

The standard program Chinese companies use for manipulating a deadline usually works in three stages, as follows:

Stage One: The first draft of the contract is always submitted by the foreign party. The Chinese company never provides the first draft because that would require they “tip their hand.” The foreign party works overtime on a tight timeline and provides its draft thirty days before the deadline. This is done under the assumption that thirty days is sufficient to work out all the deal issues and arrive at a final draft agreement on the deadline date.

The foreign party hears nothing, not even an acknowledgment of receipt. This causes concern and after three or four days the foreign party asks the Chinese side about receipt and comments. The Chinese side responds that it did a quick review and everything looks okay. The foreign party is relieved and begins preparing to implement the project on the terms stated in the draft contract.

Stage Two: Seven or so days before the deadline, the Chinese side finally sends its comments on the draft agreement. At this stage, the Chinese side proposes two or three changes. However, these changes are designed to make the contract completely unenforceable against the Chinese side. Here are my three current favorites:

1.  The key to the contract is that the obligations provided in the contract are absolutely binding on the Chinese party for a period of three to five years. The Chinese side makes no revision to the 35-page contract. Instead, they insert a single article that provides that the Chinese side can terminate the contract at will on 30-days notice.

When challenged, the Chinese side claims mutual termination is common in international contracts.

2.  The Chinese side adds what it calls a force majeure provision. The standard force majeure provision provides that neither side can be compelled to perform in situations where performance is impossible due to matters outside the control of that party: war, strike, typhoon, earthquake. The key to a standard force majeure provision is that neither party is required to perform. If the force majeure condition continues, the affected party is required to return the matter to the pre-contract status quo.

The Chinese provision is always written in a way that stands the standard force majeure provision upside down. In the Chinese version, the Chinese side is concerned only with the actions of the Chinese government. The Chinese force majeure provision will provide that if the Chinese government or its agents (foreign exchange bank) makes performance by the Chinese side impossible, the Chinese side is not obligated to perform. But the foreign party is still obligated to perform and the Chinese side is not obligated to return the matter to its pre-contract status quo.

When challenged, the Chinese side replies: force majeure provisions are standard in international contracts.

3.  In the critical provisions of the contract, in every place where it says “the Chinese party shall be obligated to do” the contract is revised to say “shall not be obligated to.” This is usually done where the revisions are not redlined or otherwise identified in a cover memorandum. The added word is only located after careful review of the contact. The longer and more detailed the contract, the more difficult it is to find this kind of revision.

When challenged, the Chinese side replies: we only inserted one word. What is your problem with that?

When the foreign side objects, the Chinese side will complain that the foreign side is being unreasonable. If well advised the foreign side will hold the line and refuse to agree to revisions like these that will essentially render the contract meaningless. The Chinese side then agrees to back down and the foreign side then feels relieved, assuming the agreement as drafted will be executed on or before the deadline. The unsuspecting foreign party does not realize that the opposite will almost certainly happen, leading to stage three.

Stage Three: Two to four days before the deadline, the Chinese side returns the contract with extensive revisions throughout the entire document, usually with no redline of the revisions. Some Chinese parties will redline some but fail to redline others. No explanation is ever given for the large number of revisions. No explanation is ever given for why these revisions were provided so close before the deadline when it is clear the Chinese side was aware of the issues weeks earlier when the draft was first provided to it.

Most foreign parties at this stage fall directly into the trap laid by the Chinese side since day one The foreign party works desperately to revise the document in the face of the by now ridiculously short deadline. In this setting, the Chinese side is hoping two things will happen. First, the foreign side will make concessions just to get the document signed. Second. the foreign side will make drafting mistakes due to the short timeline and the need to work in two or more languages. The Chinese side will then ruthlessly take advantage of those mistakes at a later date.

It is always a mistake to fall into the deadline trap. The better response is to realize from the start that the deadline is not relevant to the Chinese side. The Chinese side is merely using the deadline as a tool to gain an advantage over you. The first step when faced with this trap is to refuse to make the revisions and execute the agreement under this time pressure. Instead, tell the Chinese side that since they are the ones who responded late, you view their response as a contract rejection and for this reason, the deal is off.

Then simply walk away. Do not propose a new deadline. If you propose a new deadline, the Chinese side will go through exactly the same steps (as above) in almost exactly the same way. The only useful course of action is to tell the Chinese side that if it is still interested in doing the deal it should come back with a reasonable set of proposals and if we are still interested, we will take a look. But, since the deadline has passed, we may never come back to you. It is your risk.

In that situation, some Chinese parties will simply capitulate and come back with a reasonable set of proposals quite soon, often within one week. However, the most common response is that the Chinese side will continue to act in a manner designed to force the foreign party into making an unreasonable concession or a mistake. The only way to prevent that is to treat the deadline as a hard date and to walk away when the Chinese side is unreasonable.

It is impossible to predict what the Chinese side will do when you walk away. The Chinese side is not using this three-stage technique because it is inexperienced. The opposite is true. These entities are very experienced and they have learned that the deadline manipulation technique works very well. The only appropriate response from the foreign side is to call the bluff by walking away. But like a poker game with a stranger, you never know what will happen when you call the bluff. The response from the Chinese side is entirely unpredictable.

Be prepared.

China employment lawyersLast week, in Terminating a China Employee: Why Mutual Termination is so Often the Key, I wrote of how getting your China employee to agree to a mutual termination (with a settlement agreement) greatly minimizes employer risk. But sometimes, a mutual termination is not possible. Though China is not an employment-at-will jurisdiction, its laws do permit employers to unilaterally terminate a China employee that has committed a serious breach of the employer’s rules and regulations.

If you are going to unilaterally terminate an employee for violating your rules and regulations, it is important your rules and regulations have written provisions explicitly justifying the termination. And just moving a list of forbidden behaviors from your oversees employee handbook to your China employer rules and regulations rarely cuts it.

Suppose your employee does X and you think X is terrible and you now want to terminate that employee. You check your rules and regulations and X is listed as a basis for termination and so you terminate the employee. The employee then sues you for unlawful termination.

Let me digress a minute to discuss something our China lawyers are getting more often these days, especially on the employment law front. As China’s laws get more complicated, our China attorneys are getting more calls from companies contacting that have been sued or are being threatened with lawsuits. They are calling for our help because they “did exactly what we told them to do on China Law Blog,” and so they believe we can easily win these lawsuits for them. Sadly, they are nearly always mistaken. They failed to realize that the information we provide on this blog is information; it is not legal advice specific to their situation and it is the “specific to your situation” part that matters most. On the employment front, the applicable laws will vary depending on the size of your company, the type of employees at issue, the exact language (in Chinese) in your employment contracts and in your rules and regulations, your location, and potentially a hundred other things as well. See China Employment Law: Local and Not So Simple. Our goal with this blog is NOT to tell you exactly how to do things in your specific situation, but rather to alert you to various key issues so you can know when you need to seek out proper help for dealing with them.

This advice is particularly true with China contracts and legal documents, including your employer rules and regulations. My law firm has been drafting China contracts for so long that we — and I am not kidding about this — have at least twice been contacted by companies given one of our contracts by “friends” and now want us to help them deal with their Chinese counterpart that has “breached” the contract. Interestingly, in both instances, the contracts were so far off the mark for what these two companies needed that we declined to help them as we thought it would be pointless. In China Contract Templates: the Cons and the Cons, we wrote about why any contract not tailored to your specific situation is a really bad idea:

We don’t use “templates” for our agreements. After a lot of analysis, IF we find what the foreign buyer is trying to do fits into a pattern from a previous transaction, then we will, of course, use an agreement from a previous transaction as a model. But even in the most basic transactions, what we do is to customize it for the current transaction.

In drafting pretty much any contract for China there are literally dozens of variables that can, in turn, be combined in a nearly infinite number of configurations. So the final contract from one transaction may have no application to any other transaction. This is why providing a contract from a past transaction will have no benefit to the Western side and would likely only harm it.

As you note, our clients also need at least one of our China lawyers involved in dealing with the Chinese response. Did the Chinese side change the Chinese and not the English as they so often do? Did they redline in a way that the changes to the Chinese portion are even apparent? More important is whether their changes are the normal technical changes that are part of normal business practice (45 days to deliver a product instead of 30 days) or are their changes destructive to the whole approach, such as: “no, you do not own the technology, we do.” Or, “no, we won’t provide any warranty at all.” Or, “no, we own the molds, not you.” I do not see how anyone without a deep understanding of Chinese law and Chinese business could even begin to deal with these sorts things.

In drafting our contracts, we do of course usually pull some language from other contracts, such as confidential information language. However, the core agreement is almost always completely unique to the specific client before us and when we do use prior language, we nearly always revise it to customize it for the specific client and the specific transaction.

From our having written thousands of China agreements we know there are certain issues that need to be resolved pretty much every time. So we work with our clients to identify those issues and then we work them on how they want to deal with those issues and then we put the agreement together to achieve the goals our client has told us it has. Of course, for some of these components, we use as a base some of the language that has worked in the past in China. This is the benefit of working with us: we know what works and we know what fails. But the resulting contract in each case is unique.

So in that sense, there is no template. There is just decades of experience in drafting agreements for doing business in China or for doing business with China. This is why whenever someone asks me to send them a “template” agreement I tell them I cannot because I have no way to know which of the nearly infinite number of alternatives they should follow. How will they pick and choose from a dozen options for a relatively simple provision? What is unique about their situation? Will the most common solution we have used in the past even make sense for them? Does it make sense for their industry? Their business? Their product? Their location? What if the law has changed? What if the law changes two days after we start drafting?

I usually propose to each client three options for every important issue and I usually come up with those three from about a dozen possible. Say there are ten critical issues for their contract. Each selection of an option affects all of the other options, often in ways we have previously encountered. Before the client answers the questions, we don’t know even what structure to use. After they answer the questions, the agreement that meets all their needs does not exist.

It is also true that in-house counsel cannot write an agreement that can serve as a basis for what our client wants us to craft. Our approach to China contracts is based on three supports: 1) Decades of China experience, 2) A deep understanding of the Chinese civil law system and the Chinese court system, 3) A deep understanding of how contracts actually work in China. Any company with an in-house lawyer who combines all three does not need to come to us for a contract and they don’t. It is not helpful to us to have a common law contract [China is a civil law system] based on a highly idealized and impractical American/European practice that has no applicability or use in China.

Whether your employee termination was lawful is incredibly fact specific. Among other things, it depends on what the employee did. It also depends on exactly what your rules and regulations say (in Chinese) and how they say it. It also depends on where you are located as it is critical that your rules and regulations fully accord with the reality on the ground in your specific locale in China. If the rule on which you relied in terminating this employee is not reasonable for your locale, your termination likely will be deemed to have been unlawful. For example, your rules and regulations may say that your employees cannot date a supervisor and anyone who does so will be subject to immediate dismissal. This rule is unenforceable in most of China because China’s labor authorities and courts do not want employers restricting their employee’s freedom to date and marry. So even if your rules and regulations prohibit inter-office dating, your terminating an employee for dating probably will mean you will need to pay your employee damages and also immediately reinstate him or her.

We often see employers list grounds for termination in their rules and regulations that do not work in most China. For example, employers in China typically can only govern their employees’ behavior during work time. So though you as an employer can in most locales prohibit your employees from being a “WeChat merchant” during normal working hours, you typically cannot prohibit your employees from doing that in their spare time. Unless what an employee does in his or her personal time leads to criminal liability you typically cannot unilaterally terminate them for what happens outside the office.

Consider this hypothetical. You as an employer host an after-hours holiday party to celebrate the Chinese New Year. One of your employees attends after getting off work that day. This employee gets into an altercation with a supervisor and hits the supervisor. Your employee and your supervisor go to the police station and your supervisor decides not to press charges and no administrative or criminal charges are ever brought against your employee. You then fire the employee because you think what he did “checks the box” in your rules and regulations prohibiting any fighting at work.

How will this be resolved? In a real case in Beijing with similar facts, the employer lost. The court held that the holiday party did not count as work time and because the employee was never criminally charged the employer had no legal basis for the unilateral termination.

Bottom line: Without well-crafted rules and regulations that work for your specific business and your specific locale it is usually impossible to justify a unilateral employee termination.

China trademark lawyers
China Trademarks: Not yet billions, but getting there.

I wrote last year about the massive number of trademark applications filed in China in 2016 – 3.6 million, far more than any other country in the world, and increasing at a tremendous rate.

The statistics from 2017 are now available and they are staggering, both in gross numerical terms and in the year-on-year increase. More than 5.7 million trademark applications were filed with the Chinese Trademark Office (CTMO) in 2017, an increase of more than 55% from the previous year, which had already set a record. By comparison, just under 600,000 applications were filed with the United States Patent and Trademark Office (USPTO), which is the world’s second-busiest trademark office. At the end of 2017, China had 14.9 million active registrations overall; the US had only 2.2 million.

What are we to make of these numbers? Why are so many trademark applications being filed in China, and what does it mean for current and future applicants? Keeping in mind that correlation is not the same thing as causation, I nevertheless offer the following hypotheses and predictions:

  1. More CTMO rejection notices. It will become increasingly difficult to register a trademark in China due to simple mathematics: the greater the number of trademark registrations, the greater the chances of a conflict. And it’s still the case that many CTMO examiners are relatively untrained, with a huge backlog of trademarks and a hard 9-month examination deadline. I feel for the CTMO examiners. In all likelihood, their daily workload is governed by the thousands of applications filed 9 months earlier, which must be either approved or rejected by the end of that day. And multiple sources in China have confirmed my own experience: the default CTMO examination standard is “When in doubt, reject.”
  2. Increased value for registered trademarks. As it becomes more difficult to secure a trademark registration, existing registrations will become more valuable. China already has a robust secondary market for trademarks, and this market will only become more relevant.
  3. Greater incentives for trademark squatters. As trademarks become more valuable, the incentives for squatters to file applications will also go up. Yes, such applications will be more likely to be rejected, but trademark squatters are by definition taking a calculated risk. They’re not collecting their favorite trademarks; it’s purely a business proposition for them and some file for hundreds of trademarks at a time.
  4. More non-use cancellations. China’s trademark system allows (and implicitly encourages) trademark owners to file applications covering goods they do not actually use. See China Trademarks: Register in More Classes, Take Down More Counterfeit Goods. Accordingly, when we conduct a trademark search and find a conflict with an existing mark, one of the first things we consider is whether the mark is vulnerable to cancellation (i.e., if it has been registered for at least 3 years) and if so, if the mark is actually in use on the goods that created the conflict. At least half the time we discover that the mark is not and has never been in use on the goods in question, and we are able to cancel the mark and thereby clear a path for our client’s application to be approved.
  5. More proactive filings to forestall non-use cancellations. Some companies opportunistically file applications that specify more goods than they actually sell, as a way to stake out more ground without any added cost. Others do so as an explicit strategy to prevent trademark squatters in any class and on any goods and services. Starbucks and Disney are two companies that follow this strategy, but even their marks are vulnerable to non-use cancellation after three years. That said, nothing’s stopping Starbucks from filing a new application every three years for the same goods. It’s not cheap, but it’s a lot cheaper than dealing with trademark squatters because it means a non-use cancellation would have no effect – they’ve got another trademark right behind the canceled one as if the trademark is just a shark’s tooth.
  6. The tipping point for non-traditional trademarks. Currently, the vast majority of trademarks are either word marks or devices (i.e., graphic images, with or without words). But as it becomes increasingly difficult to register a traditional trademark, companies are starting to look more closely at filing non-traditional trademarks like sounds, colors, and even three-dimensional representations. In part this would be driven by necessity, and in part by technological innovation.
  7. Registered IP matters. It’s hard to see the vast number of trademark applications as anything but a resounding vote in favor of registering IP in China. To paraphrase Colonel Tom Parker, 5.7 million China trademark fans can’t be wrong. If owning a trademark registration in China was meaningless and only provided aspirational rights, people simply wouldn’t pay the money to do it.
  8. China Law Blog FTW. Occam’s razor holds that the simplest hypothesis is usually correct. Could it be that this blog’s clarion calls for companies to register their trademarks in China have finally resounded? Obviously not to the tune of 5.7 million, but still, we like to think we’ve done our part.
China employment lawyer
For more on China employment law, go to Amazon and get my book!

As I have previously written, mutual termination is usually the safest path to take when you have chosen to terminate one of your China employees. This is because anything other than a mutual termination is fraught with risks because China is not an employment-at-will jurisdiction. Even unilaterally terminating an employee who has engaged in misconduct can be difficult. And things get even more difficult if the employee you wish to terminate has a special status (e.g., pregnancy). Though you generally can unilaterally terminate an employee for good cause (for example, the employee has committed a serious breach of your rules and regulations), grounds for termination of Chinese employees are highly circumscribed and that is what makes mutual terminations so appealing.

Consider the following situations:

  • Your employee did something terrible, but you don’t have a set of China-centric rules and regulations, so you basically have no written basis to terminate your employee;
  • Your employee did something bad, but not terrible enough to trigger termination under your own rules and regulations. Maybe it was her first offense and your document provides for “three strikes;”
  • Your employee did something bad and it was not her first time, but you have no good proof she did all those things in the past;
  • Your employee never signed an acknowledgment form confirming she received a copy of your rules and regulations.

Under any of the above circumstances, it is usually best not to pursue a unilateral termination, but instead, seek to work out a mutual termination. The below hypothetical should prove helpful.

Suppose you have an employee who makes a mistake at work without causing significant damage. Nonetheless, you think this mistake causes you to want to terminate the employee and so you issue a termination notice to the offending employee, citing the mistake as the basis for your termination. You give the employee a small severance payment and the two of you execute a settlement agreement. The severance amount is much lower than the minimum statutory severance and your by now ex-employee sues you, claiming it is an unlawful termination.

How will this case be resolved? In a real case based on similar facts, the employee lost on his unlawful termination claim. The court noted that it would have been too harsh for the employer to have unilaterally terminated the employee for a one-time mistake, but went on to hold that because there was an agreement where the employer paid the employee a severance in exchange for the employee’s voluntary departure, the termination was mutual. The court then held that the mere fact that the agreed severance amount was much lower than the minimum statutory minimum did not change the outcome because the employee failed to show that the settlement agreement was a result of coercion or deceit by the employer. Because the termination was mutual and because the employer-employee settlement agreement was sound, the court upheld the settlement agreement and ruled against the employee’s unlawful termination claim.

The employer prevailed because it signed an enforceable settlement agreement with the employee, in a circumstance where it would not have prevailed had it terminated the employee unilaterally. However, please do not emulate what this employer did. Had this employer actually paid its terminated employee more, it likely would have avoided the lawsuit and ended up paying considerably less overall. How much to pay a mutually terminated employee is one part art and one part science. When one of our China employment lawyers is called upon to craft a mutual termination settlement, we look at all sorts of factors in determining the just-right amount, including our own experience.

Bottom line: An enforceable AND reasonable mutual termination agreement will not only help you prevail in any lawsuit, it will go a long way towards preventing you from getting sued in the first place.

 

 

 

 

 

 

US-China Trade War -- Sorghum
US-China Trade War. Sorghum is the latest move.

For the first time in over a decade, the United States Commerce Department late last year self-initiated an antidumping and countervailing duty case. This case was against aluminum sheet imports from China.  Almost all other antidumping and countervailing duty cases are initiated by domestic producers filing a petition asking the U.S. government to investigate whether the subject imports are dumped or subsidized, and injure the domestic industry. It was highly unusual for DOC to self-initiate AD/CVD cases and act as both prosecutor and judge in these cases.

On February 4, 2018, China’s Ministry of Commerce (“MOFCOM”) self-initiated its own antidumping and countervailing duty case against the United States for imports of US sorghum grain. Total China imports of US Sorghum Grain in 2016 were 5,869,000 tons worth more than $1.26 billion USD. China is a significant export market for U.S. sorghum, accounting for about 70 percent of total US sorghum exports in 2016. Sorghum is used primarily as a livestock feed, but can also is used to make alcoholic beverages like Chinese Mao-tai and other baijiu. This self-initiated action by MOFCOM is widely viewed as China’s counter to U.S. trade actions over the past year.

China’s case involves dumping claims and it also targets large US agricultural subsidies for sorghum grain, such as the following United States agricultural assistance programs: Crop Insurance; Price Loss Protections; Agricultural Risk Protections; Marketing Loans; Export Credit Guarantees; Market Access Programs and Foreign Market Development Partner Program.

The following North American sorghum/ grain exporters may be targets of this MOFCOM Action:

  • Agniel Commodities, LLC
  • Attebury Grain, LLC=
  • Big River Resources
  • Bluegrass Farms of Ohio, Inc.
  • Bunge North America, Inc.
  • Cardinal Ethanol, LLC,
  • Cargill, Inc.
  • Consolidated Grain and Barge Co.
  • DeLong Company  Inc.
  • Enerfo USA, Inc.
  • Fornazor International Inc.
  • Freepoint Commodities LLC
  • Gavilon, Illinois Corn Processing, LLC
  • International Feed
  • Louis Dreyfus Commodities
  • Marquis Grain Inc.,
  • Mirasco Inc.,
  • Pacific Ethanol, Inc.,
  • Perdue AgriBusiness, LLC,
  • The Scoular Company,
  • Southwest Iowa Renewable Energy, LLC,
  • Tharaldson Ethanol Plant I, LLC,
  • United Wisconsin Grain Producers
  • Zeeland Farm Services.

This case is important because it signals a possible escalation of the on-going trade war with China. In January 2017 China issued AD duties of 42.2 to 53.7% and CVD duties of 11.2 to 12% on another U.S. grain product used primarily for livestock feed, dried distiller’s grains with solubles (DDGS). Some of the companies who exported DDGS to China may also export sorghum to China.

At a minimum, it shows that what goes around can come around and that China has no intention of remaining idle in the face of US trade actions. If the US is going to self-initiate antidumping and countervailing duty cases against China, China is going to self-initiate antidumping and countervailing duty cases against the US. This sorghum grain trade case indicates there is a price to pay for US tariffs and trade actions. Most of the companies listed above are based in or have very close connections to America’s heartland and that is surely no coincidence; China is aiming this sorghum grain case right at President Trump’s constituency—the agriculture and rural states.

Both the Wall Street Journal and Investors Business Daily have in numerous editorials warned the Trump Administration that the economic issue that could stop the rise in the US economy is a trade war. Trump and the Republicans have tied their political star to the rising US economy. But if President Trump levies more tariffs against Chinese imports, expect the Chinese government to retaliate and aim its trade guns at products and constituencies that will hurt President Trump and the Republicans the most—agriculture.

In the meantime, any company involved in providing sorghum grain to China should be looking to retain counsel experienced with both China and with international trade.

Things are starting to get serious.

 

China NNN Agreements
China NNN Agreements. So many choices.

Good sourcing agents are both hard to find and worth their weight in gold. And they operate in many different ways. On one extreme, a sourcing agent will find a factory, take a finder’s fee and then bow out, letting you deal with the factory directly. On the other extreme, a sourcing agent will act as your exclusive point of contact: you order from them, communicate with them, and pay them, and are expressly precluded from having contact with the factory. Most, however, fall somewhere in between.

The multitude of potential arrangements creates uncertainty about the appropriate contractual protections. That is: should you have an agreement with the sourcing agent, the factory, or both? And what type of agreement?

We are big fans of using NNN agreements in China with potential business partners (especially factories). Knowing this, our clients will sometimes come to us and say that they are having goods manufactured in China and they need an NNN agreement for use with everyone. It’s not that this is per se incorrect, but it’s often putting the cart before the horse. An NNN agreement is not the proper agreement in every situation.

If you don’t know the identity of the factory manufacturing your goods, an NNN agreement with them is out of the question. You can’t enter into a contract with an unknown company! And if you have a complicated arrangement with a sourcing agent or a factory, then an NNN agreement won’t go nearly far enough.

In short, the arrangement you have with your sourcing agent will determine the agreements you need, and with whom. We addressed these issues last year in China Manufacturing: To Broker or not to Broker, That is the Question, with particular attention to the question of whether you could (or should) have a contract solely with your sourcing agent. It will probably not surprise you to hear that the answer is: it depends.

In an ideal world, if you are dealing with factories directly, you would want NNN agreements with the factories with which you have initial talks, development agreements with the factories that develop products for you, and OEM agreements (aka contract manufacturing agreements) with the factories that actually manufacture products for you. In this situation, the agreement with the sourcing agent would be fairly simple because they aren’t doing much – it’ll basically be an NNN agreement with some additional verbiage to cover the finder’s fee. You don’t want the sourcing agreement to be the only agreement in place, because it offers so little protection.

If you are dealing exclusively with your sourcing agent, then you won’t – can’t – have any agreements with the factories. You will need to look to the sourcing agent exclusively for everything: non-competition, non-circumvention, non-disclosure, quality control, ordering, warranty, etc., because you have no contractual privity with the Chinese factories and no way to hold them responsible for anything. This can be useful if the sourcing agent is based in the United States because it is a lot easier to go after a US company. But this presupposes that the US company has assets, and that your agreement with them allows you to hold them responsible for the actions of the Chinese factories. In this situation, the sourcing agreement is all-important and must be carefully drafted, because many sourcing agents will attempt to avoid responsibility for everything from delays to quality issues to IP infringement. Working with these agents is taking a huge risk: if the sourcing agent isn’t responsible for the actions of the Chinese factories, and you don’t even know the identity of the Chinese factories, you’ve got no recourse if things go south.

For all of the sourcing agents in between, you’ll want a robust sourcing agreement and at the very least NNN agreements with the factories. Whether the development and manufacturing agreements are with the factories or the sourcing agent will depend on the particulars of how you deal with the various parties, and also your ability to hold them responsible when things go wrong. If the sourcing agent is a well-established company with multiple employees and a real office and sizable assets, it’s reasonable to look to the sourcing agent for everything. If it’s one guy with a virtual office in Los Angeles who spends most of his time overseas, not so much. Of course, the ideal situation from a legal standpoint is not always possible in the real world, so you need to adjust to the situation on the ground.

Some clients ask our China lawyers if they can just have NNN agreements “with everyone” and leave it at that? Certainly, it does not hurt to have NNN agreements with every party on the sourcing agent/manufacturer side. But it won’t cover all potential forms of liability – not even close. It will only hold counter-parties liable for misuse of your IP. For some clients, this is enough, particularly during initial phases when they are unsure whether their IP can really be commercialized.

And no matter what agreements you sign with your sourcing agent and factories, you still need to register all of your IP (patents, trademarks, copyrights) in China. You could have an ironclad agreement with a great sourcing agent who only uses wonderfully compliant factories, and it won’t mean a thing if some third party registers your trademark or copies your patented goods.

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

Our China attorneys frequently get phone calls and emails from people wanting to know what they should discuss with Chinese manufacturers they are considering for their manufacturing.

In response to this question, I usually send out the below list which succinctly sets forth the bulk of the terms most companies should be concerning themselves with when outsourcing their manufacturing to China. These are the sorts of things that need to  go into your China Manufacturing Agreement.

Not everything on this list will be relevant to your company and obviously some items will be more important to  you than others. This list is in English only and once you have honed it to suit your particular situation, it oftentimes will make  sense for you to put it into Chinese as well, so as to  reduce the likelihood of any misunderstandings. The terms set forth below come from a very lage and very sophisticated  client of ours and they are very much particularized to the particular industry, the particular situation, and the particular company. Your mileage will most definitely vary. My goal in providing this list is more to get you thinking about what’s important for your company than anything  else.

For more on China manufacturing term sheets, check out China OEM Manufacturing Agreements. What Should Go In Your Term Sheet? and China OEM Agreements. Ten Things To Consider.

 

PRODUCTS

 

Very short description of product goes here.
TERM OF AGREEMENT

1 year with automatic annual renewal; provided BUYER may terminate without cause on 60 days written notice and SELLER can terminate without cause on 180 days written notice.

 

EXCLUSIVITY 

Yes, during the term of the agreement, as long as SELLER can meet capacity and quality requirements; provided, BUYER may manufacture its own devices at its own manufacturing facility.

 

QUANTITIES

BUYER’s requirements; provided, BUYER supplies a 6-month, non-binding rolling forecast and a 3 month binding forecast.  Forecast will be provided 3rd day of each month.   BUYER willing to agree to a reasonable production cap reflecting anticipated demand.

 

ORDERS

Must be placed no later than 45 days prior to requested delivery date; SELLER may not reject any order.

 

PAYMENT TERMS 

First 2 POs, we will pay 30% of purchase price when PO placed and the remaining 70% will be paid 30 days after the shipment received.  Remaining shipments in first  year net 30 days from receipt of invoice.  After first year, net 60 days from receipt of invoice.

 

DELIVERY TERMS 

FOB Port (Shanghai) to BUYER’s designated marine carrier; risk of loss and title to pass to BUYER upon delivery to carrier.  Time is of the essence.  SELLER responsible for any fines incurred by BUYER from retailers for late delivery caused by SELLER (as long as PO placed sufficiently in advance of required lead time).  SELLER will properly complete all shipping documents and maintain a record of such documents for 3 years after delivery.

 

CUSTOMS

SELLER will properly label all shipping documents with the customs classifications codes supplied by BUYER.

 

PRICING 

To be agreed upon and will be set forth in schedule. SELLER cannot increase pricing without BUYER consent.  All prices stated in US dollars and payments made in US dollars.  Parties will meet and confer every 6 months to review pricing and determine whether price change warranted. 

 

COST SAVINGS

SELLER will continually endeavor to reduce costs of manufacturing, packaging and shipping to port.  All savings to be split 50/50 between SELLER and BUYER (savings already addressed in development agreement)

 

SPECIFICATIONS

All finished products and every individual part used to manufacture or package the products must meet BUYER specifications, which will be attached to and form a portion of the agreement.  If a supplier changes a specification to a commodity or part used to manufacture product, the change must be communicated to and approved in writing by BUYER.

 

PARTS & SUPPLIERS 

Each and every part used to manufacture, label, or package the products must be approved in writing by BUYER. SELLER may not change a part without BUYER’s written consent.  All materials and parts suppliers must also be approved in writing by BUYER and represent in writing that are in compliance with wage regulations of their jurisdiction of manufacture and that they do not use child, slave or prison labor to make their materials and parts.

 

QUALITY   CONTROL

 

Must meet all BUYER requirements (to be supplied by engineering).

 

FCPA     COMPLIANCE

BUYER shall provide SELLER with FCPA compliance manual and SELLER shall abide by it.

 

INVENTORY

SELLER will be responsible for ordering all materials and parts and maintaining an adequate inventory to meet forecasted demand.  SELLER will be responsible for all costs of storing and maintaining inventory.  In the event of termination or expiration, BUYER shall pay SELLER for the reasonable wholesale cost of any materials or parts that are custom made or unique to the BUYER products.

 

SAFETY STOCK

SELLER to maintain 30 day supply of each type of product at all times at its cost.  BUYER has no obligation to pay for it until it is delivered to BUYER’s carrier.  BUYER will buy back safety stock remaining within 60 days of expiration or termination of agreement.

 

TOOLING 

Addressed in Development Agreement

 

INSPECTIONS

BUYER will have the right, no less than twice annually, to conduct unannounced quality assurance inspections of SELLER’s facilities and books and records to ensure compliance with this agreement.

 

NON-COMPETE 

Addressed in Development Agreement.

 

WARRANTY

All parts and finished product shall be warranted free from defects in materials, workmanship and manufacturing for a period of one year from date of manufacture.  BUYER will have option of repair, replacement or refund and can return defective product at any time within 1st year regardless of when discovered by BUYER or its customers.  SELLER responsible for all costs to return defective product to SELLER.

 

INDEMNIFICATION 

SELLER to indemnify BUYER for:  (1) all actions and omissions of SELLER and Employees; (2) manufacturing and materials defects; (3) BUYER’s breach of agreement, reps and warranties; and (4) damage to Tooling caused by SELLER.

 

INSURANCE 

SELLER will maintain a US-based policy of insurance, including CGL, products and completed operations of not less than $1MM per occurrence with an umbrella of not less than $30MM.  Must maintain during agreement and for 10 years thereafter.

 

LIMITATION OF LIABILITY

Neither party liable for consequential, special or incidental damages or lost profits, or business opportunity.

 

 

CONFIDENTIALITY  Subject to NNN Agreement and will tie the OEM to NNN.
USE OF BUYER’S PRODUCT IP 

Limited to manufacturing only.  SELLER can’t use for own benefit and will inform BUYER if it discovers use of BUYER’s IP by any 3P.  Will reasonably assist BUYER in asserting any rights BUYER may have against such 3P.

 

ASSIGNMENT

SELLER may not assign obligations under agreement (even in connection with change of control) without BUYER consent.  BUYER may freely assign.

 

LABOR No slave, prison, child labor.  Wages in accordance with all applicable laws.

China WFOE Formation
China WFOE Formation. It’s complicated.

Yesterday, in the first part of this two-part series, I discussed how China is requiring foreign companies reveal all layers of WFOE ownership in the WFOE formation stage, I talked about how just as so many foreign companies are realizing the importance/necessity of forming a China WFOE, China has made it nearly impossible to form a WFOE without a full list of its owners. I first wrote about this issue in China’s New Foreign Investment Law: The “Actually Controlling Person” Requirement is Going to be Tough, but it is now at the point where the China lawyers at my firm are very clear with our clients who seek to retain us to help them form a China WFOE: you either reveal pretty much all owners of the WFOE-to-be (through the various layers of ownership) or your chances of getting a WFOE are not good. Clients unwilling or unable to make the required ownership disclosure in the exact form required by the PRC government authorities cannot proceed. There are no exceptions to the rule.

As noted in my earlier post, this is a threshold issue and this issue must be resolved before it makes sense to incur the time and expense required for aWFOE formation application.

China’s intent with this new [ownership disclosure] system is clear. The PRC government will no longer allow the use of special purpose vehicles and related entity structures to hide the actual ownership of the investors in PRC foreign-invested enterprises. And any attempt by a foreign investor to invoke a foreign law that allows secrecy with respect to ownership will [almost surely] be ignored. MOFCOM has plans to carefully audit all FIEs and that audit will include carefully reviewing their ownership structures. More important, however, is that a response that does not list out owners will simply not be accepted by the automated system. A response is therefore forced. A false response is a violation of law that can result in penalties and other legal/administrative action by the PRC government and its agencies.

Consider a typical private equity fund/venture capital type of ownership structure. The investor in the WFOE is Operating Company A. The owner of Operating Company A is a Holding Company B. Holding Company B is in turn owned by three private equity funds: Equity Funds C, D and E. The largest of the funds is owned by Equity Fund Z. As you can see, there are four layers of ownership.
For the MOFCOM information report, it is certain we will be required to disclose the following:
  • Operating Company A as the investor. This will require disclosing the officers and directors of Operating Company A.
  • Holding Company B is a 100% shareholder of Operating Company A. This will require we disclose Holding Company B, together with its officers and directors. We usually argue that Holding Company B is a “private equity fund”, and for that reason, we should not be required to disclose the shareholders of Holding Company B. Some MOFCOM offices will accept this argument. Some will not. Even if the local MOFCOM accepts, the higher level MOFCOM that does the later audit may not accept and then require all shareholders of Holding Company B be disclosed.
  • The local MOFCOM office may require disclosing the three shareholders of Holding Company B. If MOFCOM makes this demand, it will also require disclosing the directors and officers of Holding Company B. For the past several months, most MOFCOM offices have required this level of disclosure and foreign investors should plan on this disclosure being required.

The big question is whether MOFCOM will require moving up the chain to mandate disclosing the shareholders of the three shareholders in Holding Company B (Equity Funds C, D and E).  We have in the last few months been asked by various MOFCOMs for this level of disclosure, but we have so far been able to convince them that this should not be necessary. In one instance, we provided MOFCOM with an organization chart showing nearly 75 owners of an LLC (including many private equity funds) but ended up convincing it not to require our client disclose the names of these nearly 75 owners, as originally requested. When MOFCOM requests/requires this sort of disclosure, we normally argue that the C, D and E entities are “private equity funds” and disclosure of their ownership should not be required for the same reasons public company investors are not required to disclose their shareholders. Several local MOFCOM offices have recently tentatively accepted this argument, but this decision is not binding and the higher level of MOFCOM could demand more disclosure, either as part of the initial WFOE formation process or later as a result of their audit.

China has rejected shareholder secrecy and its requirement of full shareholder disclosure imposed on foreign investors is simply the consistent application of PRC law to all legal persons. The shareholder disclosure requirement is contrary to European and North American legal principles and on that basis many shareholders will refuse to consent to disclosure. However, under PRC law, there is no exemption. Moreover, as noted in Part One of this series, PRC local governments and MOFCOM offices are authorized to require even more sensitive private documents, such as the shareholders’ tax returns and tax returns of the WFOE’s foreign employees.
Bottom Line: If you are unwilling or even legally unable to comply with China’s ownership disclosure requirements you cannot proceed with a China WFOE formation. It is that simple and resistance is futile.
China Manufacturing Contracts
China WFOE Formation Ownership Disclosure: Like a Maze

Just as so many foreign companies are realizing the importance/necessity of forming a China WFOE, China has made it nearly impossible for a WFOE to be formed without a full list of its owners. I first wrote about this issue in China’s New Foreign Investment Law: The “Actually Controlling Person” Requirement is Going to be Tough, where I predicted what has now transpired.

It has reached the point now where we are very clear with our clients who hire us to help them form a China WFOE: either you reveal pretty much all owners of the WFOE-to-be (through the various layers of ownership) or the odds of your getting a WFOE are not good. Clients unwilling or unable to make the required ownership disclosure in the exact form required by the PRC government authorities cannot proceed. An Anti-Money Laundering Letter will be ignored and insisting on such a letter will only produce a hostile response. There are no exceptions to the rule.

This is a threshold issue and this issue must be resolved before it makes sense to incur the time and expense required for aWFOE formation application.

I provided the explanation for this in my earlier post:

China’s intent with this new [ownership disclosure] system is clear. The PRC government will no longer allow the use of special purpose vehicles and related entity structures to hide the actual ownership of the investors in PRC foreign-invested enterprises. And any attempt by a foreign investor to invoke a foreign law that allows secrecy with respect to ownership will [almost surely] be ignored. MOFCOM has plans to carefully audit all FIEs and that audit will include carefully reviewing their ownership structures. More important, however, is that a response that does not list out owners will simply not be accepted by the automated system. A response is therefore forced. A false response is a violation of law that can result in penalties and other legal/administrative action by the PRC government and its agencies.

Since I wrote that post, the China lawyers at my firm have found the local MOFCOM authorities are becoming even stricter about enforcing its WFOE ownership disclosure rules. The current trend is to require full disclosure all the way up the line of ownership. The only concession we have recently received is that some local governments will agree to end the disclosure at the level of what can be called a private equity or SICAR type fund. That is, some (not all) local MOFCOM offices will not require disclosing investors in private equity fund/SICAR type entities. However, other local MOFCOM offices DO require disclosure of private equity fund/SICAR investors.

There are though two levels of disclosure and getting past MOFCOM just means getting past the first level. The first disclosure is made in the information report provided to MOFCOM as part of the formation process. However, the new system includes an elaborate auditing process, so even if a local MOFCOM office allows for limited shareholder/ownership disclosure, an expanded disclosure may be required as a result of an audit. This is because the audit is done by a higher level office of MOFCOM. Such higher level offices are almost always stricter than the low-level offices.
So even if you are able to convince a local MOFCOM office to accept a limited disclosure of the shareholders of the investor, this is not a final decision. The initial MOFCOM decision can be overturned at any time and the demand for full disclosure can be made at any time. This demand would likely be made after your WFOE has started operations and if you then fail to comply with the demand your WFOE would be at great risk of being shut down.
Our European clients are usually the most taken aback by China’s new ownership disclosure requirements and we therefore often must spend extra time explaining the situation to those clients. Investor secrecy is at the heart of the European investment system. Most SICAR entities do not even disclose the identity of directors and officers. However, this form of secrecy has been rejected by the PRC government. For domestic companies that are not publicly listed entities, all shareholders are listed on publicly available websites. It is now possible to trace every PRC corporation up to the point of either a natural person shareholder or a public company shareholder. This is the system the PRC government intends to impose on foreign investors in China.
The investor disclosure requirement has become a fundamental policy in Chinese law. The PRC government fully understands that its policy of full investor disclosure is exactly opposite the investor secrecy systems standard in Europe and North America. Accordingly, any argument from a foreign investor that invokes European or international law is simply ignored as irrelevant. As noted above, as foreign entities have tried to resist fully disclosing their ownership, the PRC authorities have become more demanding, not less. We expect this trend to continue.
Note also that there are other disclosure risks, including the following:
  1. As part of the audit procedure, the PRC government may demand the tax returns of the disclosed shareholder(s) to confirm the accuracy of the reported information.
  2. It is nearly certain the PRC government will at some point require the WFOE provide three years of personal tax returns for each foreign individual employed by the WFOE.
  3. Other intrusive requests for what you likely will consider very private personal information may also be required during the life of the WFOE.
If you are not willing to provide the required information you should not move forward in trying to form a China WFOE because there is no way around these requirements. The PRC laws in this area are clear and the fact that those laws conflict with the laws and norms of Europe and North America is simply not relevant. What is relevant is that if you are not willing to comply with China’s ownership disclosure laws, you will not be permitted to set up and operate a WFOE in China.
As I wrote in my previous post, the “actual controlling person” requirement does not make legal sense under modern corporation structures, but the PRC government simply ignores this fundamental point. Thus, even after we do a full disclosure of all shareholders and thereby PROVE there is no single actually controlling person, the response of MOFCOM is to say: “You must identify the actual controlling person or we will not approve the investment.” Most local MOFCOM offices accept the name of the Chairman/CEO of the first level shareholder as the “actual controlling person.” Even that result though is not certain and there are two other possibilities:
  • The CEO/Chairman/Managing Director of the majority owning private equity fund or SICAR, no matter how far up the chain of ownership.
  • Endless requests for the name of the actual controlling person, when in fact there is no such person, making a response to the request impossible.
Our China attorneys have encountered all three of the above in our work on WFOEs during the period after the actual controlling person requirement was imposed. To date, there has been no consistency in the requirements.
In part 2 of this post, to come out tomorrow, I will discuss some of the specific situations we have encountered regarding ownership disclosure requirements when trying to register a China WFOE.