The end of Hong Kong

This blog has not minced words when it comes to describing the grim situation in Hong Kong, which, as one of my former colleagues at the State Department puts it, “will get worse before it doesn’t get better.”

Signs of Hong Kong’s demise as an international business center are plentiful. The city is in recession. Hong Kong airlines are cutting flights and losing revenue. Hotel occupancy rates are down. Foreign companies and governments have evacuation plans in place. My alma mater, CUHK, has cancelled the remainder of the semester, affecting not just regular students, but the many exchange students it hosts, including those from my other alma mater. Other of the Universities have done the same, even those that are not currently besieged.

Even if the city’s streets were to calm down—and that’s a highly unlikely if—it’s hard to see a meaningful bounce-back of the economy. Ever. The international business community is irreversibly spooked. Contrary to the 2014 Umbrella protests, which were largely contained to a few hotspots, the rage of 2019 has engulfed the entirety of the SAR’s territory, on full display for everyone to see, with everyone been affected in one way or the other. As a result, that most visceral expat nightmare of being physically prevented from escaping has at times turned into reality.

In any case, Beijing has made clear that going back to business as usual isn’t its game plan. Rather, it wants to push through “national security” legislation, “improve” how the city’s leadership is chosen and patriotically “reeducate” Hongkongers. Hardly a roadmap for reducing tensions.

As the Hong Kong/China authorities continue to struggle with opposition to their plans, it will become increasingly difficult for foreign businesses to immunize themselves from the chaos around them. Some risks to consider:

  • Visa Restrictions. From Beijing’s perspective, expats are problematic. Their continued presence helps preserve Hong Kong’s uniqueness at least to some degree, with their use of English and embrace of liberal idea. The life of relative privilege that many of them lead fuels resentment in a city already wracked with social inequality. Their presence would complicate more “robust” efforts at “pacification”. There is therefore all to gain and nothing to lose by making it harder for expats to obtain work visas, placing more restrictions on visa validity, and possibly closing the door on permanent residence (currently available after seven years’ in Hong Kong). Mind you, this is not my view, but it’s probably an accurate summation of the Chinese authorities’ feelings. Meanwhile, reducing the inflow of expats opens even more doors for Mainland Chinese staff, resulting in a win-win situation.
  • Legal Degradation. Hong Kong has a long history of inviting judges from the UK and other Commonwealth jurisdictions such as Canada to join its courts, and this practice continued even after the change of sovereignty. The presence of foreign judges has come under attack, mainly by pro-Beijing figures, and to be fair there is something paternalistic about it. I have no doubt that Hong Kong has enough legal talent to sufficiently staff its courts. What would be more problematic for the city—at least to the extent that it wishes to preserve something of its current role in the world—would be a marked drift away from the larger common-law tradition. This would make Hong Kong a far less appealing destination for international companies, who draw comfort from a legal environment that for all practical purposes is analogous to that in the most advanced Commonwealth economies. Beijing has already indicated that it seeks to “reform the system governing how the Chinese National People’s Congress Standing Committee [NPCSC] interprets the Basic Law”. What this could mean in practice is granular intervention by the central government in Hong Kong legal affairs. Until now, local counsel has been able offer reasonably predictable analyses of matters based on Hong Kong jurisprudence; if references are made to an English or Australian case, then in turn there is plenty of precedent to study. But if cases start being reviewed on a regular basis by the NPCSC, every matter will be a crapshoot, subject to political and other caprices. We could even see the “invitation” of Mainland Chinese judges to join the Hong Kong judiciary, meaning that even “local” adjudication processes are upended. China’s recent decision on masks is widely viewed by many lawyers as the clear end to rule of law in Hong Kong. See e.g. Can Hong Kong’s Courts Save the City? Don’t count on it .— written even before the face mask decision.
  • Educational Disruption. Since at least 2012, there has been talk of expats leaving Hong Kong because of air pollution – imagine then how the very real risk of getting caught up in street battles or having their kids gassed and harassed by the police is factoring into parental decision-making. In addition to the physical dangers that students face when getting to school, there are academic risks. Classes at all Hong Kong schools have been suspended for “transportation and safety reasons”. Too many cancellations will lead to lost semesters, a harrowing prospect, especially for those nearing graduation.
  • Of course, it isn’t just schoolkids that face danger. Parents can get tear-gassed during their lunch break in Central. Dad can get caught up in a pitched battle on his way to Cantonese class at a university campus. As we noted before, disturbances at the airport could mean that a business trip or family break is violently thwarted. And as bad as things could get for expats, they could get far worse for local staff. They are more likely to live in neighborhoods away from the business areas, and hence likelier to be affected by transport disturbances. In addition, they might understandably be wary of going through areas where police operations are taking place, lest they be confused for a protester and be dragged away by their hair. All of this inevitably leads to lost productivity, not to mention attrition as those who can get the hell out. Needless to say, many staff will want to avoid travel to Mainland China at all costs.

As a former resident of Hong Kong, it pains me to write this, but there is no point in engaging in wishful thinking. Hong Kong as an international business center is over, and few without a direct financial stake in the city are even bothering to claim otherwise anymore.

What is happening in Hong Kong is a big deal, and in no small measure because of what it means for the city’s long-established international business community. The party’s over. The borrowed time on which the borrowed place was living has run out. Before the handover, Deng Xiaoping assured the world that the horses would still run (馬照跑) in Hong Kong’s famous racetracks. Well, the horses are not running anymore.

Follow China's laws

Since October 6, 2018, one of our recurring themes has been that China has become far more difficult for foreign companies. It is what we have been calling the New Normal. This New Normal extends to all foreign companies that do business in or with China, but it has hit U.S. and Canadian companies particularly hard. The New Normal has greatly increased the risks for foreign companies that do business in or with China.

Yesterday, in U.S. Senate Bill to Block American Companies From Storing Data in China: It’s About Time, we wrote about a newly proposed U.S Senate bill that will make it illegal (as in jail time) for American companies to store their data in China. Our post  predicted this new bill would pass and yesterday’s unanimous censure of/warning to China about its human rights violations in Hong Kong ought indicates its odds of passing are overwhelming. At the end of that post we advised American companies to act accordingly and promised we would follow up by explaining what acting accordingly would look like. This is the beginning of that follow-up.

There are essentially three keys for dealing with the new China risks:

  1. Recognize these new China risks exist. Putting your head in the sand and denying that doing business in or with China has not changed is the most dangerous risk of all.
  2. Determine your own China risks. The risks of a Canadian company with 300 employees in China selling cutting edge healthcare products to mostly Chinese government owned hospitals is going to be a lot higher than the risks for a Spanish company that has three quality control people in China to aid it in making leather handbags. It is important you know your own risks.
  3. Confront your China risks. Knowing your risks is only half of the equation. The other half is dealing with them.

Pretty much all of our clients that saw and confronted their China risks early on are thriving, while those who went into denial are mostly panicking. One of our clients that immediately chose to switch its outsourced manufacturing to Thailand is doing great, while another of our clients that makes the same product but somewhat inexplicably chose “to stick it out in China” is talking about closing its business because of plunging sales. One of our clients that makes electronics products decided at the very beginning of the US-China trade war to move out of China “no matter what” now has a thriving low/no tariff diversified supply chain, while most of its competitors are just now scrambling to get out, while still stuck paying rising tariffs and duties. See Getting out — Tariffs push some US manufacturers to exit China. But on the flip side, many of our electronics product clients have virtually no choice but to keep production in China.

What are the China risks foreign companies are facing with China today? The list is almost endless, and it only makes sense to divide those risks between those who are doing business in China and those who are “merely” doing business with China.

This post will focus on what your company should do to reduce its risks of doing business in China if it truly must continue to do business in China. A subsequent post will focus on how many companies (but not all) can switch from a business model of doing business in China to doing business with China from outside China, with little or no negative impact on your business.

You already know that China has laws. You also already know that China enforces its laws. Lastly, you know that China enforces its laws unevenly. China often will enact a law and then not enforce it for a few years and then all of a sudden start enforcing it. China also will sometimes enforce a law for a while and then stop or relax its enforcement of that law. Some regions of China will enforce a particular law, while other regions do not. Some regions will have a law they enforce while other regions do not even have that law. Most importantly for foreign companies, China enforces many of its laws depending on who is violating them. China has always been way tougher in enforcing its business related laws against foreign companies, and nowadays it is way tougher on enforcing its laws against companies and individuals from the United States and Canada and lately (mostly because of Hong Kong) as against companies and individuals from the United Kingdom.

If you are a foreign company doing business in China, the risk you need to know and confront now is that China is working around the clock to find and go after foreign companies that are violating its laws. More than anything, it wants to find foreign companies that are violating its laws in a way that is costing China money.  It wants to find those violators so that it can fine them and thereby profit from them. We can debate as to why this is happening (rising nationalism coupled with a declining economy spring immediately to mind), but those who debate the fact that this is happening will just be wasting their own precious time. I tell clients China is at “ten out of ten” in terms of going after foreign companies right now, but with United States, Canada and United Kingdom (and perhaps South Korea, Taiwan and Norway), it has taken it up to eleven.

There is a lot you can do — even as a foreign company in China — to reduce your risks and the following is our general list of those things. This list is based largely on what we have seen happen in China during high tension/high risk times and we trot it out again now because past performance is a great indicator of present performance. If you are doing business in China you should do the following:

  1. Make sure your WFOE or your Joint Venture or your Representative Office actually exists and is still licensed to do the business it is doing in China. Make sure it is current on its capital obligations. See Doing Business in China Without a WFOE: Will the Defendant Please Rise.
  2. Make sure your WFOE or your Joint Venture or your Representative Office is actually properly licensed to do business in every city in which it is doing business. It is shocking how often this is not the case.
  3. Make sure your company is doing everything correctly with its employees. Consider an employer audit and note that our China employment lawyers have never done an employer audit without finding multiple problems. In other words, the odds are overwhelming that your employment systems are putting you at risk not just for problems with the Chinese government but also problems with your employees, which can so often lead to them creating Chinese government problems for your company. Doing things “how things are typically done in China” is no longer good enough; you must do things in full compliance with applicable laws.
  4. Make sure your company is current on any and all China taxes it might owe. If you think it may not be, it almost certainly is not, and you need a good accountant and fast. Doing things “how things are typically done in China” is no longer good enough; you must do things in full compliance with applicable laws.
  5. Review your lease agreement and the relevant zoning rules. Are you renting from a real landlord? Is it really legal for your business to do what it is doing where it is doing it?
  6. Have a trusted China contract lawyer review your contracts related to your China operations to make sure each and every one of them is legal. Doing things “how things are typically done in China” is no longer good enough; you must do things in full compliance with applicable laws.
  7. Conduct due diligence on your suppliers/manufacturers, distributors, retailers, and e-commerce platforms. Your risk correlates to the company you keep.
  8. China has many business crimes that are not crimes in the West. Know these. See Criminal Law And Business In China — A Strong Caution.
  9. Make sure your IP has been properly registered.
  10. Make sure your company is not violating a China company’s IP rights.
  11. If your WFOE or your Rep Office or your Joint Venture shares are American or Canadian owned, consider forming a new company (“Newco”) in a country with good relations with China and selling the WFOE Joint Venture share or Rep Office package to that Newco. This rarely makes sense, but when it does, it really does. This is a big decision that can have major repercussions, so do not just run off and do this.

Above all else, be wary, be careful, and be ready for things to just keep getting more difficult.

More to come tomorrow.

 

China Data Privacy Lawyers

On September 30, in China’s New Cybersecurity Program: NO Place to Hide, we wrote on how China’s new cybersecurity laws strip foreign companies of any ability to maintain their trade secrets in China:

Under the new Chinese system, trade secrets are not permitted. This means U.S. and EU companies operating in China will now need to assume any “secret” they seek to maintain on a server or network in China will automatically become available to the Chinese government and then to all of their Chinese government controlled competitors in China, including the Chinese military. This includes phone calls, emails, WeChat messages and any other form of electronic communication. Since no company can reasonably assume its trade secrets will remain secret once transmitted into China over a Chinese controlled network, they are at great risk of having their trade secret protections outside China evaporating as well.

The U.S. or EU company may have an enforceable agreement with the Chinese recipient of its confidential information. So trade secrecy is protected with respect to that authorized recipient. But if the secret is easily available to the Chinese government, there is no real trade secret protection.

By giving the Chinese government and its cronies full access to its data, the U.S. or EU company may very well be deemed to have illegally exported technology to China and it could face millions of dollars in fines and even prison sentences for some of its officers and directors. There is an inherent conflict between foreign laws mandating a company not transfer its technology and China’s laws which effectively mandate that transfer.

A week later, in China’s New Cybersecurity System: There is NO Place to Hide we wrote about the Chinese government’s goal of scooping up all data, both foreign and domestic, and of how once the Chinese government gets your data, it can do pretty much whatever it wants with it, including turning it over to your competitors:

When one examines all of these various different programs together, it becomes apparent that the MLPS 2.0 system is the “hardware” component of a comprehensive data gathering, surveillance and control program. China’s plan is to create a system that covers every form of network activity in China: Internet, mobile phone, WeChat type social networks, cloud systems, domestic and international email. China’s goal is not to create a commercial system where individual players can participate and make money. It’s goals are surveillance and control by the PRC government and the CCP.

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This result then leads to the key issue. Confidential information housed on any server located in China is subject to being viewed and copied by China’s Ministry of Public Security and that information then becomes open to access by the entire PRC government system. But the PRC government is the shareholder of the State Owned Entities (SOEs) which are the key industries in China. The PRC government also essentially controls the key private companies in China such as Huawei and ZTE and more recently Alibaba and Tencent and many others. See China is sending government officials into companies like Alibaba and Geely and China to place government officials inside 100 private companies, including Alibaba. The PRC government also either owns or controls China’s entire arms industry.

Simply put, the data the Ministry of Public Security obtains from foreign companies will be available to the key competitors of foreign businesses, to the Chinese government controlled and private R&D system, and to the Chinese arms industry and military.

In How China’s New CyberSecurity Laws Can (Will?) Destroy Your Business, we set out how damaging it will be for foreign companies that turn over their data to the Chinese government, beyond even that the Chinese government and its state-owned companies and universities can now freely possess it. We wrote how turning over this data will “harm foreign businesses far beyond China because it may violate export control laws and effectively eliminate any trade secret protections that formerly attached to the data”:

The first harm comes from U.S. export control laws that require certain high-tech information not be disclosed to persons who are not U.S. citizens, green card holders or protected individuals without an export license. These export control laws directly conflict with Chinese law  requiring full and total government access to that information in China because putting information regarding a controlled technology on a server or a computer in China will instantly create significant export control problems for itself. Foreign companies typically put their private information in China on a private server in China so as to isolate that information from the Chinese government. China’s new laws make clear that foreign companies must turn over this information to the Chinese government and failing to do so can lead to prison time. This conflict will be an enormous problem for US high tech companies with computer servers in China with high tech information on them because their “willingness” to give this information to the Chinese government (which obviously is not a U.S. citizen or green card holder) will in some instances constitute criminal law violations of U.S. export control laws.

The second way China’s latest data subversions will be disastrous for many foreign companies is by eviscerating their trade secret protections. To prevail on a trade secret claim in most countries you must be able to prove the following three things:

  1. The secret taken qualifies for trade secret protection.
  2. The holder of the secret took reasonable precautions to prevent disclosure of the secret.
  3. The secret was wrongfully taken.

Number 2 above could prove to be the downfall of foreign companies in China and here is an example of how that could happen. Suppose your Australian company (this is not just a United States issue) has a trade secret regarding cost efficiently producing a particular product. Suppose you make your China subsidiary makes your product in China and you provide the production information to your China subsidiary so it can cost efficiently make that product. Now further suppose one of your employees at your Germany subsidiary quits the company and sells your trade secret to your largest competitor, based in the United States. You then sue your ex-employee in Germany and your largest competitor in the United States for trade secret violations. No doubt, both your ex-employee and your largest competitor will argue that the information they bought/sold was not a trade secret because by your having revealed this information to the Chinese Government (and to its SOEs and Universities, etc.) means you did not take reasonable precautions to prevent disclosure of the information and therefore the information lost any standing it might have had as a trade secret and your case should be dismissed.

Will your ex-employee and your largest competitor win on this argument? Who knows at this point, but I think they will because companies that go into China do so voluntarily and they know that by doing so they are making their information freely available to others.

And then pretty much every single day (including yesterday) our China lawyers and/or our data privacy lawyers and/or our international trade lawyers would talk among ourselves about how few foreign companies were grasping the dire repercussions of China’s new data laws and of how even the U.S. Government seemed mostly asleep regarding these key issues.

Some tech media were covering China’s new data laws (TechdirtCyberwire, and Boing Boing, for instance) but it was not getting the media attention it deserved. More importantly, we wondered why the United States government had remained mostly silent and we speculated it was because it wanted to lock down Phase One of a trade deal first.

But then, on November 7, at the 2019 Web Summit in Lisbon, Michael Kratsios, the United States’ new Chief Technology Officer, gave a speech indicating he is fully aware of what China has done to secure access to foreign company data:

By implementing a dystopian credit score . . . . [and by] extending its authoritarianism abroad, and in no case, is this more clear than with Huawei Chinese law compels all Chinese companies, including Huawei to cooperate with its Intelligence and Security Services, no matter where the company operates in perhaps the most disturbing account of espionage news outlets have reported after Huawei installed communications technology equipment at the headquarters of the African Union, their computer system was hacked and data was transferred to servers in Shanghai, every single night for five years.

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[A]nd now they require access to all data, information and secrets contained on any server in China.

I strongly urge everyone to read Kratsios entire speech here.

Then the just released 2019 U.S.-China Economic and Security Review Commission Report to Congress, cites China Law Blog five times for various propositions (See footnotes 30, 44, 172, 176, 177), including the following

While the [new foreign investment] law consolidates previously disparate foreign investment regulations and effectively simplifies China’s foreign investment regime, its purported protections for foreign-invested firms may prove unenforceable or be selectively enforced absent more substantive changes that promote genuine rule of law in China’s legal system.

In other words, foreign companies will not be immune from China’s new laws, including its data security laws.

But U.S. government silence on China’s new data security laws officially ended on November 5 when “FBI Director Christopher Wray and other intelligence officials testified before the Senate Homeland Security Committee at a hearing on security threats facing the U.S.” Go here to see that testimony on C-SPAN.

Then yesterday, Missouri Senator Josh Hawley introduced the “National Security and Personal Data Protection Act of 2019” to “Address National Security Concerns Raised by Big Tech’s Partnerships with Beijing.” The politically savvy lawyers at my firm (of which I most emphatically do not count myself) insist that the timing of this proposed Act is no coincidence. They say the introduction of this new Act had been put on hold to allow the Phase One trade deal to be signed, but with the New York Times’ release of the Xinjiang Papers (a/k/a the “No Mercy” papers) that deal has now been “blown up” anyway.

Hawley has this to say about his proposed Act:

And it’s not just Chinese companies that create this risk. Chinese law allows the Communist Party to seize data from American companies operating in China whenever it wants, for whatever reason it wants. This legislation takes crucial steps to stop Americans’ sensitive data from falling into the hands of hostile foreign governments.

As FBI Director Christopher Wray testified, Chinese law “compels U.S. companies that are operating in China . . .  to provide whatever information the government wants whenever it wants.” This law means that when American companies store encryption keys in China, China can read the messages those keys protect.

  • Senator Hawley’s bill prohibits American companies from transferring user data or encryption keys to China and other countries that similarly threaten America’s national security.
  • Senator Hawley’s bill prohibits American companies from storing data in China and other countries that similarly threaten America’s national security.

Senator Hawley’s bill also will greatly limit what Chinese companies can do in the United States, but we will save the analysis on that portion of it for another day.

What’s most relevant here and now is that it will prohibit American companies from transferring user data or encryption keys to China. But seeing as how when the Chinese police demand such a data transfer from an American company in China, those companies must either comply or go to a Chinese jail for a long time, Hawley’s bill prohibits American companies from storing data in China in the first place.

If this Act becomes U.S. law, it will have earth-shattering ramifications for American companies that do business in China and I predict some form of this Act will become law. But even if it doesn’t, the cat is essentially out of the bag in terms of China’s far-reaching and incredibly intrusive laws to get at foreign company data. This proposed Act will jump-start American (and European companies) learning of how their data is at extreme and essentially unmitigated risk in China and of how they need to act accordingly.  In our next post, we will explain what “act accordingly” should look like.

As we have been saying since October 6 of last year, welcome to the New Normal.

 

China Joint Venture Lawyers

This is Part Three of our new series laying out the issues companies typically face and the steps our China company lawyers typically go through when forming a China Joint Venture. In Part One, we talked about how despite the increasing difficulties with doing business in China (or perhaps because of those difficulties), our China corporate lawyers are seeing an increase in foreign companies looking to do joint ventures in China. We then discussed how the first thing we do is try to determine whether going into China via a joint venture makes both business and legal sense for the foreign company that has retained us.

In Part Two, we discussed how once both our lawyers and and our client are satisfied that doing a China Joint Venture actually makes sense generally, we see our next task as helping our client determine whether the Chinese company with which they are looking to form the joint venture is the right company for a China joint venture. In that post, we set out the questions to pose to your potential Chinese JV partner to tease out an answer to this.

In this Part Three, we talk about what our China corporate lawyers do to try to determine early whether the Chinese side is truly interested in doing a Joint Venture deal with our client, or just feigning interest as a way of gaining access to our client’s intellectual property.

With China’s economy declining (particularly the portion that most interacts with foreigners), our China lawyers have for the last year or so been seeing a massive increase in all sorts of foreign company problems including (but certainly not limited to) the following:

  1. IP theft. See China Trademark Theft. It’s Baaaaaack in a Big Way.
  2. Manufacturing quality control problems. See China Factory Disputes: The 101.
  3. Sinosure problems. See China’s Sinosure: It’s Back and It Wants Your First Born
  4. All sorts of disputes necessitating litigation or arbitration. See How to Sue a Chinese Company: The 101.
  5. The Chinese government going after foreign companies (especially American companies) for not complying with all of China’s laws, more often and with greater ferocity than ever before in the last 20 years. See Want to Keep Your Business in China? Do These Things NOW and Doing Business in China Without a WFOE: Will the Defendant Please Rise.
  6. Fake law firms. See China Lawyers: The Fakes and the Quasi-Fakes.
  7. China employment law problems. See How to Avoid China Employment Law Problems, Part OnePart TwoPart 3 and Part 4, a series written by our lead China employment lawyer (Grace Yang) because, as she puts it, “now is not the time for employers in China (especially American companies) to be doing anything that does not fully comply with China’s employment laws.”
  8. All sorts of sharp tactics and scams, old and new. See e.g., China Licensing Deals so Horrible They are Hard to Believe. See also our China Scam Week series, where In Part 1, we wrote about the scam of tricking someone to come to China to sign a deal. Part 2 was on the scam of getting money for supplying products and then supplying nothing or, more commonly, something that isn’t even close to what the foreign company bought and paid for. Part 3 was on the switched bank account, which is — by far — the most difficult to avoid scam. Part 4  was on the scam where a Chinese company gets you to provide it work or services (or perhaps even product) in return for stock or stock options you can never really own because you are a foreigner. Part 5  involved a fairly recent, increasingly common, and highly sophisticated scam whereby a Chinese company claims to be interested in investing in your foreign company to steal your IP. Part 6 was on fake joint ventures.

On the Joint Venture front, we are seeing a big increase in Chinese companies seeking to do a joint venture solely to steal the foreign company’s intellectual property.  This ruse has been common in China for 30+ years but its use has accelerated (again) in the last year or so. One of our China lawyers long ago worked on a project that nicely illustrates how this ruse often works.

A U.S. company developed an advanced and expensive aquaculture technique ideally suited for species and conditions along China’s coast. The original plan was to sell six of these systems to a state owned fish grower in Shandong province. The Chinese company agreed to purchase the systems at a bargain price. After all the terms were agreed upon, our lawyer drafted the contracts and joined the U.S. company in Shandong to finalize and execute the contract. The day before the signing ceremony, the local government officials in charge of the project called us all in and stated that the price for the six as yet untested systems was just too high. They then explained how they had instructed the Chinese company not to execute the contracts, proposing the following as an alternative:

  • The U.S. side would contribute one aquaculture system as its capital contribution. The Chinese side would contribute the space for the system in the local bay, together with all other infrastructure required for six systems.
  • The JV entity would commit to purchase five additional systems after the first system was up and running.

Our China lawyer told our client why this was a bad deal and did everything he could to try to convince it to stick with the straight sale deal. Against our lawyer’s strong advice to the contrary, the client chose to move forward with the JV, on their own and without our help.

The U.S. company later told our lawyer how the deal went down. The U.S. company delivered and installed the first system. The Chinese side claimed the system was no good. The JV then refused to purchase the five additional systems. The JV then went bankrupt and disappeared. Undaunted, the U.S. company then explored selling its aquaculture systems to an unrelated Chinese company elsewhere in China. However, when the U.S. company went on its first visit to this other Chinese company, it found ten copies of its original system up and running. The only thing this other Chinese company wanted from the U.S. company was consulting advice on how to fine-tune its ten systems. The U.S. company was permanently closed out of the China market while clones of its systems being used up and down the China coast.

This is the classic technique for using a Chinese joint venture to steal foreign intellectual property. This technique has though been refined a bit since then and the current standard technique works as follows:

  • Foreign company offers to sell complex and expensive technology on a standard technology licensing basis.
  • After much discussion, the Chinese side indicates the price is too high for untested technology. The Chinese side then offers to establish a joint venture company where the foreign side will own some percentage of the to be formed China Joint Venture.
  • The foreign side contributes one unit of its technical system in exchange for its ownership interest. The Chinese side contributes the rest. The contribution of means that the JV now owns the technology for China. The JV agrees to the purchase a number of units at full price after the first unit is up and running properly.
  • The foreign company then delivers and fully trains the Chinese side on how to operate the foreign company’s technology.
  • The Joint Venture never purchases any additional units, claiming the foreign company’s technology does not work properly. The foreign company eventually discovers its technology has been cloned and is being actively utilized by an unrelated (usually state owned) company in China. Since the JV owns the technology, this unauthorized use infringes upon the JV’s intellectual property. The JV must therefor sue to defend its rights. But, the JV is controlled by the Chinese side and the JV management refuses to take any legal action.
  • The JV then disappears. Normally, the Chinese side simply buys out the foreign side at a substantial discount.

This system in various forms is still being actively used in China. A variant of this system was used to extract high speed rail technology from foreign companies and to extract jet fighter technology from the Russians. There are various ways to prevent this from happening to you, but one of the keys is usually to license your technology to the JV if it will be using it at all and to do so in such a way as to heighten your protections. If your potential JV partner insists on the JV taking ownership of IP, you almost certainly should walk. There are various other things our China lawyers look at and do to protect our clients from thieving JVs, but we are reluctant to reveal everything for fear that doing so will give the Chinese side an edge the next time. Let’s just say you have been warned.

China joint venture lawyers

This is Part Two of our new series laying out the issues companies typically face and the steps our China company lawyers typically go through when forming a China Joint Venture. In Part One, we talked about how despite the increasing difficulties with doing business in China (or perhaps because of those difficulties), our China corporate lawyers are seeing an increase in foreign companies looking to do joint ventures in China. We then discussed how the first thing we do is try to determine whether going into China via a joint venture makes both business and legal sense for the foreign company that has retained us.

Once both we and our client are satisfied that doing a China Joint Venture actually makes sense generally, we see our next task as helping our client determine whether the Chinese company with which they are looking to form the joint venture is the right company for a China joint venture.

Because this is much more of a business decision than a legal decision, we usually put the onus of this determination on our client. But because few companies have ever done a joint venture anywhere in the world and even fewer companies have done a China joint venture, we usually end up provided them with a tailored set of questions to pose to their potential China joint venture partner that will help determine whether the two companies are a good fit.

As we so often point out, China joint ventures are notorious for their high failure rate. An old Chinese saying often applied to joint ventures is “same bed, different dreams.” This Chinese saying (同床异梦) predates joint ventures and is used to apply to any sort of partnership without a meeting of the mind. The sooner you know whether you and your potential China joint venture partner share the same dreams, the sooner you will know whether to keep spending time and money in trying to do the joint venture deal.

The following lists of fairly general are what our China lawyers use as the foundation for drafting more specific questions to aid our clients in deciding whether there is sufficient commonality to move forward with the joint venture deal. We suggest our clients pose these questions to their potential China joint venture partner.

  • What is your company seeking to accomplish with this joint venture?
  • What will your company contribute to the joint venture? Property? Technology? Intellectual property? Money? Know-how? Employees? What will our company contribute?
  • What will your company do to advance the business of the joint venture, once formed?
  • What do you see our company doing to advance the business of the joint venture, once formed?
  • Who will make business decisions for the joint venture and what mechanisms will we use for reaching the various sorts of decisions that will need to be made? Who will control what? Who will make what decisions? The more specific you get here, the better.
  • If the joint venture loses money, who will be responsible for putting more money in?
  • How will we resolve disputes? Note that Chinese companies love responding to this with something like “we will work out any issues among ourselves and if that fails, we will have a special meeting to try to resolve everything.” If you get that sort of answer, you should push them to explain exactly how they see day to day disputes getting resolved so the joint venture does not collapse.
  • Can either of our company’s use confidential JV information for our own business? Can our own businesses compete with the JV? Can our own businesses do business with the JV?
  • How and when will the joint venture end? What if one of us wants to buy the other one out?

In part three of this series, we will talk about the sorts of things we look at to make sure the joint venture is not being proposed by the Chinese side as a mere front for getting access to our client’s intellectual property.

Three Steps to Forming a China WFOE

Our China corporate lawyers are often asked about the steps it takes to form a China WFOE. So often, in fact, that we long along drafted a stock response to that question and we are sharing that response below. Please note that the below is a generic roadmap for WFOE formation and the exact details for forming a WFOE in China will depend on, among other things, the WFOE’s business scope and the city/district in which the WFOE will be formed. Just as a for instance, a trading WFOE will have additional steps relating to import/export procedures.

If all goes smoothly, the overall WFOE formation process usually take 2-5 months. We do not break down the timelines for each of the steps below because those times can greatly vary, usually depending on how long it takes to prepare the financial information, to negotiate the lease, to obtain documents from the landlord, to authenticate relevant documents, and to validate the corporate structure. The MOFCOM authorities have lately been very efficient at processing WFOE applications and once you provide them with all required and requested information in the exact format they need/want, you usually will have a response back in 2-3 weeks. It is the time necessary to get to the point of giving the WFOE authorities all that they need that can take so long.

The below are the three steps necessary for forming a China WFOE.

 

Generic WFOE Formation

 

Step One. Name Approval Application
  1. WFOE Investor(s): corporate structure chart, authenticated corporate documents, passports and other documents identifying key personnel.
  2. Business Scope: define scope of business.
  3. Registered Capital: determine amount of capital to be invested, pursuant to financial projections.
  4. Total Investment Amount: determine maximum investment amount (capital + investor loans).
  5. Capital Contribution Timeframe: default is within 30 years.
  6. Proposed Chinese Name(s) for WFOE: at least 6-10 choices.
  7. WFOE Address: dependent on lease/office space.
  8. Name Approval Application Form: prepared by your lawyers, signed by client.
Step Two. The Formation Process
  1. Select accountant.
  2. Select bank.
  3. Draft labor and employment documents: employment agreements, WFOE rules and regulations, non-compete agreements, confidentiality agreements, etc.
Step Three. Post-Formation
  1. Open bank account.
  2. Carve chops.
  3. Open social insurance accounts and begin tax reporting.
  4. Other post-formation activity as relevant.

 

For more on the issues you will face in forming your WFOE in China, check out the following:

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

Let me begin this post by saying that I am a perpetual optimist. Ask people who know me well and I’m sure they will back me up. I’m not just the kind of person who views a glass half full, I will immediately tell you why this half-fullness is such a great thing and how all we need to do to get the glass entirely full is to do XY and Z. My optimism is so “bad” that I have to fight against it. If someone has cancer, my first instinct is that “we’ll fight it and win and so I’m not even going to worry about it.” I’m tempted to say something like that but I’ve learned that nobody wants a lawyer (and not a doctor) saying something like that, so I don’t. But I have once or twice when been told that someone with cancer is “pretty much out of the woods” said, that’s great but I knew that would happen. That gets me weird looks. Not claiming to be scientific here, but that is how I’ve always thought about life.

I mention all this to explain my pessimism about United States-China relations. Optimism and hope are great but as a lawyer tasked with representing companies that put livelihoods and financial returns on the line, I am not retained and paid to give advice intended to make people feel better or to condone proposals I do not believe will work. I am retained to give the facts and the laws and my opinions based on an objective analysis of those facts and laws. I am not retained to make people feel better or to condone actions I do not believe will work. I am retained to find solutions or when there are no solutions to be clear about that as well. Believe it or not, we would much prefer to get fired for telling the truth about a client proposal we know will not work than to just go along with it and hurt our reputation and our integrity by encouraging a sure failure. The great majority of lawyers I know act likewise.

This is all my preface to today’s question. Our China lawyers and our international trade lawyers are constantly getting asked, “what next for US-China trade?”

My response is that I see the United States and China continuing to decouple. I see this because both the United States and Chinese governments want this for the long term and everything you see that looks like things are otherwise are just short term solutions to forestall possible economic problems. So for instance, when someone says, “how can you say greater decoupling is inevitable when the United States and China are right now on the verge of reaching agreement on at least some of the disputed issues?”

I can say this because whatever “baby” agreement is reached will focus on the pure trade or economic issues. They will not resolve the deeper issues, such as China’s intellectual property theft, China’s closed market for foreign companies, and China’s subsidies for its own companies. Most importantly, they will not resolve the United States’ issues with China’s handling of Hong Kong, Xinjang, Tibet, Taiwan and the South China Sea. To see where things are going with US-China relations stop focusing on the little issues like the amount of agricultural products China will buy from the United States in the next year (especially since China is in desperate need of ag products because its own farm system is such a disaster). If you want to discern the future of US-China relations you should be reading or listening to the big picture long term pronouncements by government leaders. Reading the following will help:

The trade dispute between the United States and China entered its second year and remains mostly unresolved. The Chinese government’s unwavering commitment to state management of its economy remains a major stumbling block. In response to decades of unfair economic practices, the United States wants the Chinese government to codify commitments to strengthen intellectual property protection, prohibit forced technology transfer, and remove industrial subsidies. But these practices are core features of China’s economic system, and the Chinese government views U.S. demands as an attack on its national development.
China continues to ignore the letter and the spirit of its World Trade Organization (WTO) commitments. The resulting impasse has led to multiple rounds of mutual tariff actions impacting more than $500 billion in bilateral goods trade, and reducing trade between the two countries. In response to U.S. measures to address illegal activities of Chinese technology firms, China’s government strengthened pursuit of technological self-reliance and its state-led approach to innovation, which uses licit and illicit means to achieve its goals. This will continue to pose a threat to U.S. economic competitiveness and national security.
None of the top-tier Democratic presidential candidates have truly questioned the United States’ trade war against China and as far as I know, none have called for removing the tariffs against China. Many of spoken out even more strongly than Trump regarding China’s military and human rights practices. In other words, this decoupling is not just a Trump thing that will end if he is not re-elected.
Read the above links and if you still believe decoupling is not our fate I would welcome your explanation in the comments section below.

China Joint Ventures

Despite the increasing difficulties with doing business in China (or perhaps because of those difficulties), our China corporate lawyers are seeing an increase in foreign companies looking to do joint ventures in China. This is the first part in a new series of posts in which we will explore the issues involved in forming a China joint venture, from beginning to end.

Our firm usually gets a China joint venture matter when a company calls or emails us, saying they are “looking to do a China joint venture” and asking us if we can help. Our immediate answer is to say yes we can, because we can.

Our first questions to this foreign company are usually geared to telling us whether a joint venture makes both business and legal sense for the foreign company. We usually get at this by asking the foreign company why it is looking to do a China joint venture and what specifically its joint venture will do in China. We then listen to their explanations with an eye toward determining whether a joint venture is necessary on either legal or business grounds. China’s economy remains closed to foreign businesses in many industries and part of that closure involves requiring foreign companies enter into the Chinese market only via a joint venture.

If Chinese law does not legally limit market entry to joint ventures, we then seek to determine whether a joint venture makes business sense. Oftentimes, we will at this point ask the foreign company about their prior experiences in and with China and their prior experiences in other countries around the world. The experience in China question is deployed to gage their knowledge of China. The question about their experiences around the world question are to gage how they typically enter foreign markets — more specifically, whether they use joint ventures or not.

Around half the time it quickly becomes apparent to us that a joint venture will likely be a bad idea. Generally (though not always), if you can go into China via a Wholly Foreign Owned Entity (WFOE), doing so is preferable to a Joint Venture. For the long (but not too long explanation) for why this is the case, I urge you to read this article I wrote for the Wall Street Journal about a decade ago, entitled, Joint Venture Jeopardy. Generally (though not always) if you can go into China via a manufacturing contract, a reseller agreement, a distribution agreement, or some sort of service agreement, doing so will also be preferable to a Joint Venture.

If our China corporate lawyers initially believe that some way of going into China other than via a joint venture would be preferable for the foreign company, we tell them that and we explain why we see things that way and we ask them whether they agree with our assessment. Roughly 50 percent of the time the foreign company will tell us that they did not realize they had other options and they would like to discuss those other options with us. Many times, these same companies tell us that their putative Chinese joint venture partner had claimed that doing a joint venture was legally necessary and they feel (rightly) deceived upon learning this was a lie.

Roughly 50 percent of the time the foreign company will reveal that they fully understand they have options other than a joint venture for going into China or for doing business in China, but doing a joint venture makes sense for them because of what their putative Chinese joint venture partner will be able to contribute. At that point, we usually tell them how they can secure those same contributions from that same Chinese company, but via a contract, and we ask them whether that might make sense for them. Much of the time their response to that will be something along the lines of how they understand all this but their potential Chinese joint venture partner is well-positioned to help them in China and it has made clear it will do so only via a joint venture. Other times the foreign company has never had a “joint venture versus no joint venture” discussion with its Chinese counter-party and it decides it should have such a discussion before moving forward in forming a joint venture.

At this point we move forward with the joint venture for those foreign companies that still wish to go into China as a joint venture and we move forward along other avenues for those who are now uncertain whether a joint venture makes sense or have determined that a joint venture is not for them.

In our next post, we will discuss what is usually our next step for those moving forward on the China joint venture track — how to determine whether the Chinese company with which they are looking to form a joint venture is the right Chinese company with which to form the joint venture.

China Lawyers

“It’s not dark yet, but it’s getting there.” Bob Dylan, from Not Dark Yet

In the 1990s, I represented a number of international fishing and timber and mining companies that did business with Russia. This was not so long after the fall of the Soviet Union and there were a bunch of large Russian companies — many of them formerly state-owned — looking to do deals with my clients, mostly American and Western European companies. My clients would set up long term deals with these Russian companies which nearly always went bad quickly because the Russian company would grab whatever money there was and walk away.

This would leave my clients dumbfounded at how the Russian company would so “irrationally” sacrifice so much money in the long term to grab a relatively small amount of money in the short term. I would find myself explaining the following to them:

You have to understand that for most Russian companies there is no long term. They are used to the Soviet Union where the rules and the laws constantly and unpredictably changed to their detriment. They do not believe they will be able to operate freely five years or even one year from now. So though you see them as having irrationally sacrificed massive long term gains for much smaller short term rewards, they see themselves as having quite rationally grabbed what they could while it was still there.

I am writing about this now because China today is feeling a lot like Russia in the 1990s. I am getting the sense that many Chinese companies are pessimistic about their futures and they are acting accordingly. Our China lawyers are seeing evidence of this everywhere.

China’s economy is hurting right now. On the one hand, food prices are soaring. See China’s consumer prices rise at fastest clip in nearly 8 years, as pork prices continue to soar. On the other hand, exports are plunging. See China’s exports decline for third successive month in October. Reliable economic indicaters (as opposed to official government statistics) paint an economy in trouble.  See China’s economy is in more trouble than markets think. See also China’s car sales drop for 16th consecutive month as October falls 4 per cent. The tariffs are not helping nor is the Chinese government’s crackdown on private businesses.  On top of the economic issues, many Chinese companies have become both wary of and angry at the West, particularly the United States. This too makes things riskier for foreign companies.

We are seeing the results of all this in many ways.

Practically every week one of our China lawyers will get an email or a phone call from someone who bought product from China and received nothing in return or nothing even approaching what they actually ordered. This sending of “junk” instead of real product has spread to pretty much every industry in China and ordering your products from allegedly reputable online sites provides little to no protection.

The below email (modified so as not to reveal anything) is par for the course:

I worked with a company in China to manufacture doggy beds [I made this up] on which I have a U.S. patent pending and also have trademarked.  I received samples from them and all was good. I placed an order for 50,000 pieces and they are of the wrong material and falling apart. They told me they would send me the right product but now they are ghosting me. I cannot sell the product they sent me. I’m still trying to get my new product to market but that is proving really difficult because I have been hurt so badly financially. Can you help?

My response to these sort of emails is usually to explain that the odds of our getting even some of their money back are less than 50 percent and they should think long and hard before throwing good money after bad. I refrain from telling them what they should have done differently, but I can discuss that here and it is the following:

  • These things usually happen when product buyers do not conduct sufficient due diligence on the seller. Do your due diligence before you send money. Send people you trust to investigate the manufacturing site. Do a site inspection on goods before payment. Make sure the company exists and is legally able to conduct the business for which you will be paying it. Doing just these few inexpensive things will greatly increase your odds of not getting scammed.
  • These things often happen with Chinese companies that want to make a few final overseas sales before they shut down and disappear. Just imagine the profits to be made from three $350,000 sales for which laughably bad or no product is ever provided. Now just imagine the incentive Chinese manufacturing companies have to sell and not supply foreign companies right before (or sometimes even right after) they shut their doors for good.
  • Oftentimes the Chinese company that committed the fraud does not exist. It is not registered anywhere in China or if it is registered as a real company in China it is registered for something like kitchen repairs, not for manufacturing whatever product it is they sold you.
  • These fraudsters are smart and there are good reasons why they spend the money to send you something instead of nothing at all and why they initially say they will remedy the problems and why they often continue making that claim. Sending even really bad product is less likely to lead to criminal charges than sending no product at all. They can tell the police that they sent you the product you ordered and it’s not their fault those Americans/Europeans/Australians are so picky. By stalling you they can keep their scam alive. They’ve paid for advertising and for a website and they’ve even bought the really bad product and they want to maximize these expenditures. Act early on these sorts of problems and your chances for a recovery increase.
  • Use a contract that actually works for China and that sets forth clearly what you are buying and what happens if your China supplier fails to comply. See China Contracts: Make Them Enforceable Or Don’t Bother and China Contracts that Work.
  • Know the market price of whatever it is you are seeking to purchase before you purchase it. Do not trust a company that gives you an unreasonably low price quote.
  • Consider a small trial order to reduce your risk. The problem with this is that many scammers will provide you with a good trial order and then scam you when you order the full amount. But if you combine this with a contract that works for China and proof that the company actually exists and is operating legally, you will be greatly lowering your risks.

One more thing that warrants its own special mention. Do not buy product from China without first registering your trademark in China because many of the fraudsters sending out bad product are now also registering YOUR brand name and/or product name and/or logo in China as THEIR trademarks in China and then coming back later seeking to sell you these trademarks for a lot of money under threat of blocking your products from leaving China for violating THEIR trademarks. See 8 Reasons to Register Your Trademarks in China.

Speaking of trademarks and IP, we have also seen a massive increase in what I call early IP theft, which also stems from Chinese companies’ lack of confidence in their future. We wrote about this in China Trademark Theft. It’s Baaaaaack in a Big Way:

For years we probably averaged a call a week from someone who had lost their trademark to China to someone who had gone ahead and filed it before the non-Chinese company did so. Then, starting maybe 5 or 6 years ago, the number of these calls declined. I have ascribed this decline to two things. First, foreign companies started getting wiser about the need to get their brands, their logos and their company names registered as trademarks in China. Second, and of equal importance, China instituted rules to try to stop Chinese manufacturers and trading companies from registering as trademarks the brand names and logos and company names of the foreign companies for whom they were manufacturing or sourcing products. To simplify a bit, your China agent could not hang on to a China trademark that you were using before you brought them on for your manufacturing or product sourcing. We went from one China trademark “theft” call a week to maybe one a month.

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

There is a third reason trademark and IP theft has so dramatically increased in China of late. More Chinese companies have stopped thinking long term. Just yesterday, in The Right Way to Reduce Your China Product Costs, we wrote how Chinese companies have become wary of their foreign buyers leaving them for tariff-free manufacturing outside China:

But you must be very careful in negotiating lower prices from your Chinese factory because just asking for lower prices could cause your company some very serious blowback. The first thing you should know is that Chinese factories are sick and tired of losing so many of their customers and they are very wary of anyone who they believe may leave them for another factory in another country.

If your Chinese factory is not convinced it will be making your widgets for another three years, it knows it can make more money by making “your widgets” for itself and then selling them wherever it can. In the last year, more foreign companies have come to us after their Chinese manufacturer “stole” their product (and its IP) without ever having made a single one for the foreign company than in the last five years combined.

We are also seeing an incredible uptick in Sinosure cases. We wrote about this earlier this year in China’s Sinosure: It’s Back and It Wants Your First Born:

Like clockwork, the downturn in China’s economy is leading to a big uptick in American companies contacting our international litigators for help in fending off Sinosure threats. For the full import of what I mean by Sinosure threats, I urge you to check out Owe Money to China? Meet Sinosure, Leviton Law Firm, and Brown & Joseph and China Sinosure: What You NEED to Know. To summarize, Sinosure is China’s Export and Credit Insurance Corporation and what that means in real life is that it insures most of China’s exports. It insures those exports by paying its policyholders when a foreign company fails to pay for product it has received from its Chinese supplier.

So how does an increase in Sinosure cases against American companies reflect the downturn in China’s economy? Well over half of the many Sinosure cases our lawyers have seen over the years arise from bad product delivered by the Chinese manufacturer. The typical Sinosure case involves a Chinese company sending over (let’s say) $500,000 in bad product. The American company cannot sell that product for its usual $950,000, but instead is forced to unload it for $350,000. The American company tells all this to the Chinese company and seeks to resolve its alleged $500,000 debt to its Chinese supplier with a one time $250,000 payment. The Chinese company goes silent and a few weeks later, the American company receives an aggressively threatening letter from one of Sinosure’s U.S. lawyers.

In As trade war deepens, a state-owned insurer in China helps soften the blow, Reuters News wrote about the increasing number of Sinosure cases:

Last year, as the trade war started to bite, Sinosure’s claim payouts surged more than 40% to nearly $2 billion, according to data from the company, which is owned by an investment company controlled by the finance ministry.

Payouts are poised to climb further this year with tariffs rising, according the company’s internal estimates.

*    *    *    *

Dan Harris, a lawyer who represents U.S. importers, said he has received increasing requests for help dealing with Sinosure demands for payment on behalf of Chinese exporters.

“Before the trade war, I might go … four, five months without getting a Sinosure email, now I’m getting four or five a week,” said Harris, managing partner at international law firm Harris Bricken

Sinosure is China’s state-owned export insurance company that pays Chinese manufacturers that were stiffed by their foreign buyers and then seeks to collect from the foreign buyers that allegedly failed to pay. Before this year the Sinosure cases we handled always involved situations where if the Chinese manufacture did not get Sinosure involved it would almost certainly never get paid. We are now seeing Sinosure cases where the Chinese manufacturer has made what we think are fraudulent policy claims to Sinosure because they are desperate for cash and they don’t care about maintaining their relationship with their foreign buyer.

Lastly, our China lawyers are dealing with an increasing number of situations where the Chinese side of a China joint venture has essentially taken over the joint venture and stops communicating with its foreign joint venture partner. Maybe these joint ventures are no longer even profitable, but our clients are entitled to determine this and if the joint venture should be shut down, our clients are also entitled to a share of the joint venture company’s existing assets. For how to prevent/mitigate such problems, check out this article on China joint ventures. It’s as though the Chinese side in these joint venture partnerships views it as their patriotic duty to kick their foreign partner to the curb.

For some companies, China’s increasing risks now exceed its rewards, but for others this is not at all true. Do you really need a legal entity in China with Chinese employees or might your company be better off with no operations in China beyond a third party distributer or reseller? Our China lawyers have been doing a lot of work in the last six months helping our clients reduce their China footprint and thereby reduce their China risks. No matter what you are doing in or with China, now is a good time to look at how you too can reduce your risks. The following posts are relevant for this:

Bottom Line: China in the last year has become far riskier on nearly all fronts. It is important you recognize this and act accordingly.

International Manufacturing Lawyers

In China Factories Are Exporting Lower Prices Around the World, Bloomberg News wrote this week about something our internmational manufacturing lawyers have been seeing: Desperate Chinese factories are lowering their prices. Are all Chinese factories desperate? Absolutely not. Are all Chinese factories lowering their prices? Near as we can tell, a great many are, especially for their best customers.

But you must be very careful in negotiating lower prices from your Chinese factory because just asking for lower prices could cause your company some very serious blowback. The first thing you should know is that Chinese factories are sick and tired of losing so many of their customers and they are very wary of anyone who they believe may leave them for another factory in another country.

China’s factories just suffered their third straight month of declining production and nearly all legitimate economists see this decline continuing. More importantly, nearly all Chinese factory owners see the same thing. This is important because if you tell your Chinese factory that you “need” a price reduction, it will think you will leave if it does not give you the full amount you request and this can be dangerous. If you tell your Chinese factory that if it does not lower its prices by 10 percent or you will go elsewhere and your factory cannot lower its prices you just put your company at major risk. In The Single Best Way To Avoid Being Taken Hostage In China, we wrote of how Chinese companies often take hostages to try to collect on alleged debts or to protest employee layoffs or the closing of a China facility:

As the [Associated Press] article states, “it is not rare in China for managers to be held by workers demanding back pay or other benefits, often from their Chinese owners, though occasionally also involving foreign bosses.”

My law firm’s advice every single time to our clients who are laying off workers in China or closing a facility in China or allegedly owing money in China is to stay outside China for all negotiations.  One only needs to be a regular reader of our blog to know that we took this position long ago and have never waffled:]

If you are in a debt dispute with a Chinese company, the best thing to do is not go to China at all.

If you must go to China, think about using a bodyguard or two and think very carefully about where you stay and where you go. Most importantly, be very careful with whom you meet.

Consider preemptively suing the alleged creditor somewhere so that you can very plausibly claim that you have been seized not because you owe a debt, but out of retaliation for having sued someone. If you are going to sue, carry proof of your lawsuit with you at all times while you are in China.

You are probably wondering why I am writing about debt collection and hostages when the theme of this post is reducing your China factory pricing. The reason is simple: when Chinese companies believe you will be leaving them/leaving China, alleged creditors come out of the woodwork. The tax authorities will come up with taxes that you owe. Your factory will explain why you owe it way more than you thought you did. Your factory’s sub-suppliers may send you bills for components you never ordered and never knew you were responsible for paying. You will get a bill for the molds and the tooling and the design work your factory did years ago and you thought (rightfully so until now) was included in your product pricing. These sorts of things do not always happen, but they happen often enough that you need to be prepared for them. The first rule is that you should have this discussion with your factory from your own country, not at a face-to-face meeting in the corrupt Chinese town where your factory wields its power.

If the “bad things” described above happen and none of your personnel are held hostage, can you not just “walk away” in the middle of the night never to return to China? That is possible, but that comes with risks and it seldom will make sense unless you absolutely certain neither your company nor anyone who can be relatively easily identified with your company will ever again do business with China or find itself in China. As someone who has many times been in an airplane that had to land somewhere other than its intended destination (I once spent four unplanned January days in Magadan, Russia, when the city had essentially no fuel for heat) you also will need to be completely certain that neither you nor any of your personnel will ever involuntary find yourself in Mainland China (or Hong Kong or Macau?).

if you are going to try to negotiate lower prices from your China factory, you need to have a Plan B setting out what to do if your relationship with your China supplier ends that day. These days, about 10 percent of the time when one of our clients goes to its China supplier to negotiate a lower price the supplier flat out says something like “we are done manufacturing for you. We don’t need you anymore. We are selling our own products direct now.” That ten percent figure is even higher for any foreign company whose products are being shipped to the United States because so many Chinese companies have come to believe those companies will soon be leaving China entirely — and they are right. Oh, and its “own” product that it will be selling (or has been selling already for months) could very well be a clone of your product.

What then should you do to plan in advance for something as simple as asking your Chinese factory for a price reduction? First, make sure nobody from your company is in China when you make the pricing request. Second, make sure that you have secured your molds/tooling and all product for which you have already paid before you do anything that might tip off your China supplier regarding the possibility that you may start manufacturing elsewhere. Third, line up new suppliers (preferably outside China) that can start producing quickly.

Over the years our China manufacturing lawyers have repeatedly seen the following:

  • Foreign company tells its China manufacturer it will be ceasing to use China manufacturer for its production. China manufacturer then keeps all of the foreign company’s tooling and molds, claiming to own them. The way to prevent this is to get an agreement from your Chinese manufacturer that you own the tooling and molds before your Chinese manufacturer has any inkling you may be moving on. For more on the importance of mold agreements, check out How Not To Lose Your Molds In China and Want Your China-Based Molds? You’re Probably Too Late For That.
  • Foreign company tells its China manufacturer it will stop using the China manufacturer for its production. Foreign company then learns that someone in China has registered the foreign company’s brand names and logos as trademarks in China. Foreign company is convinced its China manufacturer is the one that did these registrations, but it has no solid evidence to prove this. Foreign company is now not able to have its product — at least with its own brand name — manufactured in China. Foreign company is also now faced with having to deal with a low cost Chinese competitor that can legally make products in China with the foreign company’s brand name and logo and sell those products anywhere in the world where the foreign company does not itself possess the trademark rights in its brand name and logo. The way to prevent this is to make sure your IP registrations in China are current before you say anything to anyone that may lead them to believe you may be leaving them, or even just reducing your purchases from them. See China Trademarks: Register Yours BEFORE You Do ANYTHING Else. Not long ago, a U.S. company came to us after having told its China manufacturer that it would need to add an additional manufacturer because it needed much greater production capabilities. The China manufacturer responded by saying that “we own the China trademarks to your products and the China patent to your product designs and if anyone else in China tries to make your products we will get an injunction to stop them from doing so and another injunction to stop any of your products from leaving China. SIX lawsuits later the warring companies reached a settlement. Do not let this happen to you!
  • Foreign company tells its China manufacturer that it will be ceasing to use China manufacturer for its production. A few weeks later, foreign company has its products seized at the China border for violating someone’s trademark or design patent. The foreign company is (rightly) convinced that its China manufacturer is the one behind the product seizure, believing the Chinese manufacturer registered the foreign company’s brand names as trademarks in China long ago and is just now using that trademark to seize product as revenge (or just registered the design patent). China has laws forbidding its manufacturers from registering the trademarks of those for whom it manufactures, but because it is usually not possible to prove that your manufacturer in Shenzhen had a cousin in Xi’an do the registering, this sort of thing goes on unchecked. For how to prevent this from happening to you, check out the following:
  • Foreign company tells its China manufacturer that it will be ceasing to use China manufacturer for its production. China manufacturer then says that it will not be shipping any more product because foreign company is late on payment and owes it hundreds of thousands of dollars. China manufacturer then reports foreign manufacturer to Sinosure and Sinosure then ceases to insure product sales to this foreign company, which can have the effect of convincing other Chinese manufacturers not to sell to foreign company without getting 100% payment upfront. For more on Sinosure’s role regarding China exports, check out Be Sure Regarding China’s Sinosure. Note that if you are planning to move your business to a country other than China, Sinosure’s power over you will be greatly diminished. More importantly, note that with the downturn in Chinese manufacturing, Sinosure has gotten incredibly aggressive at going after foreign companies. See this Reuters article, As trade war deepens, a state-owned insurer in China helps soften the blow
The bottom line is that if your Chinese factory believes you may be leaving it or leaving China, your company is at risk and asking for a price cut will often be viewed as your having one foot out the door.
Despite all the risks, now is the ideal time to be looking at moving your supply chain out of China and/or trying to get your China suppliers to lower your product pricing. Our international manufacturing lawyers are working nearly non-stop to help our clients move all or diversify their manufacturing to countries outside China — so far this has mostly been to other Asian countries, such as Vietnam, Cambodia, the Philippines, Malaysia, Pakistan, India, Thailand and Taiwan, but also to Mexico, Colombia, Eastern Europe, Portugal, Germany and Spain. Even to Canada and the United States — more so after the announcement of the “new NAFTA” agreement, a/k/a the USMC.

But what if you have no choice but to stay in China? Seeking to lower your product pricing will be your best option.

What you need to know about the new realities of China factory pricing is that the Chinese government is doing whatever it can to prop up its factories. More than anything, the Communist Party does not want to see factories closing and jobs being lost and huge numbers of people marching in the streets, as is happening in Hong Kong.

So to avoid that, China has been doing the following (and more)

  1. It has reduced income tax rates for Chinese export manufacturers, thereby reducing overall costs by about 4%.
  2. China has reduced its VAT rates for the export of various (but not all) products, thereby reducing overall costs by roughly 4%.
  3. China has pushed down the value of the RMB, thereby increasing by about 4% the amount of RMB Chinese export manufacturers get from their Dollar/Euro sales.

So right there we have about a 12% reduction in costs for China Factory. Note that the numbers above are rough calculations and individual valuations will vary. Note also that we are hearing rumors that Sinosure is now providing export insurance to Chinese factories at no cost and this is just one of many cost/expense subsidies/reductions of which we are hearing. But because we have not run down any of these rumors, we will ignore them for purposes of today’s cost-cutting discussion.

What you need to do then is try to get your Chinese factory to share at least some of its 12% windfall with you. Tell your factory that you have heard that China’s recent income tax reductions and VAT rebate increases and RMB devaluations — and who knows what else the Chinese government is doing and will do to subsidize Chinese manufacturers — has reduced its manufacturing costs by 15% to 20% and with all this it ought to be able to cut your pricing by 10%. Tell them how you know this will cut into their profits a bit but your having to pay the tariffs has cut into your profits and because of your great relationship with them over the years and in recognition of your plans to stay with them for many more years, they should reduce their prices to you.

This sort of price reduction request works sometimes, not all the time. But it is obviously working often enough for Bloomberg to write about how China product prices are declining.