China Software as  Service SaaSThe market for software has shifted to the cloud. Using the Internet cloud, software products are no longer delivered as compiled programs installed on physical devices. The software is delivered online as an Internet-based service. This is known as Software as a Service (SaaS).

SaaS works fine when confined to the Internet of a single country or region such as North America or the European Union. The core concept of SaaS is that an open Internet exists on which SaaS can be built and delivered. But what happens when companies attempt to deliver SaaS into a closed Internet system?

That is the ultimate issue in providing an SaaS product in China. SaaS products not approved by the Chinese regulators are either blocked or in danger of being blocked. Gmail, Google Docs, Dropbox, and GitHub are all examples of SaaS products that are always at risk of being blocked in China. For SaaS products housed on servers located outside China, Chinese regulation makes active commercial exploitation difficult.

This applies to new SaaS products. Both IBM and HP are planning to roll out SaaS-based blockchain products. HP even calls their new offering “Blockchain as a Service.” Almost by definition, the blockchain system is intended to be global. But what happens when that service hits the closed Internet of China?

There is essentially only one way to deliver SaaS in China. The system must be housed on a server located in China and be licensed to a Chinese owned entity that has direct contact with Chinese customers.

The China server/China licensee model works like this:

1. The SaaS software is housed on a server located in China. This means the Chinese government will at all times have the right to access the server and inspect the contents of the software and all related data and information.

2. The SaaS service typically must be provided by a Chinese owned entity even though the regulations suggest this entity may be a Sino-Foreign joint venture.

3. The SaaS service is licensed to the Chinese entity in accordance with a very expensive and restrictive set of minimal requirements.

4. The SaaS software/platform has received the required approvals.

It has been difficult for many foreign SaaS developers to accept that the China server/China license model is in most cases the only way to sell SaaS products to Chinese consumers but the major SaaS players have already figured this out.

For example, the developers of video games have always been plagued by pirating in China. Game developers moved to the online model and developed the Massive Multiplayer Online Game model (MMOG), which is a form of SaaS. All of the major U.S. MOOG game developers now deliver their product in China using the China license model:

  • Valve Software’s Dota 2 is provided in China by Perfect World.
  • Blizzard Entertainment’s World of Warcraft is provided in China by Netease.
  • Riot Game’s League of Legends is provided in China by Tencent.

In the field of business software, Microsoft provides its Office 360 and Azure cloud service in China through a license with 21 Vianet.

Having accepted that a license in China is required, the real difficulties begin. The Internet infrastructure in China is quite advanced and due to the work of 21 Vianet and others, there is plenty of server space and bandwidth available for effective delivery of even the most complex SaaS products. The success of MOOG products in China is proof of this.

The real problem in China is in finding an appropriate partner/licensee. For the Chinese entity, operating as a licensee is expensive and technically demanding. So the real challenge in China is to find a licensee that is a) willing to take on the burden, b) has the technical capability to do the work, and c) the financial ability to take on the burden of ICP licensing, obtaining and maintaining approvals and then operating the complex server and software systems. Finding a willing licensee is oftentimes difficult for small SaaS systems and start-up products with no existing base of customers to provide immediate cash flow for the licensee.

For large, established SaaS providers, the issues are different but still significant. In this setting, due to the advanced technical requirements, the licensee will often be a direct competitor. So the challenge for large SaaS developers comes from managing the business in China, in protecting IP, and in dealing with the development and marketing of spin-off products. For many SaaS developers, these spin-off products are where the real value is generated.

In trying to evade the rules to avoid the China server/China licensee requirement, foreign SaaS developers are missing their opportunity to access the Chinese market. The real challenge is in finding ways to work within the China system in a way so the foreign SaaS developer both remains in control and earns a profit from China.

So resistance to China’s system for foreign involvement in SaaS is futile, but success is possible, so long as you get clear on what needs to be done.

China e-commerce laws
China e-commerce laws

The PRC National People’s Congress last week promulgated a second discussion draft of the PRC E-Commerce Law (电子商务法草案). If you are interested in commenting, you can find the new statute and a portal for comments here.

This statute is an attempt to gain greater control over the online consumer markets. These markets have exploded in China, in a situation where there is little or no regulation. The lack of regulation has not slowed development of e-commerce in the PRC. The success of online marketing is shown by the recent results of Alibaba’s November 11 “Singles Day” online sales event. As reported by ZD Net, the results were impressive:

Alibaba Group has raked in US$25.3 billion (168.2 billion yuan) in gross merchandise volume (GMV) from its annual online shopping festival, breaking last year’s record sales by 39 percent.

Held on November 11, its Singles Day shopping bonanza this year involved more than 140,000 participating merchants, including 60,000 international brands. Some 165 of these each generated more than US$15.1 million (100 million yuan) in sales, including Gap, Nike, and Samsung, with 17 merchants exceeding US$75.4 million (500 million yuan) and six surpassing US$150.9 million (1 billion yuan) in sales.

Japan, Australia, and Germany were amongst countries with the most sales selling into China during Singles Day this year.
At its peak, Alibaba processed 256,000 transactions per second and US$1 billion (6.6 billion yuan) was processed within the first couple of minutes. In the first two hours, it registered US$11.9 billion (78.8 billion).

Overall, Alibaba processed 1.48 billion payments, up 41 percent year-on-year, and 812 million delivery orders via its logistics arm, Cainiao Network. This was 23 percent higher than last year’s 657 million delivery orders.”

As you can see, foreign products played a big part in the success of the Singles Day event. Section 5 of the Discussion Draft sets out the proposed rules for cross-border sales. The Singles Day even illustrates the way the Discussion Draft plans for the future of cross-border online sales:

1. Foreign retailers will not be permitted to directly participate in online sales in China. All online sales will be limited to Chinese owned entities that have obtained the required commercial ICP license. Though there had been some hope there would be a limited exemption to the ICP license rule for e-commerce product sales, there is no hint of such a change in the Discussion Draft. The PRC government intends to continue restricting e-commerce sales to Chinese owned or controlled entities.

2. Foreign-owned operators of e-commerce platforms will also be excluded from operating in the Chinese market. Sales of foreign products will be forced to come into China through Chinese owned or controlled platforms.

3. The Discussion Draft provisions on cross-border e-commerce focus on ensuring cross-border sales comply with Chinese law and only approved products are imported into China and all taxes and duties on those products get paid. The Discussion Draft seeks to shut down online sales as a way to import illegal products into China and to shut down online sales as a method for evading China taxes and import duties.

4. The method for control proposed by the Discussion Draft is to create highly centralized e-commerce processing centers. The China (Hangzhou) Cross-Border E-Commerce Processing Pilot Area is an example of the ultimate goal. The idea is that these centers will handle the procedures related to e-commerce: foreign purchase, shipping to China, import into China with full compliance with all PRC applicable regulations on product approval, inspection and quarantine, payment of duties and taxes, and warehousing and distribution.

The plan is to funnel all cross-border e-commerce through a limited number of processing centers, all of which are controlled by the national government. These processing centers will also be under the control of a single e-commerce sales platform. The Hangzhou Center will be controlled by Alibaba, with competing online sales giants in China presumably establishing and controlling their own competing centers. This would be the opposite of the freewheeling approach that typifies e-commerce development in the U.S. It is though quite consistent with the current domination of retail e-commerce in the U.S. by a limited group of large players.

The success of the Alibaba event shows that the model envisioned by the Discussion Draft is already fully functioning. Foreign retail brands were excluded from direct sales. They were instead funneled through the single channel provided by Alibaba. Alibaba assumed all liability for compliance with PRC rules and regulations. No foreign entity was involved in any way with the actual direct sale of its product or with any direct relation to any Chinese consumer; all of this was handled by Alibaba.

This is the future of e-commerce in China. For foreign brand owners that want to penetrate the PRC online sales market, the Discussion Draft makes clear how the system will work.

Resistance is futile.

China manufacturing contracts
Use your China manufacturing contract to get out

When foreign buyers purchase products from Chinese factories the big issue is usually who owns the design of the product. This issue is often discussed in a theoretical way, based on intellectual property law principles, without getting to the real point. You are having a product made at Chinese Factory A. You decide the price Factory A is charging you for the product has become too high. The fundamental issue is this: can you take that exact product and have it made at factory B?

Say you are using the following procedure. You find a product made and designed by a Chinese factory. Normally, you will not purchase off-the-shelf products in their “as-is” condition. Normally you will customize the product by maybe changing its colors, and/or its surface design and/or small surface features such the number of buttons.

In this situation, the Chinese factory will take the position its own the design and you have no rights to the underlying design. In general terms, the Chinese factory will say:

a. Chinese Factory owns the underlying design and can sell that product anywhere in the world.

b. Chinese Factory agrees to “customize” its product for you by making surface changes such as color, logo, surface design features. Chinese Factory agrees not to manufacture and sell a product using those same features for sale anywhere in the world.

Given this basic position, what happens if you want to go to a different manufacturer for the same product? There are several alternative responses:

i. The normal response is that the Chinese Factory says you can go ahead and customize the product made by a different factory, but you CANNOT have that factory manufacture your product based on our underlying product design.

ii. In the alternative, some factories will say that you can go to a different factory, but you must pay us a royalty.

iii. In the alternative, some factories will agree to give you a license to go to another factory solely to manufacture the product but not to make any adaptation or other “new work” relying on the underlying design.

Where does your Chinese program fit into this system? Most buyers settle on alternative b. This is a type of stand-off. The Chinese factory cannot sell “your” customized product anywhere in the world, but you are stuck with the Chinese factory. If you want to go to a different factory, you have to start over from scratch or pay what is usually a very high royalty. This can be a disaster if there is no readily available alternative source for your product.

Another issue that arises from this situation is the question of exclusivity. If you have worked hard to create a market for a specific product in a certain territory, you will not want virtually the same product to be sold in that territory in direct competition with your product. It is common to provide that your factory is not permitted to sell the customized product to any other buyer. On the other hand, the factory is free to work with a different buyer who customizes the product in a different way. It is that alternative customized product that will then appear as a competitor in your territory.

Obtaining the agreement of your Chinese factory not to sell your customized product to anyone else is relatively easy because no one else really wants that product. It is much more difficult to get your Chinese factory to agree not to sell an alternative product to another foreign buyer. If you are looking for that kind of protection, you must be clear about the rules and you must expect the Chinese factory will only agree to those rules if it receives a substantial benefit for doing so. That benefit is normally your agreement to a specific volume of product purchase for each year of exclusivity. Big companies often get this sort of deal; SMEs, far less often.

China VAT TaxesConsider the following situation. Your company is a service provider. Let’s say your business assists domestic and foreign entities register drugs with the FDA. You are contacted by a Chinese entity to do a registration. Having read China Law Blog (See Getting Money out of China: It’s Complicated), you submit a written, signed invoice to the Chinese entity and you require payment in advance. Within five days, you receive payment.

But, you are surprised to see your payment amount has been reduced by 6 percent. You complain to your Chinese client, and your Chinese client explains that the 6% was deducted as VAT tax on the payment, upon the demand of the local tax authority. You explain that all services were performed in the United States. No services were performed in China. For this reason, there is no basis for the Chinese tax authorities to impose any tax of any kind. The Chinese side explains: we agree, but if we had complained, our payment to you would have been denied and you would not have received any payment at all.

This has become a standard scenario for service providers that provide services to Chinese entities. It applies to all types of services:

  • Legal services
  • IP registration services
  • Product and advertising design services
  • Software development services
  • Environmental consulting services
  • Architectural services, both structural and landscape.

In all these areas, the Chinese foreign exchange banks will refuse to make any payment without documentation. Often the request for documentation is onerous and can cause considerable delay. Finally, when approval for payment is received, the foreign exchange bank then requires a deduction from the payment be made.

Now get this: the amount of the deduction varies from bank to bank and from region to region. We have seen deductions range from 5% to 40%. What is the reason for this wide variation? Since there is no legal basis for the deduction, its amount and its supposed basis vary. This variation means there is no way to predict in advance the amount of the deduction. Even within the same bank for the same services we have seen the amount of the deduction vary from payment to payment, depending on the attitude of the bank at the time and the identity of the bank officer and the local tax office personnel involved in the transaction. Of course, the status of the payer in the local economy is a factor. An SOE that is the sole employer in a small town is treated differently than a small privately owned business in Shanghai.

Our China lawyers constantly get calls seeking help from American and European service providers whose payments have been held up by China’s banks. We tell them the following: “we can help you get the money out, but it will be net of taxes and we do not know what that amount will be.” A classic good news/bad news scenario.

What though can you as the foreign service provider do to eliminate this tax deduction risk? The only solution is to put all of the payment risks onto your Chinese customer by providing in your service contract that all payments must be made net of taxes and fees. If the amount of the invoice is $60,000, the service provider must receive $60,000. All taxes and fees are paid by the Chinese customer on behalf of the foreign service provider. This approach places the risk where it belongs: on the Chinese side. The Chinese government/foreign exchange bank is imposing the fee. The Chinese payer is the only party that can object to the fee and argue it should not be imposed or should be reduced. You as a foreign entity receiving payment have no standing and no power to impact the decision of the Chinese authorities, but your Chinese customer does. Placing the risk on the Chinese payer is, therefore, the only practical way to deal with this issue.

It is essential to deal with this issue in advance in the written service contract and in the written invoice for services. If the written documents are silent, the Chinese side will fall back to the basic rule that VAT and income tax is the liability of the foreign party and make little to no effort to prevent or reduce it. Though this rule has no application to arbitrary and illegal exactions imposed by foreign governments, the foreign service provider will always lose on this kind of claim.

So this then leads to the following rules for performing services for Chinese entities:

1. Execute a written service agreement.

2. Provide a written, signed invoice for every payment.

3. Provide in the agreement and invoice that payments are net of taxes and fees.

4. Do no work until after full payment is received.

Service providers outside China normally operate with a relaxed contracting and billing system. The rules for China are very different and contrary to service provider culture. Moreover, many Chinese entities will resist following the rules. My response to all this is: So what? As my first law firm boss explained to me: there is only one thing worse than working. That is working and not getting paid. If you want to get paid by a Chinese customer, you need to follow the rules.

China lawyersIn my first post on payments from China, I discussed the risk that payments from China will not be made due to failure to obtain approval from the transmitting bank or from the Chinese government. In this and my next post, I will discuss the general ways to mitigate those risks. In this post I will discuss the basic principles. In my follow up post, I will give specific examples keyed to the four basic types of transactions I outlined in the first post.

The basic rules for dealing with payments from Chinese entities are as follows:

Rule Number One: Always put the the burden of dealing with Chinese banks and government authorities on the Chinese side. And always put the burden of a successful resolution on the Chinese side. China is the rare country where its resident businesses will try to shift the burdens of its own governmental actions onto a foreign party. This is not acceptable. A country resident must be liable for the actions of its own government, since the country resident is the only party to the transaction with any real chance to influence the actions of its local government and banking institutions. Think about this for a minute: are you or your Chinese counter-party more likely to be able to persuade a Chinese bank and/or Chinese government official to get money out of China? If your Chinese counter-party is trying to put this burden on you, this is a red flag and a good indicator it knows it likely will never get the money out.

In the area of payments, this means two things:

First, the Chinese side must take on the burden of paying China taxes and fees. That is, all payments to you on the foreign side must be net payments, free of the imposition of taxes and fees on the Chinese side. If a tax is or fee is imposed by the Chinese bank or local tax authority, the Chinese side must pay this tax/fee, with the payment to the foreign side being unaffected. If the payment to the foreign side is $5 million, the foreign side must be paid $5 million. It makes no difference to the foreign side whether the tax/fee imposed in China is zero, 10% or 100%; the foreign side still receives its $5 million payment.

The reason for this is obvious. First, the Chinese side must be motivated to have the tax or fee reduced. If the tax or fee is simply passed on to the foreign entity, no such incentive exists. Second, there is little consistency in the taxes and fees imposed by Chinese foreign exchange banks. The same transaction my be treated differently from region to region and from bank to bank. Even within the same region and the same bank, treatment may change from transfer to transfer. This means it is difficult to predict the amount of any tax or fee that may be imposed. The Chinese side must take the risk of this uncertainty; it is unreasonable to impose the risk on the foreign party.

Second, the Chinese side must take on the risk that payment will be approved within strict timelines. These timelines should be tight. The Chinese side should not be given 30 days to pay. Ten days should be the maximum and five days is better. The reason for imposing a tight deadline for payment is that it is critical you determine as early as possible whether the Chinese side will be able to make payment. Due to the capricious nature of Chinese banks and taxing authorities (especially in the last year or so with China’s increasingly tight capital controls), approval has to be determined for every payment. You should do no work nor take on any risk until after receipt of the applicable payment from China is confirmed, and I mean really confirmed.

Your contract should provide that if payment from your Chinese counter-party is delayed for any reason — including for lack of approval by the Chinese bank or government authorities — you have the right to terminate the underlying transaction. Chinese parties will often argue that failure to pay due to bank or government lack of approval should be treated as a force majeure event that excuses the Chinese side from enforcement. That is, the Chinese side will argue that the foreign party is not permitted to terminate and even call for a force majeure provision in the contract making this explicit.

This provision might then mean you are required to perform under the contract even though no payment is made by the Chinese side. This is not, of course, what the standard doctrine of force majeure provides. However, the Chinese side will often seek to insert this absurd provision. As clever negotiators, they will insert this in an otherwise standard force majeure clause. Since this type of clause is treated as “boilerplate,” the language is often not read carefully, leading to very unpleasant results for the foreign party. For this reason, I routinely refuse to allow any form of force majeure clause to be included in any contract I draft for China. We also have more than once been contacted by foreigners whose contract says one thing for force majeure in China and something very different in English, but the Chinese controls. Do not let these sort of things happen to you!

Rule Number Two: Force early payment. It is important to test as early as possible whether the Chinese side actually has the ability to make a payment. The test is made by providing for an early payment from the Chinese side in an amount large enough to force the Chinese side to go through the full approval procedure with the Chinese bank and with government authorities. A small, token payment is not sufficient.

One purpose of the initial payment is to ensure your written documentation related to the transaction is acceptable to the foreign exchange bank. For example, for any payment that can be classified as a royalty, a number of issues can arise concerning the documents, including the following:

  • The bank may require the underlying agreement be registered with the applicable government regulatory body. This is common for technology transfer and licensing agreements.
  • The bank may require the transaction itself be approved by Chinese government authorities. This is standard for outbound investments. Approval is also normally required for licensing in the publishing and audio-visual fields.
  • The bank may impose various requirements on the written contracts. Typically the bank will require the main agreement be written in Chinese. Many banks also will require an written, signed invoice for each separate installment payment.
  • The bank may work with the local tax office to impose various taxes and charges on the payments. Both the amount of tax and the processing of tax payment can be confusing and can cause delay.

By requiring an initial payment from the Chinese side, the parties can isolate the problems and correct them before the foreign side begins work or takes risks by relying on the ability of the Chinese side to actually make payment. Our China lawyers are constantly getting called by American and European companies that have not received payment under their contracts with a Chinese entity and in many of those instances it is because their contract has not been drafted in a way that will permit payments to leave China.

Your receiving the first payment is NOT sufficient to pass the test. You as the recipient must also check that payment for the following three things:

— First, was the payment actually made by the Chinese side from China (not Hong Kong), or was it made by another entity, perhaps located outside of China?

— Second, was the payment made through a standard Chinese foreign exchange bank, or was it made through some irregular payment mechanism such as a credit card or through a U.S. financial institution or by bitcoin?

— Third, was the payment made in a single lump sum, or is the payment an aggregate of a number of separate transfers?

All of the above are common and these sorts of irregularities show the Chinese side did not obtain China-side approval for payment. This means the Chinese side failed the test. You now know you are facing significant risk for the later, more substantial payments, unless, of course, the Chinese side for whatever reason will be able to sustain its irregular payment methods beyond its first payment, which is rarely the case.

Rule Number Three: Never get behind on getting your payments. Always get paid first. Get paid before you manufacture and ship your product. Get paid before you start the service work. Get your royalty payment at the beginning of the year, not the end. For the sale of your business (or shares in your business) and the sale of real estate, use a tight closing date with a substantial pre-closing escrow deposit.

In some cases, it is not possible to get all payments in advance. In such cases, you should limit your risk should to loss of profit and avoid getting hit with the loss of your out of pocket costs. For example, in the sale of expensive and highly customized equipment, your should set your risk of non-payment by ensuring the initial installment from China will cover all of your manufacturing cost. The risk for the final payment is then limited to your potential profits, and not to your out of pocket costs in material and labor.

A similar approach should be taken in other fields. For example, license payments may be split into a beginning of year fixed payment, with a variable payment based on sales or earnings paid at the end of the year. This approach ensures you will receive at least some payment that can cover your costs and give you a basic level of profit. It is never advisable to depend substantially on a final payment from a Chinese company; it is almost always better to agree to a smaller, secure fee than to seek a higher fee that shifts the payment risk away from the Chinese side.

The critical point is to recognize there is always payment risk when dealing with payments from Chinese companies. To succeed in selling to Chinese entities, you must recognize the risks and mitigate against those risks as I describe above. In my next post, I will describe some of the strategies our Chinese lawyers recommend for specific types of transactions where payments will be received from a Chinese entity.

UPDATE: And do not for a second believe that even China’s biggest and best-known companies are immune from payment problems. Today’s papers are proof this is not so. See today’s big China story: China cracks down on Dalian Wanda’s overseas deals.

Getting paid from China: Takes more than just pressing a key
Getting paid from China: more than just pressing a key

We are frequently contacted by foreigners who want advice on “how to get money out of China”. Usually the questions concern the purchase of assets like real estate or stock and other securities by a Chinese entity. The standard situation is that the deal is closed, the closing date has arrived, but the Chinese side fails to perform, claiming the Chinese authorities will not allow it to remit the funds. Simply stated, the Chinese side wants to make the payment, but the government will not let them.

This problem is not limited to high value asset transactions. This common situation is, however, a result of a more general issue that arises with doing business in China. The fact is that every payment made from China must be approved. That is, it is not just large sum foreign investments that must be approved. Every remittance, no matter how small and no matter how routine, must be approved prior to remittance from China.

Approval is not automatic. Every remittance from China requires conversion from RMB to dollars or to some other foreign currency. The Chinese foreign exchange bank works with the local tax and other authorities to review every conversion and remittance.

When the Chinese government decides to limit outflows of currency, transactions that have been routinely approved in the past can suddenly become problematic. Delays occur, new taxes and fees are imposed and in some cases the payment is denied. This then means that there is real payment risk for every payment made from China. This is not limited to big investment transactions. All payments from China are reviewed by the foreign exchange bank. It is never certain what the bank will decide. For this reason, all payments from China are subject to payment risk due to government restrictions.

This issue arises in a number of business sectors:

— In the sale of high value equipment, it is common to accept payments in installments. Many problems can occur. In some cases, the Chinese buyer will make and order but then fail to pay the down payment, claiming that the Chinese authorities will not approve the payment. The Chinese side then asks for “cooperation” in providing additional documentation demanded by the foreign exchange bank or local tax office. Eventually, the Chinese side pressures the U.S. seller to start work or to ship prior to payment, blaming the delay in payment on the Chinese authorities. In a similar situation, where several installments are involved, the buyer will succeed in making the first several installments, but then will delay in making later payments, blaming the delay or failure to pay on the Chinese regulatory authorities. In these cases, the foreign seller is now trapped: the product is shipped and it is not clear whether full payment will ever be made.

— In licensing of technology or the licensing of media, there are often annual royalty payments that must be made. The Chinese side will normally negotiate a system that provides for payment of the royalty at the end of the royalty period. The payment day arrives and no payment is made because the foreign exchange bank refuses to process the payment. There are many reasons the bank may refuse to remit. One common reason is that the license has not been properly registered. Some banks will insist on a particular form of invoice. Other banks will require proof of the existence of the licensor and the validity of the license. In other cases the local tax authorities will impose withholding taxes of a type or in an amount that was not anticipated by the parties. The problem in all of these cases is that the Chinese side has obtained the benefit of the license for a full year before the issue of payment is raised. The foreign party is now assuming all of the burden for non-payment with no corresponding cost imposed on the Chinese side.

— Service contracts of all kinds are particularly risky. The reason is that a primary way Chinese entities illegally transfer funds out of China is via false service contracts. Since the risk of fraudulent transfer is quite real, Chinese banks are particularly careful in reviewing service contracts. This means legitimate service agreements are subjected to the same careful scrutiny. Since service agreement are typically quite informal and poorly drafted, the agreements often fail when examined by the banks and tax authorities. When this occurs, the Chinese entity reports that their attempted remittance has been denied or a large tax no one anticipated has been imposed. This can be a major disaster for service providers when the service has already be provided. Since the service is intangible, there is no way to repossess in the way that could be done for piece of equipment or a parcel of property.

What all this means is that every foreign business expecting payments from a Chinese entity must understand that payment risk is significant. Since the risk is real, mitigation measures are essential in order to avoid disaster. In my next post I will discuss the various ways to deal with this China payment risk issue.

China contract lawyersIn my first post in this series (here), I described the five basic attitudes Chinese companies have regarding advanced equipment being sold into China.  In part 2 (here), I set out two of five tactics high value equipment sellers should follow when selling advanced (and therefore expensive) equipment into China: One, do not discount, and two, get paid before you deliver your equipment to your China buyer.

In this, part 3, I wrap up this series by setting forth the remaining three tactics equipment sellers should employ when selling their equipment to Chinese companies.

3. Do not deliver the equipment until first verifying that the conditions for its installation have been met. Remember that the Chinese side believes your equipment works based on an almost “magic” formula and your rules on how to set up for its installation and the specifications for its use are just a subterfuge you use to “hide the magic.” The detailed set up work is therefore unnecessary. Meeting the specifications is not necessary. So the Chinese side will not do the proper set up and they will ignore the specifications. But then when your equipment does not work as it was supposed to, the Chinese side will blame you for its failures.

The following are two (of many) true stories that illustrate how this typically goes down:

  • A heavy equipment manufacturing company delivers iron pipe casting equipment. The conditions of sale provide that the floor of the casting room must be perfectly level. When the equipment is delivered, the casting room has an uneven dirt floor. The casting machine does not work and the Chinese side does not pay a single penny on the contract. The Chinese bank that guaranteed the payment sides with the Chinese buyer. Why create a level, clean concrete floor for a dirty machine used for metal castings, one of the China company’s engineers asked at one point.
  • A water power equipment manufacturing company delivers a new hydropower generation set of equipment. The specifications provide that the current flow can never exceed 6 knots. When the equipment is delivered, the Chinese side installs it in an unapproved location where it is well known the current exceeds 8.5 knots. Within one year, the entire facility is destroyed. The Chinese side defaults on the last payment and the reputation of the foreign company is destroyed. The foreign company lost money on the project and never did another sale in China.

Foreign equipment sellers cannot rely just on clear contractual specifications and then relying on the specifications when there is a problem. The foreign seller should itself ensure the conditions are met before it delivers the equipment. And if the conditions are not met, the foreign seller should not deliver. If there is a cost in confirming your Chinese buyer has met the specifications (and there usually will be), you should build that cost into the cost for your product. Remember: the failure of the installation is always your fault and the Chinese side will always find a way to make you pay for that failure. We have said this before and it made people mad, but some of our most experienced and sophisticated and successful China essentially charge a premium to Chinese buyers simply to cover themselves in advance against these sorts of problems.

4. Build required training and after sales maintenance and support into the price of the equipment. No matter how much your potential Chinese buyer tries to get you to decouple the pricing for maintenance and support (and then eliminate it entirely) do not make these optional add-ons that are billed for an additional fee. If you make these optional and charge extra for them, the Chinese side will almost always choose not to pay. So you have to force them to accept training and support as part of your sales price.

Why do the Chinese refuse to pay? Your trying to require them to pay for after sales maintenance is just you admitting that your product is somehow defective and why should they buy a defective product. If properly manufactured your equipment should work forever, with no service or maintenance required and your trying to make the Chinese side pay for training and service as an add-on is you unfairly seeking to increase the price of a product that is already unfairly expensive.

There is one exception related to training. If the Chinese side is planning to clone your equipment, they will seek extensive training in how the equipment operates. Their goal though is not training; their goal is to somehow obtain the formula that will allow them to clone your machine. For this reason, you should carefully control your training with Chinese companies.

During training, the Chinese side will ask for more information and more training time than is necessary. They will also insist on visiting the U.S. manufacturing facility and they will expect to spend substantial time in that facility. For this reason, all training obligations must be carefully defined to prevent your costs from skyrocketing out of control. You should carefully limit time, location and access to information. One good way to control this is to require the Chinese pay by the hour for all training provided in excess of the basic training included in the purchase price.

Many foreign equipment suppliers say they will provide whatever training proves “reasonably” necessary. This sort of an approach is nearly always a mistake because neither Chinese companies nor Chinese courts truly understand or employ the concept of reasonable. You therefore should state state with precision the training you will be providing, where you be providing it, who will be providing it, and for how many hours you will be providing it. The same rules apply to provision for after sales support. Chinese companies tend to abuse after sales support obligations. So those obligations should also be spelled out clearly in your contracts as well. Again, I base this not on any “feelings” I have about China, but based on my having represented countless foreign equipment sellers on countless China equipment transactions and on what I have heard from other equipment companies and from other China lawyers who represent them.

5. Protect your IP through with a China-centric contract. Protecting the intellectual property you have in the advanced equipment you sell into China should be a core goal in all of your sales. Understand the basic approach from the Chinese side: your product is too expensive and b) any form of IP protection is just a unfair device you are using to force them to pay the unfair price of the machine. So the goal of the typical Chinese company is to purchase one or two items at a bargain price and then clone them in China at a “fair” price.

The obvious way to protect the intellectual property in your advanced equipment is to register your patents in China. But for various reasons (including time bars) this is often not possible. Where there is no patent registration (and oftentimes even when there is), your best solution is to incorporate basic IP protections into your sales agreement. This is essential for China.

To accomplish this, either your sales contract or a collateral agreement must provide for the buyer agreeing to the following:

  • Buyer will not reverse engineer or manufacture a copy/clone of the product or engage any affiliate or third party to do the same. A complex legal definition is not required. A blunt, simple statement (in Chinese) is what is required.
  • Define confidential information information (such as the information you provide in training and support) and require no confidential information can be used by your buyer or by any affiliate or by any third party to infringe on your product.
  • Provide for monetary damages if these restrictions are violated. Injunctions rarely work in China, so contract damages are required.
  • Impose these restrictions with a written agreement enforceable by litigation in China. This is a key requirement. Your English language sales agreement that is enforceable in the New York or in London or in Geneva is not going to be helpful in protecting your IP and if it makes sense for you to use that sort of agreement on the sell side (and sometimes it does), you should have a separate IP protection agreement in Chinese, subject to Chinese law and enforceable by litigation in China.

China contract lawyersIn my previous post in this series (here), I described the five basic attitudes Chinese companies have regarding advanced equipment being sold into China. Given these attitudes, what should a foreign seller do? In this part 2 post I set out two of five tactics high value equipment sellers should follow when selling advanced (and therefore expensive) equipment into China. In part 3, I will wrap it up with the remaining three tactics.

1. Do not discount. The first mistake most Western companies make when selling their high end equipment to China is to discount its price. The usual explanation my clients give me for doing this is that “we will discount the first equipment sale and then make up for that discount on future sales.” Wrong.

If you offer a discount you are simply confirming the China side’s basic assumption that your price is too high and you will virtually never get the opportunity to make up for the discount. The Chinese side will do one of two things. Some buyers (especially state owned enterprises or SOEs) will treat the initial discounted items as “samples” they will distribute to other enterprises to be cloned in China. For other buyers, the discounted price will treated as a new floor price for the product. If additional purchases are discussed, the Chinese company will then ask for an additional discount against your already discounted price.

It is therefore critical you hold the line on price. You may perhaps offer a very small quantity discount for purchases of multiple units. You may even offer a small “customer loyalty” discount for return purchases. But never offer a major discount for the initial purchase. Hold the line and explain that your price is both fair and the same price you offer to everyone in the world, on the same terms. What reason is there to change this policy for China?

2. Get paid before you deliver. For companies that are successful in selling to China, this is the golden rule. There really is no alternative. In many countries, issues related to payment can be resolved through the use of carefully drafted letters of credit. Chinese buyers, however, will only use Chinese banks for their letters of credit and those banks will always favor their Chinese buyer customers, so the letter of credit approach will not work for China.

For Chinese companies planning to clone your equipment in China, paying you by installments fits perfectly into their plan. The standard approach works as follows. Set up a system with five installment payments. The equipment will be delivered and installed in stages, in accordance with the installments. Then, the Chinese company will delay payment from the very start and then use the payment delay (which it will usually blame on China’s capital controls or some tax issue) to push the foreign side to deliver more than is required for each installment. The Chinese company will then reluctantly make a payment or two, all the while extracting equipment, training and know-how. When the Chinese side thinks it has gained  “enough” from what you have already provided it, the payments stop. The common standard is to make two of five payments in exchange for 50% of the product and expertise. Our China lawyers warn our clients about this all the time and yet it just keeps happening.

Other Chinese companies will use installment payments to force you to discount. The Chinese side will negotiate for a series of installment payments with a major final installment to be paid after installation and approval by the Chinese side. This approach virtually never works well for the foreign seller as Chinese companies are expert at finding problems with the equipment. The Chinese side will raise these problems as excuses for continual payment delays and then use their own delays to seek an after the fact discount in price from you, while holding the installment payments as hostage to achieve this goal.

If the Chinese company is unable to secure its desired discount from you during the basic installment period, it simply will not make the final payment, achieving a 10% to 15% discount by that single refusal to pay. If the foreign side threatens to sue for that final payment, the Chinese side will trot out a list of problems with the product and its installation — normally problems the Chinese company itself caused. However, this will still be enough to convince the foreign side seller that it will need to mount a long and expensive legal battle to get that final payment and that doing so probably will not make sense.

It is important to note that these tactics by Chinese companies are not unusual. Your price is too high, so they do not see themselves as acting unethically; they are just leveling the playing field. I have spent about half of my life in China and I have heard this reasoning about once a month while there.

How to sell to ChinaThis is the first in an eventual series of posts I will do on the business and legal issues related to foreign companies selling high value equipment to Chinese companies. The behavior of Chinese companies in this area is quite uniform, and it is therefore possible for me to present a uniform approach to sales into China. Before moving to a detailed analysis, it will be best to step back and consider how Chinese companies view the process. Once the fundamental viewpoint of the Chinese side is understood, it is then much easier to determine how to craft an effective sales strategy for China.

Chinese companies purchased a fair amount of advanced equipment from foreign companies in the 90s. But these purchases slowed considerably as Chinese companies shifted their focus to manufacturing for the export market. However, these export oriented Chinese companies have recently started showing a renewed interest in purchasing advanced equipment from foreign manufacturers. That China is now Germany’s largest trading partner is good proof of this.

The reason Chinese companies are buying more advanced equipment from overseas is clear to anyone who visits Chinese factories. The simple truth is that much of the production equipment in these factories is old technology nearing the end of its useful life. The Chinese businesses that have made China the factory of the world have  pushed their manpower and outdated tools to the limit and for them to continue to compete in the world manufacturing market, technical upgrades are required. Chinese companies are mostly unable to innovate in this area on their own; so they are reluctantly making purchases from foreign entities.

Though the world has greatly changed since the 90s, the attitude of Chinese companies towards the purchase of foreign equipment has not. There are five basic beliefs that drove Chinese advanced equipment purchases back when I was working on them in the 1990s and those same five basic beliefs drive these purchases today. Once these beliefs are understood, Chinese behavior on these equipment transactions becomes easy to understand. Once you understand the basis for the behavior of your Chinese counterpart on these deals, you can design a program that can be successful in the Chinese market.

In entering into a sales agreement with a Chinese factory interested in buying your high value equipment, you should understand that the Chinese factory owner almost certainly holds the following five fundamental beliefs that will drive its behavior in the sale process:

1. Your price is unfairly high. The important thing to know is that the Chinese side believes your price is both too high and fundamentally unfair. The Chinese side views this as the legacy of foreign imperialism, designed to keep the Chinese down, always under the thumb of the foreign oppressor. This attitude is supported by the general ideology of the PRC government. Under this basic belief, the Chinese factory owner feels morally justified in working to avoid paying you the full price for the equipment.

To achieve this, the basic strategy of the Chinese side will be the following:

a. Insist on paying in installments, then not paying the last installment.

b. Insist on a major discount, in the range of 30% to 40%. This then becomes the new base price for the equipment.

c. After paying the discounted price for the first two units, insist on an additional discount for future purchases.

2. Training is not necessary. Any requirement for training the Chinese side in how to use your equipment is just another way for you to unfairly extract more money from the Chinese side. It is also a way to keep the Chinese side down by showing that the Chinese have something to learn from foreigners. The Chinese believe that operation of the equipment is governed by a simple magic pill. Foreign companies that insist on a training program are withholding access to the magic pill.

3. Proper equipment set-up is not necessary. Your requirement that the Chinese side retain you for proper equipment set-up is a waste of time and designed to shift blame for operational failure onto the Chinese side. The Chinese side believes the equipment should “just work.” For this reason, elaborate site set up and pre-operations testing should not be required. Just turn the key and go.

4. After sale support and maintenance is not required. Requirements from the foreign equipment supplier for such after-sale support is designed to do two things: unfairly extract more money from the Chinese side and keep the Chinese side employees ignorant about the true nature of how the equipment operates. That is, you are unfairly hiding the magic pill from them. In addition, the equipment should “just work,” with no need for after sale maintenance or support. Your requiring a service contract or related after-sale support is either your admitting that your equipment is fundamentally defective or your trying to unfairly milk more money from the Chinese side.

5. Your attempts to protect your IP is foreign oppression. Intellectual property protection that prevents the Chinese side from copying your equipment is just another form of foreign oppression. The Chinese side does not believe the design of your equipment is the result of years of hard work and R&D and it wants to be able to copy it so that it can be manufactured in China at a “fair” price.

This then means the Chinese side’s standard strategy will be to purchase as few units as possible and then use its initial purchase(s) to extract the “magic formula.” The strategy is to abandon future purchases and have clones of your equipment manufactured in China.

Obviously not all Chinese companies subscribe to all five of these beliefs and some Chinese companies do not subscribe to any of them. But most do and I know this from what they have told me (in Chinese), from what I have overheard (in Chinese) and from what I have read (in Chinese). I mention all this because foreign companies find this all hard to believe and even when they do believe it, they find it hard to truly internalize and adjust their selling behavior accordingly. The typical Chinese factory owner will negotiate and implement its purchases of advanced foreign equipment based on these five beliefs. Many foreign suppliers, when faced with the resulting behavior, will conclude that the Chinese are operating in bad faith. However, to deal with the Chinese buyers, the first step is to understand that they believe their approach is fair. They are simply working against the unfair advantage of the foreign seller by making a more level playing field.

The important thing from the standpoint of the foreign seller is to recognize the following:

  1. These basic beliefs are natural and will not be changed.
  2. Since these basic beliefs are pretty much universal among Chinese companies, it is easy to predict how the Chinese buyer will behave at every critical point in the sales process.
  3. Since the approach of the Chinese side can rarely if ever be changed, foreign companies that want to sell their high value equipment to China should design their sales programs based on what the Chinese side will do, with contracts that protect the foreign seller from the negative consequences of near certain Chinese company actions.

In my next post, I will outline a basic program for achieving this.

My first post in this threeChina manufacturing lawyers part series focused on a post entitled The 7 Major Risks You Run With Your China Manufacturers, by China manufacturing expert Renaud Anjouran. In that post, Renaud outlined the business risks foreign companies face when having Chinese factories manufacture their products. I noted how Renaud’s list nicely accords with what our China lawyers tell our clients who retain my law firm to draft their Chinese manufacturing contracts. See China Manufacturing Agreements: Binding Contract or Contract Terms. I noted how our manufacturing clients usually want to focus on a) intellectual property protection/prevention of counterfeiting, ownership of molds and tooling and after sales warranty service. In other words, the sorts of things legal agreements are really good at resolving. But oftentimes, core business issues like price, quantity, delivery date, quality and resolution of quality issues, subcontracting and shipping are of at least equal importance.

My second post focused on the first four items on Renaud’s China product outsourcing list. In this, my last post in this three-part series on China manufacturing, I focus on the last three items from Renaud’s list.

Risk Five: Subcontracting. Subcontracting of production presents a number of risks often not clearly understood by foreign buyers. Renaud identifies the first and most common risk. The foreign buyer goes to substantial effort to verify that the Chinese factory it has chosen is capable of meeting its quality standards. If the factory then subcontracts the foreign buyer’s product manufacturing to another factory, all of the buyer’s verification work becomes meaningless. This then leads to other issues: How will inspections take place? How will quality control standards be enforced? How will worker safety or worker age rules be enforced? How will anti-bribery and related rules be enforced? Working to the next level, manufacturing by a third party where there is no contractual relationship means that confidential information agreements are automatically breached, and this is a primary way intellectual property gets lost in China. Finally, molds and tooling are often moved to the subcontractor, resulting in loss of control and the inability to retrieve these items when required.

There are three reasons Chinese factories typically subcontract. First, the “factory” is a front for a trading company that actually does no actual manufacturing on its own. This type of trading company will subcontract all of the manufacturing and will limit its involvement to supervising (usually very poorly) the manufacturing process. Second, the factory may be capable of doing the basic manufacturing process, but it requires subcontracting assistance on key elements of the production process. For example, it is normal for Chinese factories to subcontract mold making and electroplating of key components. Finally, the factory may decide that the foreign buyer’s purchases are too small to justify the effort of setting up production and it will subcontract to a factory with the time and the interest. Such a factory is almost guaranteed to be of lower quality, leading to the problems Renaud describes in his post.

Since subcontracting is always an issue when manufacturing in China, it is necessary to confront the issue directly in a formal agreement. The standard approach is to provide that subcontracting is prohibited without notice to and consent by the foreign buyer. The foreign buyer should condition its consent on inspecting the subcontractor and getting the subcontractor to execute a separate manufacturing contract with the same key terms as the foreign buyer has with its original manufacturer.

Though this approach is best, many Chinese factories insist on an absolute right to subcontract. In that situation, if the foreign buyer agrees, then the normal contract provision is to require (a) the Chinese factory at least identify its subcontractor(s) (b) the subcontractor grant the foreign buyer access to its premises for inspection and c) the Chinese factory agree to be directly liable for any violations committed by the subcontractor. Some Chinese factories will not agree to these conditions. When that happens, our China lawyers recommend the foreign buyer refuse to purchase its products from that factory.

Renaud identifies a more difficult problem: undisclosed subcontracting. This situation is unfortunately quite common. It arises most often during the busy season when a factory simply cannot keep up with the orders it has accepted. The best way to prevent this from taking place, the foreign buyer must regularly inspect the factory operations to ensure that the factory is really doing the work on the premises. Since the high season is the most likely time subcontracting will occur, this is the time when appropriate, unannounced inspections should occur. It is also crucial to enter into a formal agreement that prohibits undisclosed subcontracting as described above.

Way back in 2009, in The Six (Not Five) Keys To China Quality, we wrote about the tremendous value of putting a no-subcontracting provision in your China manufacturing agreements:

We typically put a provision in our OEM agreements (which we nearly always do in Chinese for better enforcement in China against the manufacturer) mandating that the Chinese manufacturer cannot subcontract out the manufacturing. We have been doing this for years and, as far as we know, no manufacturer has ever violated this provision. I know many of you are dubious of this record, but hear me out. Let’s say the Chinese manufacturer has 30 customers for whom it manufacturers product. Let’s say only four of those customers have a no subcontracting provision (my guess is this number is more like to be two, but for the sake of argument, let’s go with four here). The China OEM manufacturer gets really busy and has to subcontract out some of its manufacturing. It can subcontract out the product manufacturing of any of its 30 customers, so why wouldn’t it choose to subcontract out the product for the 26 customers who have no contract provision prohibiting subcontracting? I call this the bike lock theory of Chinese law because the no-subcontract provision operates like a good bike lock. The thief can still steal your bike, but why would he when there are so many easier targets out there?

In our experience, these no-subcontracting provisions work shockingly well.

Risk Six: Failure to Deal with Defective Product. The problem of defective products raises several issues. First, it is critical to identify a factory that will attain and maintain a reasonable defect rate. If the defect rate during production is over an “epidemic percentage” level, it is almost certain success will not be achieved. As Renaud illustrates in his post, the defects in Chinese factories are often at the cosmetic level. The base product is acceptable, but the finish is defective or scratched; fingerprints show up on glass in an enclosed case; greasy footprints are found on well sewn, elegant handbags.

There are two issues relating to dealing with such defects. The first is how to locate the defect. It is best to locate the defect during the production process. Second best is to locate the defect before shipping. Third best is to locate the defect after your receipt of the product. The worst case is to learn of the defect after delivery to the down stream customer.

As Renaud notes, once defects are found, the parties must have in place a formal plan that clearly deals with what will be done with the defective product. It is critical not to allow the defective product to enter into the retail market. Many Chinese factories will sell defective product “out the back door.” When this product gets into the market, the damage to your reputation can be substantial.

But what should be done with defective product? We usually provide that the defective product must be destroyed. However, this is not always the best alternative. In some cases, the defective product can be repaired or otherwise reworked. This is a common approach for complex and expensive cast metal parts for large equipment. In other cases, the defective product can be disassembled so that valuable components, such as precious metals, can be recovered.

Once you resolve how to handle defective products you receive from your China factory, your next issue is how to get reimbursed for the defects. The Chinese side will usually propose that the value of the defective product be applied as a credit against your future purchases. This is a bad system because the foreign buyer can only obtain credit if it makes another purchase. This forces the buyer into a relationship with a factory that makes defective product. Even worse, the amount paid to the factory is going down for each new purchase, which means the factory has even less incentive to do a good job.

The practical solution is for you to inspect your product before making any payments for its manufacture and reducing the invoice price to account for any short delivery resulting from removal of defective product from any given shipment. If the defect level reaches an epidemic failure rate (this rate must be determined on a product by product basis), your manufacturing contract should provide for you to be able to impose additional penalties. Foreign buyers that delay dealing with quality issues until after they have made full payment for their product are virtually never able to successfully resolve their China product defect issues.

The above discussion shows that a detailed, formal system for dealing with quality control and handling of defects is required and the only way to do this is with a formal, written manufacturing agreement. The common one line statement that the Chinese factory will warrant the quality of its products will never work. Manufacturing in China will ALWAYS result in defects. A workable plan for dealing with those defects is therefore not optional. It is required.

Renaud’s post raises an even more important issue. In some cases, the defect level from the factory will be high and will remain high. In that situation, where a defect rate is over 20%, it is normally impossible to develop a workable solution with the factory. The solution here is to monitor the process from the very beginning. In China, factories do not do better work over time. Their performance almost always only gets worse over time. As soon as an excessive defect rate is identified, you should take immediate action. Usually that immediate action means cutting your losses and moving to a new factory. A good manufacturing agreement will make this transition as easy as possible.

Risk 7. Logistics Cost Increases Due to Factory Error. As Renaud notes, you need to beware of increased shipping costs due to your factory making an error in the size of container required to ship your product. This issue arises from a common mistake make by foreign buyers. Inexperienced foreign buyers often do not understand that in international transactions, “logistics” is an integral factor for success. Shipping costs, shipping timing, method of shipment (air/ground/ocean), port of delivery and a host of other factors can have substantially impact the marketability/pricing of your product.

This then leads to the standard mistake. The foreign buyer looks for the lowest China Price. So the China manufacturer provides a product price that does not include the shipping cost: free carrier or the (erroneous) FOB price. Under these terms, it is the foreign buyer’s responsibility to make arrangements for shipping. The illusory concept is that the foreign buyer will then negotiate the lowest shipping rate, making for an even higher profit.

In fact, however, foreign buyers are normally unable to effectively manage shipping in China. So even though they specify free carrier terms, they in fact end up needing to rely on their Chinese factory to make all the arrangements for shipping. But under this scenario, the foreign buyer has taken on all liability for mistakes and yet it has no effective control to prevent those mistakes. This then is a perfect setting for the kind of disaster that Renaud describes.

From a legal perspective, resolution of this problem is simple. The foreign buyer’s contract with its China factory should reverse impose all of the responsibility and liability for shipping on the China factory. This is done with a manufacturing contract that provides for the product price to include shipping fees. The standard CIF (cost insurance freight) shipping term will achieve this goal. Use of CIF terms does not mean that your China factory will not make mistakes, but it does mean that your factory (not you) will be liable for those mistakes. Your China manufacturing agreement should also include a provision that requires your factory ship by air freight if delivery of your product will be delayed beyond a certain number of days. The only way to ensure that your China factory treats your key business issues as important is for your manufacturing agreement to impose an immediate penalty on your factory that does not require a cross border lawsuit to enforce.