Steve focuses on assisting foreign companies in doing business in and with China. He prides himself on working in the “real” China: the world of factories, fish plants, and farms that lie outside of Beijing and Shanghai. Having mastered the Chinese language and legal system, Steve’s unique expertise makes him an invaluable resource to our clients.

How to avoid the china tariffsAs has been widely reported, the United States and China agreed to a temporary “cease fire” in the current round of tariff escalation. This happened this weekend at the G20 meeting in Argentina and the formal results of the meeting are not known. However the White House has issued a press release that outlines the basic terms of the deal that was cut in Buenos Aires.

On the tariff issue, there are two components to the G20 agreement:

First: The U.S. had threatened to raise tariffs on $200 billion in Chinese product from 10% to 25% effective January 1, 2019. In exchange for the United States not raising tariffs in January, China has agreed to purchase a “substantial, amount of agricultural, energy, industrial, and other product from the United States” so as to reduce the trade imbalance between the the U.S. and China. Note the following regarding this:

First,

  1. The list of products has not been determined.
  2. The purchasing dates have not been determined.
  3. This kind of agreement is standard. China obtains concessions in return for agreeing to purchase products but it never does purchase the products as promised. There is zero doubt the US negotiators are well aware of this predilection.
    The trade deficit is not the core basis of the United State’s Section 301 claim against China. So even if China makes these purchases, this does nothing to address the issues that support the imposition of the existing and proposed tariffs.

Second, the parties will enter into negotiations over a 90 period. These negotiations will be designed to resolve the issues that actually do form the basis of the U.S.’s Section 301 claim against China. As summarized by the White House, the US and China will discuss forced technology transfer, intellectual property protection, non-tariff barriers, cyber intrusions and cyber theft, services and agriculture. None of these issues can be resolved by China merely increasing its purchases of U.S. goods and services. The White House release then states in absolute terms:

If at the end of this [90 day] period of time, the parties are unable to reach an agreement, the 10% tariffs will be raised to 25%.

As someone who has been involved with these sorts of China IP issues for decades, I view the odds at near zero that China will make significant and meaningful changes in their system on the issues that will be discussed.  This means that if the White House is serious about its absolute deadline the chances of the tariff rate being increased come March are nearly 100%. However, tariffs are very unpopular in the U.S. business community, so it is not at all clear what Trump will actually do 90 days from now.

All of this means the new normal is still operative for China-United States business relations and U.S. companies that are doing business in China should us the next 90 days to make their plans on (a) how to begin or continue relations with their Chinese counterparts and (b) whether and how to move to other countries to mitigate the continuing China risk.

What will you do?

China high technology transfers

As we have been writing pretty much since the US-China (and to a lesser extent — but soon to be much greater extent — the EU-China) trade war started, the new normal for China will go beyond imposing tariffs. Other measures will be adopted by the U.S. government (and by the EU) to address the issues of forced technology transfer and intellectual property theft. One of those measures is prohibiting the transferring of key technologies to China pursuant to proposed U.S. federal rules. With the initiation of rule-making by the U.S. Department of Commerce, it is clear the new normal has gone beyond the prediction phase; it is already happening.

So what is going on with the proposed rules? On November 19, 2018 the U.S. Bureau of Industry and Security published a notice of proposed rule-making to identify emerging and foundational technologies. These technologies would then be subject to various restrictions on transfer to foreign persons, particularly persons located in China.

The rule-making is mandated by the recently adopted Export Control and Reform Act of 2019 (ECRA), adopted on August 13, 2018. The process is mandated by Congress and is a core component of U.S. national policy. The rule-making and the subsequent control measures have not been dictated by the current administration. A change in the administration or in the composition of congress will have little to no impact on this core policy.

What will happen is that the proposed controls on the transfer of emerging and foundational technology will be extended to include prohibitions on investment by foreign persons in U.S. high tech companies. This will be done by applying the same definitions of emerging and foundational technologies to controls both inbound and outbound investment as currently administered by CFIUS. This will be done through the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) which was adopted on the same date as the ECRA.

Welcome to the new normal.

The proposed rule-making is designed to identify emerging and foundational technology to be subject to licensing by the Bureau of Industry and Security. The media have mostly focused on the inclusion of artificial intelligence in the list of proposed technologies, but the list goes far beyond AI and actually covers virtually every innovative technology currently being developed in the United States. Go here for the full listing of 14 technology categories,

It is important to get clear on what the rules are designed to do and what they are not designed to do. Press reports have stated that the new rules would prohibit exporting physical devices that embody foundational technology. The suggestion has been that exporting smart phones from the United States that use Siri technology would be prohibited. In the same way, exporting video games that incorporate AI game techniques would be prohibited.

These statements are incorrect. The rule-making is based on Section 1758 of the ECRA. Unlike other sections of ECRA, Section 1758 does not apply to the export of physical items. Section 1758 applies only to the transfer of emerging and foundational technology. It does NOT apply to the export of devices that incorporate such technology.

Section 1758 is very clear on this point:

1758 (b) (4) (C) ADDITIONAL EXCEPTIONS.—The Secretary shall not be required to impose under paragraph (1) a requirement for a license or other authorization with respect to the export, reexport, or in-country transfer of technology described in paragraph (1) pursuant to any of the following transactions:

(i) The sale or license of a finished item and the provision of associated technology if the United States person that is a party to the transaction generally makes the finished item and associated technology available to its customers, distributors, or resellers.

(ii) The sale or license to a customer of a product and the provision of integration services or similar services if the United States person that is a party to the transaction generally makes such services available to its customers.

The new rules under Section 1758 will not prevent U.S. companies from selling high tech products to Chinese person. What will be restricted or prohibited is the transfer of the underlying technology to Chinese persons.

These rules will have a major impact on technology companies dealing with China. Currently and under the new rules, Chinese companies are generally free to purchase high-tech products from U.S. manufacturers and service providers. But U.S. companies have mostly had little success in direct sales to Chinese persons/entities. Chinese persons/entities will usually only purchase from Chinese companies, so U.S. companies are forced to transfer to Chinese entities to make their sales. After these “forced transfers,” the technology is then “assimilated” for the benefit of the Chinese side.

ECRA Section 1758 is designed to end the forced technology transfer regime, at least for emerging and foundational technologies. Since virtually every technology of any interest to a Chinese buyer will fit into that category, Section 1758 has the potential to eliminate nearly all technology transfers to Chinese persons/entities. However, Section 1758 will not prevent Chinese persons/entities from purchasing high technology goods and services from U.S. companies through normal cross border sales transactions.

Most countries in the world (See Europe, the United States, Australia, Canada, almost all of Asia and of Africa) do business this way. The impact will be that Chinese persons/entities will be forced to behave in a more standard way in the global market economy.

On the other hand, most technology transfer projects currently being considered between U.S. companies and Chinese persons/entities will be impacted by the proposed licensing of emerging and foundational technology transfers. Even technologies not within the current very broad listing could eventually be pulled into coverage. Though all of this is in the preliminary rule-making stage, the outlines of the policy are clear and virtually inevitable. This means that every U.S. company considering technology transfer to Chinese persons must consider the impact of this licensing regime. And like I said, the EU is making similar moves. See EU moves to protect interests against predatory China in the Financial Times. 

This is the new normal.

China lawyers
Image by Florian64190

The trade and investment relationship between the U.S. and China is going through permanent change, with the current round of tariffs just the start. As the tariffs fail to bring a resolution, we should expect the United States to implement other restrictive measures, including, some combination of the following:

  • Prohibiting the selling or licensing of technology to China.
  • Prohibiting Chinese companies from purchasing all or part of U.S. technology companies;.
  • Prohibiting Chinese students from attending U.S. schools and universities
  • Prohibiting the hiring of Chinese nationals by U.S. business
  • Ending cooperative research programs with Chinese scholars and researchers.

This will be the “new normal” in China/U.S. business relations and U.S. companies that do business in or with China should start now to prepare for this new reality. Many companies are waiting to react because they believe this conflict is a temporary political problem and will soon blow over. This view is a mistake.

The tariff measures are the first step in a much more general conflict over the entire Chinese system. The U.S. objects to virtually every aspect of China’s economic/trade/investment system. Rather than take on the entire Chinese system as a first step, the current tariff dispute with China has been narrowly defined.

The USTR 301 Report bases the US tariffs on two concrete issues: China’s well-documented propensity to engage in forced technology transfer and IP theft. When confronted regarding these two issues, the Chinese government response has been to simply deny every claim. In its White Paper responding to the 301 Report, the Chinese government flatly denied every claim in the report. On forced technology transfer: it does not happen and U.S. companies that transfer their technology to China do so voluntarily based on their own business calculations. On IP theft: it does not happen and accusations of trade secret theft and cyber-hacking are simply lies.

China’s consistent and complete denial of every statement in the 301 Report has been maintained by every layer of the Chinese government. There has been no movement at all. For example, in the forced transfer area, the Chinese government has refused to even consider opening the network, e-commerce and cloud computing markets in China to foreign based businesses. In the IP theft area, the Chinese government has refused to cooperate in investigating and extraditing those sought under recent U.S. indictments in several high profile cases.

There is a reason for China’s hardline position. Its forced transfer and IP “assimilation” regimes are at the core of China’s economic system. The current leaders of China understand this and that is why they cannot even suggest a compromise on these critical issues.

With China standing resolute and with there being no hint or likelihood of this changing quick resolution of the US-China trade war will require the U.S. trade team to capitulate. U.S. businesses have waited twenty years to see real improvement in the Chinese system only to see things grow steadily worse. China has lost nearly all of its former supporters in the U.S. business community. Since China has lost its main body of support in the U.S., there is very little pressure on the U.S. trade team to back down. It is therefore unlikely it will.

The situation is critical and nearly all foreign companies that operate in China should be analyzing how they can best deal with the trade situation. These companies need to make concrete plans for dealing with the impact the US-China trade war is having and will have on their business operations. Many companies believe they must either abandon China or pretend nothing is happening and go on with business as usual. For nearly all companies neither of these approaches make sense.

Some companies will continue to work with China based the same way they have for the past decade. For these companies, their major adjustment should be that they quit dreaming anything will change. For other companies, developing supply relations outside of China will become critical. For some of these companies a move out of China will be required. Others will be best off splitting their production between China and other countries.

What is consistent for pretty much every company that operates in China is the need for it to evaluate its operations in China under the New Normal of increasingly restrictive trade and investment measures. In assisting our own clients with this sort of evaluation we’ve been targeting the following:

1. How will current and future tariffs impact the business. For some of our clients, the tariffs are largely irrelevant. For others, the impact is so severe that failing to move quickly could lead to their demise.

2. What can be done about the tariffs? Is an exclusion from the tariffs possible? Will the Chinese factory agree to a price adjustment? Should the supply chain be moved to another country? Should the company shift the sales of its products to countries (other than the U.S.) where tariffs are not being imposed?

3. If the supply chain needs to be moved to another country, a careful analysis is required. Will you need to build a factory in that other country or can you purchase your products from an existing supplier or contract manufacturer? Is the infrastructure and legal system in the target country adequate for your needs? How long will it take to move and what will be the cost? As high as the costs are going to get to manufacture in China, this analysis often reveals China is still many companies’ cheapest and best choice.

4. China currently requires many technology companies to license their technology into China. For example, such licensing is essentially required in the network, cloud, SaaS sector, e-commerce and fin-tech sectors. The Chinese government has made clear this policy will not change. Companies in these sectors that have held off on “going into” China in the hopes of a change in policy should now either accept the licensing requirement or just abandon China as a market.

5. Many U.S. companies engage in co-development of technology and products in China, working with many types of Chinese entities. Over the past 15 years, the Chinese court system has been largely receptive to protecting the contractual rights of foreign entities, provided that the contracts are properly drafted. See China Contracts: Make Them Enforceable Or Don’t Bother. Will Chinese courts continue to enforce these manufacturing contracts, especially on behalf of American companies? Or will U.S. companies need to look to different ways to protect their innovations that do not rely on the Chinese legal system? Fortunately, all signs still point to continued contract enforcement.

6. Will new rules (either from the U.S. or from China) make it difficult or impossible for U.S. companies to sell or license their technology to Chinese companies? For U.S. companies that want to bring in Chinese investment, what will be the impact of restrictions that are currently being proposed? For U.S. companies that rely on hiring large numbers of Chinese professionals, what will be the restrictions? For U.S. education and research institutions that want to work with Chinese researchers, will that be possible? What about Chinese scholars who have become naturalized citizens of other countries? Will they also be banned?

Every party from the U.S. that works with China in any way should be asking themselves at least some of the questions above. Foreign companies that sell their Made in China products to the United States should be doing the same. China will not be completely and permanently cut off from business relations with the United States, but the nature of the US-China relationship has changed and it is not going to return to the way it was for a long long time.

The US-China business relationship is fluid and its final configuration has not yet been settled. Nonetheless, businesses that wait for a final resolution will be left behind. Now is the time to evaluate and take action.

What is your company doing to get ready?

Asia manufacturing lawyers

The key issues in nearly all the contract manufacturing agreements we draft (be they for China, Vietnam, Pakistan, Malaysia, Indonesia or wherever) are price, quantity and delivery date. Yet many foreign buyers fail to address these critical issues as they are more focused on issues like intellectual property protection and control of molds. They assume the basic business issues will take care of themselves. This is a mistake.

Here is what often happens. The foreign buyer does not know whether a particular product will “take off” or not so it enters a contract with its manufacturer that sets out the basic terms for purchase but does not mention any commitment on how much product it will purchase or when.

The buyer then makes small purchases of its product to determine whether there is a market for its product or not. The product then becomes a hit and the buyer returns to its manufacturer (in China, Vietnam, Malaysia, India, Indonesia or wherever) with a purchase order to buy substantial quantities of its product to be delivered just in time for the holiday season. The price and payment terms are the old terms set forth in the purchase order.  Based on that price, the buyer already has signed contracts with major retailers to provide its product in time for the holidays. The factory in Asia will be excited to receive the big order? Right? No, wrong.

Here are some of the more common responses we have seen from factories that refuse to accept a purchase order:

  • We have to increase the price. Raw material costs have increased. Our production costs have increased. From those first small orders we discovered that it is more difficult to make the product than we originally thought.
  • We don’t have the capacity to meet such a large order. Sorry.
  • To meet such a large order, we need to purchase materials, hire new employees, and expand our production line. To do all this, we will need you to pay a substantial deposit, much higher than the original deposit we required. We also need you to commit to a long term purchase agreement at terms favorable to us.

Since the factory is not required to accept the new PO, it is in control. If the foreign buyer does not agree, the factory can simply walk away. The factory knows all of this.

This situation can be a real disaster for the foreign buyer. In fact, for every one company we’ve seen bankrupted by IP infringement we’ve seen three bankrupted by missing out on an entire holiday sales season because they could not obtain product at a price, quantity and delivery date needed to satisfy their market.

Some foreign buyers will enter into an agreement where their factory agrees to locking in price for a specific period, believing this will protect them. They then think that they are covered. But this does not work because the factory still has the right to reject purchase orders.

This is because as a legal matter, it is unreasonable to require that a factory must accept your purchase orders without exception. What if your purchase order contains provisions never agreed to by the factory? There are an infinite number of possible conditions other than price. Quantity and delivery date are just the two most salient ones. Until you have an agreement with your factory on all relevant terms you have no “contract” requiring your factory fulfill your purchase order. If you submit your PO and your manufacturer accepts it, you have a contract: but only on the point of acceptance. Without your factory accepting your PO, you essentially have nothing.

Even on price, without an accepted purchase order or a binding commitment to purchase, no price lock from the factory is meaningful. The factory can always argue that a change in conditions requires an increased price. In many cases, this argument is legitimate. Since the argument may be legitimate, a court will not look deeper and the manufacturer will nearly always prevail.

Foreign buyers usually miss this fundamental issue: a PO is not a contract until it is accepted. Until the full set of terms has been agreed upon by the factory and the buyer, the factory will not be bound by a PO you submit to them. The factory is only bound bound by an accepted purchase order or a formal written contract that provides all the terms of the purchase transaction and for which the PO is just a formality. This is why my firm’s manufacturing lawyers so vehemently discourage our clients from operating on a per purchase order basis. A full contact is required. But a full contract requires a binding commitment to purchase a specific amount of product over a specific period of time.

Many foreign buyers are not in a position to make a hard commitment on product purchases What is to be done in that sort of situation? Very briefly, the below is what our manufacturing lawyers have proposed and had work.

1. The Asia factory agrees on a price lock period. This is never more than a year.

2. The foreign buyer gives a one year quarterly estimate of its purchase amounts and delivery dates. The factory has a period of time in which to accept or reject this estimate. This right to accept is the critical issue. If the factory has a problem with the rolling estimate, the factory is required to respond. If there is no response, the estimate is accepted.

3. The foreign buyer submits its PO to the Asia factory on a quarterly basis.

4. If the PO complies with the accepted rolling estimate and the price lock, the factory is required to accept.

5. We often provide that the foreign buyer has the right to adjust its quarterly PO up by 100% or down by 50%. This adjustment sometimes still requires the final purchase amount be within the annual estimated amount, sometimes not.

6. We have never tried to run this kind of program beyond the price lock period. If a price adjustment mechanism is included, it could run for a longer period of course. However, the factory is not obligated to accept a PO unless and until a final agreement is reached, and that final agreement requires the factory accept the rolling estimate.

Some factories accept the above and some do not. For most factories, the big issue is the price lock. The factory states that the price it is offering is based on the quantity and delivery date and if those change then its price changes.

The procedures for assuring your factory will accept your POs are complex, varied and variable. The key is that you as the buyer must face the issue and decide on how to proceed. If you do not do this, you likely will find yourself in a major jam right when your product is about to rocket to commercial success.

China scams. China attorneys. China lawyers.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

And be careful out there.

China Transactional LawyersOur China transactional lawyers often work on deals involving the foreign subsidiary of a Chinese parent company. When we raise the issue of getting paid on these deals, our clients sometimes insist these deals are secure for two reasons. First, the contract is enforceable in the United States so there is no need to deal with the Chinese legal system. Second, the Chinese parent is sitting on a pile of cash and if the subsidiary cannot pay its debts, the U.S. based contract will force the Chinese parent company to bail out the subsidiary. This premise is just wrong.

Consider this very real scenario. A (formerly) cash rich Chinese company forms a Virgin Islands subsidiary. That subsidiary then sells bonds on the international market. To repay the bonds, the subsidiary must pay in dollars or whatever foreign currency the bonds are denominated.

The foreign subsidiary does not do any real business. The basis of the bond valuation is that the parent Chinese entity is sitting on a pile of RMB in China. When the bonds are due, if the foreign subsidiary is unable to roll over the bonds or to find alternative financing, it is assumed the Chinese parent company will convert its RMB to dollars and then remit those dollars to the foreign subsidiary. Because of this “the parent will cover it” assumption, the bonds are priced at investment grade. (For purposes of this analysis we will assume the pile of cash held by the Chinese parent company is real, though often it is not. But that is another story).

The fundamental issue is that the Chinese parent does not have the power to freely carry out the conversion from RMB to dollars. The Chinese government has the right to not allow the RMB/dollar conversion for payment on these bonds because it wants the RMB to stay in China. See Getting Money Out of China: It’s Complicated, Part 6, along with the previous five parts of this series.  The Chinese government might deny this RMB conversion because it was a speculative venture and it will not allow PRC foreign exchange reserves to be depleted to cover that speculation. “Invest your RMB at home or at least repay your creditors at home,” it might tell the Chinese parent company.

As a result of the Chinese government prohibiting the conversion and off shore remittance the subsidiary will have no ability to pay on the bonds and it will default if no alternative funding source is found. We are assuming that the parent has plenty of cash in the form of RMB, so it is not a matter of the parent company not having the resources to pay its debt to its foreign bondholders. The issue is that the Chinese government will not ALLOW the group company to pay its debts.

Something along the lines described above actually happened in the case of one of China’s largest and best known companies — Wanda. There was a credible threat the PRC government would not allow offshore remittances to cover payment on Wanda foreign bonds. For this reason, the Wanda foreign denominated bonds have been reduced to junk status by all the rating companies (BB or lower). Junk status means the chance of a rollover or other funding alternative is relatively low. This is a problem for Wanda, but it is even worse for the original owners of the bonds.

Our China lawyers are often called on to review deals with VIE entities formed in the Cayman or the Virgin Islands. The Chinese side of the VIE asserts that it is sitting on a mountain of cash. This assertion pumps up the value of the foreign issued stock. But when the shareholders insist that the cash be remitted offshore for distribution to shareholders, the Chinese side nearly always states: we would really like to do that, but the Chinese government will not allow us. Sorry.

Your takeaway from all this should be that if you are doing a financing or other project with a subsidiary of a Chinese company, you cannot rely on payment support from the Chinese parent company. If the Chinese parent company’s money is not already in a bank account outside China, even if the mountain of cash exists, there is no certainty that  money will be permitted to leave China. In fact, the most likely scenario is that the cash will not be permitted to leave China. Why should debts to foreigners be paid when there is plenty of need for the funds in China?

This then relates to the question of the reliability of investment from Chinese companies in general. Big Chinese companies are fond of making announcements regarding their huge investment plans. People (especially Western businesspeople) rely on these announcements, but in the end nothing happens. The Chinese investment community has a term for this: “We heard the thunder and we saw the lightening, but we never felt the rain.” That is, until the money is in the bank, never believe a thing. The Chinese don’t. Why should you?

China self driving cars As I outlined in my previous post, Self Driving Cars in China: The Roadmap and the Risks, the Chinese government is pushing hard for development of a Chinese based self driving car. In reviewing China’s proposed legislative framework and recent books from China, we can see how Chinese’s system offers unique advantages for developing fully autonomous vehicles.

China does not seem to have the atavistic fear of robots and AI common in the Western world. Recent surveys show that over 75% of Chinese car buyers have a favorable opinion of self driving vehicles, as opposed to only 50% in the U.S. More significant is that 60% of Chinese auto buyers believe developing self driving cars is a significant issue, as opposed to less than 20% in the U.S. and in Germany.

Fear of autonomous driving is not a factor in China. The issues in China are more direct. Is a self driving car available? Will it be available in a reasonable time frame? Will a self driving car work well? How much will it cost? Will the vehicle be owned by an individual or by a ride sharing entity or (in China) by some service owned or managed by the government? These are rational economic considerations, not gut level fear of robots and artificial intelligence.

A Chinese consumer may decide self driving cars are not an important issue because they rationally believe they will never happen. But they do not oppose self driving cars due to a fear of robot control. The Chinese are generally not in love with driving. Driving in China basically sucks, and if they can leave the driving to someone else, the Chinese are generally happy to do that. And if the someone else is a robot, they don’t care. The issue to the Chinese consumer is: how much will that robot cost? [Editor’s Note: Peter Hessler’s book, Country Driving: A Chinese Road Trip, makes for a great read on driving in China.]

The Chinese also do not generally make unreasonable requirements on the safety of a self driving car. In the U.S. and in Europe there is an unstated but very real demand that self driving cars must be perfect. Every accident involving a self driving car is head line news and endlessly reported online. At the same time the 40,000 U.S. deaths and the ~25,000 EU deaths per year from human controlled driving are taken as business as usual.

The Chinese regulators and public make no such unreasonable demands. One goal of the Chinese government is for self driving cars to reduce the current very high Chinese passenger vehicle accident rate (~260,000 people die on China’s roads a year). However, the goal is to reduce the accident rate by a reasonable percentage. No one in China demands self driving cars be accident free. It is assumed they will NOT be accident free. The issue in China is whether the rate of accidents will be at an acceptable level or not. In China, it is assumed that the accident rate will decrease due to autonomous vehicles, but no one expects that rate to be dramatically lower than the current rate. For that reason (and probably some others), accidents involving self driving cars simply are not news in China.

Finally, the Chinese are free of the Western (especially U.S.) need to assign blame for accidents involving self driving cars. U.S. legislation and discussion of self driving cars almost obsessively focuses on this issue. Who will pay if there is an accident? Will it be the software developer? The auto manufacturer? The vehicle owner? What if the accident is determined to have been caused by a flaw in the software? Or a flaw in the installation? Or a flaw in the smart transportation network? Or the result of hacking by a third party? Or by operator error? Or by circumstances beyond the control of any party? Or even something as relatively routine as failed brakes?

If you examine U.S. based discussions of self driving vehicles, you will see these issues are primary and this is certainly even more true among the lawyers. Self driving projects then focus on issues like the ethics of driving decisions, insurance coverage, liability and damage allocation. Though these are primary issues in the U.S., they hardly exist in China. I have 200 pages of Chinese government proposed rules and regulations for autonomous vehicles on my desk. I have five full length Chinese language textbooks on self-driving cars, all published in the last two years. The issue of liability and insurance is simply not discussed at all in these thousands of pages. It is a complete blank.

There are two reasons for this. First, the Chinese are generally far less concerned with assigning guilt than Westerners. In Chinese traditional morality, guilt is not the main focus of an enquiry of what to do when a person is harmed or injured. In China, the focus is on how the social equilibrium can be restored as quickly as possible. The damage is repaired and the parties move on. Guilt and the associated liability for guilt is usually not a fundamental issue. Second, the Chinese insurance system is a no fault system so there is no reason to assign guilt. Auto accidents do not give rise tot moral issues. The issues arising from auto accidents in China are usually clear: what was the damage and what sort of payment is required to restore the parties to their original situation. Lawyers are virtually never involved, the award is limited to economic compensation and there is no high value award for non-economic matters like pain and suffering.

From the U.S./Western side, the fear of robots, along with unreasonable safety demands and allocation of liability in a guilt based system create substantial barriers to developing self driving cars. In the U.S., these barriers are at least as significant as the considerable technical barriers. In China, these non-technical barriers do not exist. It’s not that they are reduced; they don’t exist at all.

China can therefore focus on the technical issues. It is the technical issues that will drive the development of the vehicle of the future. So thought Chinese companies are currently behind the West on the technical side, they can move forward free from so many of the non-technical barriers that will both slow down and increase the costs of autonomous vehicle development in the West. This means China will reign as the primary testing ground for new technical solutions in the self driving car field. So even if China is not the place where the technology is developed, China will be the place where the technology is applied in real world applications. This is already happening in the electric vehicle market and this same trend will continue in the self driving car market.

Autonomous VehiclesDevelopment of the self driving car is the centerpiece of the Chinese government’s plan to redesign its manufacturing and technology sector. The Chinese have coined the term Intelligent and Connected Vehicles (ICV) (智能网联汽车)as their own technical term for describing the China version of what is an international race towards a difficult technical goal. The ICV is an ideal goal for China because it combines elements of all three of its current key technology programs: Made in China 2025, Internet+ and the Artificial Intelligence Strategic Plan.

As is typical of the Chinese system, the central government seeks to place itself on the top of the system, providing guidance and control from the top down. In furtherance of this goal, the PRC Ministry of Industry and Information Technology together with a number of related PRC agencies just issued a comprehensive set of national guidelines (建设指南) to provide the framework for development of ICVs in China.

The full set of guidelines is as follows:

(i) the National Guidelines for Developing the Standards System of the Telematics Industry (Overall Requirements) (国家车联网产业标准体系建设指南 (总体要求)). (June 2018)

(ii) National Guidelines for Developing the Standards System of the Telematics Industry (Intelligent and Connected Vehicles) (国家车联网产业标准体系建设指南 (智能网联汽车) (December 27, 2017)

(iii) the National Guidelines for Developing the Standards System of the Telematics Industry (Information Communication) (国家车联网产业标准体系建设指南 (信息通信) (June 2018).

(iv) the National Guidelines for Developing the Standards System of the Telematics Industry (Electronic Products and Services) (国家车联网产业标准体 系建设指南 (电子产品和服务) (June 2018).

Though the Guidelines are detailed and complete, these are only guidelines. That is, this is a standard to be followed for the drafting of binding regulations and statutes. The Guidelines merely set out the path to be followed. The real work remains to be done.

To date, the most important regulation with substantive impact is the Intelligent and Connected Vehicle Test Management Practices (智能网联汽车测试管理规范) issued on April 12, 2018. Under this regulation, individual Chinese cities are permitted to develop standards that allow for on the road testing of autonomous driving vehicles on public roads. In response to this new regulation, Chinese cities that seek to host the development of ICVs are working with the players to host testing in their own city. The typical regional divisions that characterize Chinese technology development are already taking form:

a. Beijing has set up a licensing program for Baidu.

b. Shanghai has set a licensing program for Ali Baba.

c. Shenzhen has set up a licensing program for Tencent.

Each city is seeking to establish its own regional champion in this new area. To avoid being left behind, other Chinese cities are joining in to create their own ICV on road testing programs. For example, the city of Tianjin recently announced its own ICV testing program in collaboration with the Tianjin Intelligent Connected Vehicle Industry Research Institute. It is expected that other Chinese cities will follow suit, with all of them seeking to create a regional (not national) ICV champion.

This movement towards regional rather than national ICV champions is of course contrary to the MIIT goal. But the overall development of the Chinese vehicle market shows that regional rather than national development is the dominant trend. There is little prospect that the Beijing authorities will be able to do anything to stand in the way of these regional developments. Note that this move to city/regional based ICV fiefdoms is dramatically different from the experience in the United States. California recently opened its roads to self-driving car testing. In response, over 50 different manufacturers have chosen to conduct tests on California roads. Consistent with general U.S. policy, California makes no attempt to favor one company over the other. The market will choose the winner. The Chinese system is developing in exactly the opposite direction, where regional governments are picking their winner in advance. Developments over the next decade will show which system works best.

This then leads to my central theme in considering this issue. In the development of the ICV, technology is everything. The Chinese central and regional governments have plenty of money for developing this program. But that money will be used in classic Chinese fashion. It will be used to purchase land and to build factories. That is, the money will be used for hard infrastructure.

But the question for China is what will those factories actually do? Without the most advanced technology, the factories will do nothing more than build the sort of low standard electric vehicles that already clutter the roads of China’s second tier cities. For the second tier cities like Tianjin, the technology issue is even more acute because the players in Beijing/Shanghai/Shenzhen are not planning to share their technology. In this project, it is every region for itself. So each regional player is faced with a existential issue: after the factories are built, from where will the ICV technology come?

The search for technology will be intense. A huge company like AliBaba can perhaps develop the technology on its own. But that only works for the Shanghai fiefdom. What about everyone else? In response, Chinese regional governments, research centers and production companies will be scouring the world for the latest in ICV technology. Since China currently appears to be the major market for electric and ICV vehicles, foreign companies will need to decide whether or not they want to work in China. For those companies that decide to work in China, the real issue will come down to the issue we continuously raise on this blog. Will you retain control over the technology or will you give it away? Will you get paid for what you give away, or will you wrap it up as a gift?

This growing market for ICV technology is an opportunity for foreign companies. The demand will increase over time, making the market for the transfer of ICV technology to China a long term trend. The question for foreign companies is whether China is a market where a profit can be made or is it just a trap leading to bankruptcy?

Though U.S. companies continue to complain about IP theft and forced transfer of technology to Chinese companies, there are ways to avoid presenting your technology to the Chinese side as a gift. But avoiding this result requires two things. First, you have to accept that if you refuse to make the gift, the Chinese side may walk away and you will then be excluded from that market. Second, you have to do the work required to provide yourself with protection. That means entering into tough, enforceable contracts and making the required patentcopyright and trademark registrations in China. If greed blinds your eyes to the risk, then you will not do either and the result will be predictable.

China attorneysThis is part 5 in our series on what we have dubbed “China free look schemes.” Essentially, China free look schemes are methods employed by Chinese companies to get a “free look” at the intellectual property and trade secrets of foreign companies. In part 1 of this series, we looked at how Chinese companies use their purported interest in investing in a foreign company to convince the foreign company to give the Chinese company access to the foreign company’s IP. In part 2, we explained how Chinese companies use Memoranda of Understanding (MOUs) to get free looks at foreign technology. In part 3, we explained how Chinese companies use Joint Ventures (real, fake and non-existent) to get at foreign technology without paying for it. In part 4, we noted how there are plenty of legitimate Chinese companies seeking legitimate deals with foreign companies and then explained how to determine whether the Chinese company with which you are dealing is serious about doing a real deal or is just trying to get a free look at your IP.

In this, part 5, we address how best to deal with the risk of a China company free look scheme.

The Chinese money looks good, but you don’t want to give away the technology base of your company and then never see the cash. So how do you spot the schemer? The first step is to get clear about the motive of the potential investor from China. Is the Chinese investor focused on financial return or on the technology?

It is possible the investor from China is what we can call standard financial investors. These are venture capital or private equity funds focused on financial return. It is relatively easy to identify a financial investor. Their interests are not focused on the content of technology; they are interested in making money. Negotiations with a financial investor will focus on business terms: price, payment schedules, control, board representation, exit strategy and related. Negotiations on these critical issues with Chinese investors is usually quite difficult. In particular, Chinese investors like to make a last minute bid for a reduced price.

But their motivation remains clearly financial. Such an investor will not seek to investigate the technology. Such an investor will not propose joint ventures and tie ups in China. Discussion will be limited to hard nosed business terms. U.S. companies and their advisors are used to this type of investor. The approach is the same all over the world. So the standard deal techniques and documentation generally will apply.

Note, however, that just because the Chinese investor bills itself as a private equity or VC fund does not mean it is not focused on technology. In fact, in today’s China, the opposite is most likely to the be the case. Beneath its indigenous innovation rhetoric, the Chinese government understands that Chinese companies and academic institutions do not have the capability to develop modern technology quickly enough for Chinese government plans. For example, the deadline for a program like Made in China 2025 is already drawing quite near and to jump start development the Chinese government has made acquiring foreign technology a primary goal.

To implement this acquisition program, the Chinese government has taken two approaches. First, it has pressed Chinese companies to make acquisitions in their areas of business that are not focused on financial benefit but rather are focused on acquisition of technology. Second, the Chinese government has instructed private investment funds and banks to quit investing in non-essential sectors such as foreign real estate and media and instead to concentrate on the acquisition of technology. Existing Chinese funds have changed their focus. New funds are being created that are focused solely on acquiring foreign technologies in government mandated key sectors.

In the old days, the way you spotted a technology focused investor was to simply ask whether the Chinese company directly competes with your company? Now though far more research is required. If the investment comes from a Chinese based fund, you have to ask whether the goal of this fund is limited to financial return or is its goal to acquire advanced technology for the benefit of China as a whole, rather than for the financial gain of the holders of the fund.

Once you determine the potential investor is focused primarily on technology you then have another set of decisions to make.

Our China attorneys typically see three types of investor that should be rejected because they are only planning on a free look:

1. The investor has no intention of investing. They only want a free look. This type of investor should be rejected as soon as possible.

2. A more clever Chinese investor strategy is to seek to access to the technology of the target company in exchange for a modest investment. It is common for Chinese investors to take this position. Their position will go even beyond the standard free look. They will say: “We are now part owners of the company so the company should provide us with free access to all the technology information owned by the company and it should follow our direction in doing business in China. Joint ventures, distributors and business partners should be selected by us.” This is a violation of basic company law. A minority investor usually does not have a right to access confidential information or to direct the operations of the company. This is particularly true when that minority investor directly competes with the company. When Chinese investors make this kind of demand, this usually shows they are just planning on following the free look strategy. When they reveal their real intention, they should be shown the door.

3. The more difficult type of investor is the investor who at least claims it intends to purchase a majority interest in the company. As is generally known, acquisitions by Chinese investors face a number of obstacles: a) agreement on the business terms, b) approval by the Chinese government, and c) approval by the U.S. government. So even when the Chinese investor is sincere in its intent, an acquisition from China can take a lot of time and may never happen at all. The risk here is that the investment from the Chinese side will turn into a free look scheme. This is a very common result and must be resisted.

The conversion into free look centers on the due diligence period and the content of due diligence demanded by the Chinese side. The sequence generally works like this:

The Chinese side starts the negotiation agreeing to a very high price. Then, just before the initial closing date, the Chinese side pushes for a substantially lower price and give one of three reasons: a) It no longer has faith in the technology, b) The Chinese government will not allow the investment, or c) The ultimate backers of the Chinese side (banks and funds) will not agree. In each case, the solution proposed by the Chinese side is that the investment target provide inside data about the technology or it enter into a cooperative project in China to demonstrate and prove the technology.

The process continues, as the Chinese side pushes for more and more technical information. In the end, if the U.S. side finally agrees to substantially reduced prices, the Chinese side will close on the deal since it has acquired the technology at a bargain price. Sometimes the deal simply fails, with this failure never attributed to the decision of the Chinese investor. Instead, the Chinese company usually blames the failure of the deal on a decision of the Chinese government or the unknown Chinese “backers” of the deal.

In the end, the Chinese investor either acquires the technology at a bargain price or converts the deal into a free look scheme. So what looks like a legitimate investment proposal turns into a free look scheme or an absurdly cheap one. This common situation, where a failed Chinese acquisition turns into technology theft, is often reported in the financial press. See, for example this weeks New York Times story, Inside a Heist of American Chip Designs, as China Bids for Tech Power. 

But you are a start-up and you need the cash. So what do you do to weed out the genuine Chinese investors from the free look schemers. We will set out the basic plan in our next and last post in this free look scheme series.

This is part 4 in our series on what we have dubbed “China free look schemes.” Essentially, China free look schemes are methods employed by Chinese companies to get a “free look” at the intellectual property and trade secrets of foreign companies. In part 1 of this series, we looked at how Chinese companies use their purported interest in investing in a foreign company to convince the foreign company to give the Chinese company access to the foreign company’s IP. In part 2, we explained how Chinese companies use Memoranda of Understanding (MOUs) to get free looks at foreign technology. In part 3, we explained how Chinese companies use Joint Ventures (real, fake and non-existent) to get at foreign technology without paying for it.

In this, part 4, we note how there are plenty of legitimate Chinese companies seeking legitimate deals with foreign companies and explain how to determine whether the Chinese company with which you are dealing is serious about doing a real deal with you or just trying to get a free look at your IP. There is no doubt that there are a large number of Chinese companies, fund managers and investors who see the potential in bringing Western technology and know-how to China and are willing to pay Western companies for that and/or share the profits from that with Western companies.

The core of the free look scheme is the proposal of a Chinese company to make an investment in a foreign technology focused entity. To prevent the Chinese side from playing out a free look scheme, it is essential to work out a “clean” investment agreement. The basic features of a clean agreement are as follows:

1. U.S. and European style investment agreements are normally too vague to be effective in working with Chinese investors. For Chinese investors the investment agreement should include at least the following:

a. An exact date when funds must be paid.

b. Funds must be paid free and clear, in cash, to the company bank account on the closing date. Any claim that funds have been or will be wired from China or Hong Kong or wherever should be ignored. Only cash actually in your bank account, free and clear, counts as an investment.

c. Require the Chinese side to agree that no approval from the Chinese government or any other foreign government is required to make the investment and that no decision of a foreign government or foreign bank will excuse the Chinese side’s obligation to make the payment by the closing date.

d. To give teeth to these provisions, you should require your Chinese counter-party to make a substantial good faith escrow deposit on the date the investment agreement is executed. Provide that the escrow deposit will be forfeited if the investor does not make payment on the closing date. Absent this hard deadline with a substantial penalty, the Chinese investor is almost always late in paying, even when payment is made from a Hong Kong or a U.S. or a Canadian account.

Using the above approach will usually prevent the Chinese side from making use of the free look approach and tell you whether they are free real or not. This is because no Chinese company planning to use the free look approach will agree to the above terms. In refusing to agree, the free look schemer will argue that you need have to prove the viability of your technology before it (or its so-called outside investors) can make any payment or investment. At this point, the best thing to do is usually to walk away.

But most U.S. and European companies choose to continue working with the Chinese side, attracted by the potential of  substantial investment and developing the massive PRC/Asia market for their product. The U.S. or European side will at this point agree to a due diligence period before the final investment is made. This due diligence period is where the free look scheme is executed. The U.S. or European side should enter into an agreement with its Chinese counter-party that is specifically designed to prevent the free look scheme from succeeding.

Some of the following issues arise from this:

1. Who will be the actual investor in your company or your technology? Many Chinese companies find it difficult to transmit funds from China for making an investment. Even for good faith investors, it is often impossible to to make the investment directly from the PRC. To get around this problem, Chinese investors often provide that “their” funds will be paid by some other entity located outside China. This raises a number of issues. First, under U.S. and European know your investor and anti-money laundering rules, it is critical you know from exactly where this funding is coming. Second, payment from a different party is a common source of delay and delay must be avoided in this kind of transaction.

2. Most investment agreements prohibit ownership of stock by nominees. This follows on the know your investor and anti-money laundering rules discussed above. But when the actual PRC investor proposes to use funds provided from another entity, they often then request that this other funding entity own the stock in your company on behalf of the PRC entity as some sort of nominee. This kind of nominee ownership is common in the PRC, but the practice should generally be avoided in the West.

3. If the Western company is working with other potential investors, it is usually important it make sure any special terms provided to the Chinese side do not conflict with agreements with other investors. For example, it is often provided that for a single round of investment, the round will not close until after all investments have been made. If the Chinese side is given a substantial due diligence period prior to being required to invest, this may conflict with the basic requirement imposed on other investors.

5. In this setting, the standard Western style investment agreement is not adequate. You need a separate and specialized escrow/due diligence agreement with the proposed PRC investor.

The following are some of the key points for these due diligence agreements:

a. Who will be the final owner of your company’s stock? Will it be the PRC entity with which you are negotiating or will it be some Hong Kong or Canadian or Cayman Island or Isle of Man or Luxembourg company you have never heard of nor ever dealt with? Even if your due diligence agreement is with a PRC entity, it is not unusual for that PRC entity to demand provisions giving rights to some third party you do not know. Are you willing to issue stock in your company to an entity of which you know nothing?

b. Even riskier is the situation where the PRC entity requires the investment/due diligence agreement be done directly with their non-PRC nominee. Since these nominees are usually mere shells with no assets it is judgment proof. This renders meaningless the entire due diligence agreement.

c. The U.S. side must describe with reasonable clarity what access and information will be provided to the putative investor during the due diligence period. First, the information disclosed should be strictly limited. The Chinese side will nearly always demand more and it is important you set and maintain your disclosure limits. Second, the participants in the due diligence process must be carefully controlled. The Chinese side usually works with a group of related companies. A standard technique is for the Chinese side to negotiate a provision that allows them to disclose your information to one of its related companies. When an infringement of your IP later occurs, it is done by that related but independent company with which you have no contractual relationship. This means you have no contractual basis for making a claim against the actual infringer and your Chinese counter-party thus can walk away with a free look.

d. If you are going to require other investment conditions you must list those with hard deadlines. For example, if PRC government approval of the deal is going to be required, you should put in your contract that such approval must be received by the end of the due diligence period. If a license is required, drafting must be complete at least one month before the end of the due diligence period. If a JV company will be formed, the Joint Venture’s registration must be complete by the end of the due diligence period, with only capitalization remaining — this means the JV registration process must start immediately after execution of the due diligence agreement.

e. At the end of the due diligence period, the Chinese side must be required to “go hard,” meaning all of the conditions to closing the investment must be met or waived by the end of the due diligence period. That is, the Chinese company either walks away or enters into a formal investment agreement that provides for either payment in full in five days or payment of a non-refundable escrow deposit with closing to occur within thirty days. Chinese companies that are working the free look scheme will usually not agree to this quick close. They will instead seek a process where negotiating and drafting the investment agreement and other collateral agreements begins only after due diligence is completed. To avoid the free look scheme, you should insist the investment be made immediately after completion of due diligence. It is not uncommon for Chinese companies to stretch the approvals/documentation period out for several years with no investment in the end.

f. As noted above, the investment and due diligence agreements should provide that no action of the Chinese government or of any Chinese bank or any other Chinese agency will be a defense to the requirement that the Chinese investor perform and if the investor does not perform, its escrow deposit or advance payment will be forfeited. Chinese companies often will insist on including a long force majeure provision in an otherwise simple investment agreement. If you allow for this sort of provision, you are all but guaranteeing there will never be any Chinese government approval. It is actually a good idea to include the exact opposite provision whereby the Chinese side warrants that its investment has already been or will be approved by the Chinese government and that no action of the Chinese government can used by them as a defense.

There are a number of ways to neutralize the free look scheme, even in cases where you agree to prove your technology to the Chinese side. Legitimate Chinese companies will work with you to resolve the issues, but Chinese companies that are in it for the free look will not. It is important you determine where they stand as soon as possible. You do that by providing clear and reasonable terms to the Chinese side along the lines discussed above.

If the Chinese side has problems with the straightforward terms outlined above, you should ask them to outline their specific concerns in writing. If their concerns are legitimate, you probably can deal with them. If the Chinese side does not respond or if its concerns are not legitimate you know where you stand. Chinese companies can run you around for a very long time — years in some cases. You cannot afford that. You need to quickly get to a reasonable arrangement with the Chinese side or move on.