International manufacturing lawyers

Control Your Molds

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

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

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

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

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

Mold Fabrication Shops

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

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

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

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

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

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

The Factory that Makes Your Products

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

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

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

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

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

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

Products Held Hostage 

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

Conclusion

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

What are you seeing out there?

China bank fraud

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

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

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

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

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

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

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

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

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

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

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

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

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

international law

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

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

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

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

Here we go, in absolutely no particular order.

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

China contract damages
  Joost Bakker

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

China tariffs

Some very important news today from the United States Trade Representative (USTR). Approximately 20 percent of the items set to be hit with a 10 percent tariff on September 1 had their tariff date pushed back to December 1, this morning, per the following announcement from the USTR:

USTR Announces Next Steps on Proposed 10 Percent Tariff on Imports from China

Washington, DC – The United States Trade Representative (USTR) today announced the next steps in the process of imposing an additional tariff of 10 percent on approximately $300 billion of Chinese imports.

On May 17, 2019, USTR published a list of products imported from China that would be potentially subject to an additional 10 percent tariff. This new tariff will go into effect on September 1 as announced by President Trump on August 1.

Certain products are being removed from the tariff list based on health, safety, national security and other factors and will not face additional tariffs of 10 percent.

Further, as part of USTR’s public comment and hearing process, it was determined that the tariff should be delayed to December 15 for certain articles. Products in this group include, for example, cell phones, laptop computers, video game consoles, certain toys, computer monitors, and certain items of footwear and clothing.

USTR intends to conduct an exclusion process for products subject to the additional tariff.

The USTR will publish on its website today, and in the Federal Register as soon as possible, additional details and lists of the tariff lines affected by this announcement.

The USTR then almost immediately came out with two new tariff lists. One, called List 4A, is a 121 page lists of products that will be subject to a 10 percent tariff on September 1, as originally planned. The other, called List 4B, is a 21 page list of products that were to be subject to a 10 percent tariff on September 1 but will instead not be subject to that tariff until December 15.

Cellphones, laptop computers, video game consoles, certain toys, computer monitors and some shoes and clothing make up the bulk of the list of items on which tariffs have been delayed. This delay is believed to have been instituted to avoid higher prices on items often bought by back-to-school and holiday shoppers.

Doing business in Hong Kong

Not sure why nobody has just come out and said this yet, but Hong Kong as an international business and financial center is no more. I take no comfort in saying this because I have many friends in Hong Kong and I’ve always loved going there, but Hong Kong’s special position is over. Kaput. Fini. Terminado. 完. законченный. Done. Over. No more.

I challenge you to say “one country two systems” with a straight face.  

For the last few months I have been relentlessly asking everyone I know in Hong Kong or who used to be in Hong Kong or who at one time contemplated setting up a business in Hong Kong how what has been happening in Hong Kong has and will or would impact their doing business in Hong Kong. Based on those responses and on my own experience with how international companies operate, I foresee the following:

  1. Companies that were deciding between Hong Kong or Singapore for their Asian headquarters will choose somewhere other than Hong Kong.
  2. Growing companies with offices in Hong Kong and with offices somewhere else in Asia will increase their hiring outside Hong Kong and decrease or eliminate their hiring in Hong Kong.
  3. Companies with offices in Hong Kong and with offices somewhere else in Asia will be move personnel from their Hong Kong office to their other offices.
  4. Fewer contracts will be drafted with Hong Kong as the venue for arbitration.
  5. Companies will move their Hong Kong bank accounts elsewhere. It is no coincidence HSBC stock hit its 52 week low today.
  6. Travelers will choose somewhere other than Hong Kong as their Asia stopover. It is no coincidence Cathay Pacific stock hit its 52 week low today.
  7. Many Hong Kongers will eventually go elsewhere.

I am not saying any of the above will be noticeable tomorrow or even a month from now, but I am saying that all of the above have already begun and all of the above will accelerate once China’s army goes in at full force, which is pretty much inevitable. Within two years Hong Kong will be a very different place than it is today and within five years it will hardly be recognizable for those of us who have been there within the last five years.

Since the inception of the US-China trade war, this blog has been relentlessly downbeat about the US-China trade war and its impacts. Way back in October 2018, we called the US-China trade war the “New Normal” and in Would the Last Company Manufacturing in China Please Turn Off the Lights, we forecast an inevitable sharp decline in China manufacturing. On May 8, 2019, in The US-China Cold War Starts Now: What You Must do to Prepare, we warned of a “straight line decline in US-China relations” and we laid out what businesses should do in response to that. Long before that, my law firm brought on three additional sourcing experts experienced with product sourcing from Southeast Asia and with other countries outside China.

Our gloomy predictions have angered many, and I get it. What we are saying is not pleasant, especially for those with companies or livelihoods that depend on free trade with China or on Hong Kong remaining as Asia’s leading business hub. But please understand that we are only calling things as we see them, not as we want them to be.

As for Hong Kong, we are now suggesting our clients (and you) (1) consider places like Singapore and Bangkok as your Hong Kong replacement, (2) implement plans for evacuating your Hong Kong personnel, (3) cease using Hong Kong arbitration clauses (except with Hong Kong companies), and (4) avoid going there unless truly necessary. If corporate responsibility or data protection are at the core of your business your Hong Kong decisions are more pressing.

What are you doing about Hong Kong?

 

China risks

I recently participated in a publicly broadcast round table discussion on the US-China trade war. This discussion was organized in response to President Trump’s recent announcement that the U.S. will on September 1 be imposing 10% tariffs on a new list of Chinese products. Many analysts were surprised by this move. They treated the announcement as a wild card. The US stock market responded in the same way with a major decline.

The organizers of the discussion asked me for my list of PRC/U.S. trade war wild cards. Below is my list, at least for today. Note however that when a deck holds a wild card, the impact of the wild card is something that can be predicted. The wild card changes the rules, but the players all know the wild card will eventually be coming and they can make their plans and their strategies based on this. This is key: understanding the risks and then taking action to minimize the potential of devastating impact that can result from those risks becoming a reality. In this way, a careful consideration of the wild cards is essential for planning by companies currently working with the PRC. You cannot eliminate the risk, but you can reduce their impact.

The below are the China wild cards I see now:

1. The Dow and other U.S. stock markets continue to respond negatively to the various reports of increased tariffs and other U.S. – China trade issues. If the markets suffer a serious decline in the next several months, it will be hard for the Trump administration to continue to take a hard line on China trade. The same issue applies for the economic damage that has been inflicted on the U.S. farm sector. This sector is a major supporter of President Trump. Negative impact on the farm states could also soften the U.S. position against China.

2. The situation in Hong Kong has continued for over two months, with no resolution in sight. The PRC government has already blamed the U.S. and Taiwan for the unrest and it has warned the HK protestors against starting a color revolution (the CCP’s biggest fear). The PRC has massed 12,000 riot police on the border and the PLA is on alert. If the PRC takes military action in HK, the impact on trade will be immediate and severe. Sanctions against China will likely come from the U.S., Japan, Australia, and Europe, disrupting trade for many years.

3. The South China Sea and the Taiwan straight are getting “hot.”  Armed vessels and warplanes from a number of countries are moving in this region in direct defiance of PRC claims that such movement is prohibited. In this chaotic situation, armed conflict could easily break out by mistake due to the actions of “hot headed” local military officers. Keep in mind the Gulf of Tonkin incident and the Corfu Channel Case. One led to a hot war and one led to a cold war. Either could happen here.

4. China has started importing oil from Iran in direct defiance of U.S. sanctions. Violation of Iran sanctions is the reason for the U.S. banning sales to Huawei and detaining Meng Wanzhou in Canada. The U.S. might impose sanctions on the companies importing Iranian oil. More significantly, the U.S. might impose sanctions on the China banks financing these oil trades. Some in the U.S. have even proposed a “nuclear” option where the entities and banks involved would be cut out of the CHIPS and SWIFT systems.

5. The FBI says it is currently investigating more than 1000 IP/trade secrecy thefts involving China. Reports are that most of these cases also allege Chinese government participation. If formal proceedings are commenced, normal trade in many sectors will be disrupted and cooperative R&D with Chinese companies, research centers and universities will be curtailed or even eliminated. Finally, U.S. hiring of PRC nationals in the tech sector will be impacted or even eliminated.

6. Huawei is still on the Entity List and sales of technology of all kinds is still banned. The tentative commitment to ease the sanctions President Trump made at the G20 meeting has not resulted in any change. In fact, U.S. actions against PRC companies in the tech sector have expanded with the recent announcement that the U.S. government cannot make purchases from five PRC companies, including Huawei, ZTE and Hikvision. It is not unlikely that this purchase ban will extend beyond government contracts to a more general ban on all U.S. purchases from Huawei and other PRC tech companies. There has also been talk of late of the United States banning China tech companies that facilitate surveillance of Chinese citizens.

The six above are the most critical wild cards, but there are plenty more, including the following:

7. The Taiwan election is in full gear. At one point, some politicians in Taiwan were pro-PRC, seeking to expand and improve relations with the Mainland. But with the recent events in Hong Kong, the ban on travel from the PRC to Taiwan and the open military threats against Taiwan, no Taiwan politician who wants a future can take any form of pro-PRC position. This all could lead to escalating conflicts in the Taiwan Strait. The continued support of Taiwan by the U.S. will strain relations with the PRC on the military level.

8. The U.S. Congress continues to propose anti-PRC legislation. In the past, such legislation has been symbolic and has not been adopted. If the Trump administration shows weakening in its trade war position, some or all of this legislation may be adopted. This would then take the anti-PRC policy out of the hands of the president, leaving no room for negotiation.

9. The SEC seems intent to cut PRC companies out of the U.S. securities markets. If the SEC will not take action, Congress has threatened to step in. PRC companies see the writing on the wall and most are shifting their big IPO plans to the Hong Kong markets. This trend then further decouples the PRC from the U.S. with impacts both on the U.S. and the PRC. See China and the U.S. Stock Market: Nowhere to Go.

10. There may be a tipping point at which consumers in the United States and the EU and elsewhere become so bothered by the way China treats its Uyghur and Tibetan populations (see this and this) or with how it is acting against Hong Kong or Taiwan or with its efforts to exert control outside China. These sorts of things are leaking out more of late as the bloom is off the rose and we are hearing more and more from our own clients (American and otherwise) saying that they are having employees refuse to go to China or consumers complaining about their goods being made in China. Take a company like Patagonia which has a stellar reputation for caring about the environment and people and even goes so far as to call itself The Activist Company; how much longer can it maintain its moral high ground while still having some of its products made in China?

11. The U.S. has identified the PRC as a currency manipulator for the first time since 1994. The PRC has responded by continuing to weaken the RMB. If this trend continues, the U.S. could respond by raising tariffs rates even higher than the current 25% rate. The back and forth on this currency issue would then further disrupt purchase of PRC manufactured product.

12. Countervailing duty and anti-dumping cases against PRC industry sectors continue to increase. Higher and higher duties against Chinese industry are being ordered. These actions are independent of the administration. Continued action in this area threatens major sectors of trade with the PRC. No change in administration will have any impact. See Yet Another International Trade (AD/CVD) Petition Against China: This Time it’s Metal File Cabinets.

13. To avoid the impact of tariffs, many companies are leaving China. But it is not unlikely that the U.S. government will expand the current tariffs to other countries, particularly countries in S.E. Asia that are seeing the first wave of moves. Moreover, as more product is made outside of the PRC, it is likely that countervailing duty/antidumping actions will be expanded to cover those other countries as well. This may mean there will be limited options to avoid U.S. tariffs and other duties.

14. There are a host of internal factors in the PRC that could have a major impact. Factors I look at are: a) the inability of the PRC leadership to take any stand other than defiance, leading to no chance of any resolution of issues by diplomacy and mutual agreement, b) African swine fever cuts Chinese pork supply in half, c) African army worm substantially reduces Chinese grain crop, d) consumer price inflation coupled with factory price deflation.

As you can see from the above, my view is that the larger geo-political issues and U.S./Chinese domestic political issues are the real wild cards for doing business in or with China over the next decade. It is these issues that will determine the ultimate course of the Section 301 case tariff based trade war. Focusing on the narrow and technical 301 case issues threatens to blind businesses and analysts to where are the real risks.

As we have been saying on China Law Blog for going on a year now, welcome to the New Normal. But take heart. As Baron Rothschild said, “the time to buy is when there’s blood in the streets.”

Importing from China

Companies importing goods into the United States can find themselves having to respond to a U.S. Customs and Border Protection (“CBP”), Request for Information (CBP Form 28) or what may be worse, a CBP Notice of Action (CBP Form 29). CBP Form 28 – Request for Information is a tool routinely used by CBP to verify if the goods are properly classified, valued or otherwise meet U.S. import requirements. CBP Form 29 – Notice of Action can be used to inform an importer of a proposed action, including assessment of additional duties on the goods, or to notify the importer of an action already been taken by CBP. Both communications may be considered red flags for CBP to investigate prior transactions of an importer to initiate a penalty investigation.

Though you as an importer may have an easy response to a CBP inquiry or a valid basis as to why CBP’s proposed action should not be taken, your response often will require you provide information from your overseas product supplier. In these situations, it can be critical for your supplier to work with you to ensure you have all necessary information for the goods you imported. It is also critical that your communications with CBP not provide the agency with information it can use against you. Pulling together a sufficient response for CBP within a short time frame is no small task, but you can almost always ease that task and improve your odds by anticipating and preparing for your customs problems within the framework of import procedures and controls.

It is a common misconception among importing companies that they do not have to be exact on their commercial invoice or other import documentation. But to properly import goods for entry in the United States, a complete product description, accurate country of origin, and correct value in accordance with CBP rules are all key pieces of information that must be accurately provided. These requirements fall under the importer’s legal responsibility to exercise “reasonable care.” If you as an importer fail to attend to these basic legal requirements, you will be greatly increasing (1) your risk of delays in the release of your goods, (2) further scrutiny by CBP through an audit, and (3) penalties.

The import compliance burden shifted to U.S. importers in 1994, when Congress passed the Customs Modernization Act or “Mod Act” as a part of the same legislation package as the North American Free Trade Agreement (“NAFTA”). It is under the Mod Act that CBP expects importers to exercise “reasonable care” when addressing the following, per CBP’s Reasonable Care Checklist:

  • Customs documentation for entry;
  • Complete merchandise description for tariff classification and proper duty rates;
  • Valuation of merchandise consistent with specific CBP valuation rules;
  • Country of origin verification, marking, labeling; and
  • Free trade agreements

Despite its name, CBP’s Reasonable Care Checklist is not a formulaic standard, but rather a list of questions to prompt U.S. importers to create their own internal framework or methodology to meet United States import compliance standards. CBP allows U.S. importers flexibility in how to manage their reasonable care responsibilities based on the importer’s own transactions.

If you import products from overseas, your first step in managing your reasonable care responsibilities so as to minimize your importing compliance risks is to start with the basics and become familiar with CBP’s Reasonable Care Checklist. Answering the questions posed by CBP will help you formulate your necessary internal import procedures and controls.