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.

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.

China technology IPThe standard story is that the Chinese government has decided to “corner” the world market for electric vehicles. The most expensive and important component for an electric vehicle (“EV”) is the battery pack. So the the logic goes that the first step in this plan is for Chinese companies to dominate production of EV batteries.

The recent Shenzhen stock exchange IPO of Ningde, Fujian based Contemporary Amperex Technology Ltd (CATL) has been seen as a key phase of this process. According to the press reports, CATL raised USD $830 million in its IPO completed on June 10. Though far less than the $2.0 billion CATL had originally planned to raise, this is nonetheless a substantial sum.

CATL plans to use the proceeds from its IPO to buildd new production capacity for 24Gwh of batteries focused on the EV market. CATL plans for its Ningde facility to become the largest EV battery maker in the world, with a final projected capacity of 50 Gwh scheduled to come on line by 2020. This can be compared with the Tesla Nevada Gigafactory 1 which is projected for 34Gwh capacity.

Though this is a considerable achievement for a company located in the isolated country town of Ningde, its significance is not as reported. The real issue here is not the Chinese government’s decision to promote high volume manufacturing of a basic industrial product. The issue is rather with the technology behind the product and the control of that technology. Production within China may become controlled by Chinese owned companies, just the way so many other basic industrial commodities are under such control today. But it is unlikely China will develop new EV technology through indigenous innovation. That is where the real challenge rests.

Consider the basic issues:

  1. CATL’s advantage rests almost entirely on China’s preferential policies. First, the Chinese government is providing substantial subsidies to EVs for domestic transport. Second, the Chinese government has set the rules so that only EVs using product from Chinese battery makers (CATL and BYD) qualify for these subsidies. This is not a market phenomenon, it is simply an artifact of Chinese government subsidies. This means CATL is entirely dependent on the subsidy program. If the subsidies end, the CATL market advantage disappears
  2. Production of EV batteries in China is largely irrelevant to U.S. EV manufacturers. Batteries are heavy and dangerous and so battery manufacturers seek to locate as close to vehicle manufacturers as possible because long distance shipping is not practical. China is currently the largest market in the world for EVs so the big battery manufacturers are moving as much production capacity to China as possible. Panasonic, LG Chem and Samsung are major players that have invested heavily in China production. Even Tesla has announced plans for a battery gigafactory in China. But the key is that the production for those factories is limited to China EVs. Regardless of the capacity built in China, it will have little impact on the market for EV batteries in the United States or in Europe.
  3. What CATL is doing is just old fashioned Chinese industrial policy. It is manufacturing a product that has mostly become a commodity. Its strategy is to make an “adequate” product in high volume, competing almost solely on price. In 2017, CATL reduced its product price by 30%. As it expands production, further price reductions are expected. Usually this policy leads to overproduction and value/market destruction and this could happen in China as CATL and BYD and others engage in a race to the bottom. However, unlike what Chinese industry has done in steel and electronics, this race to the bottom will not have a major impact on world markets because the product cannot be readily exported. The situation is more like that of cement in China: the destructive industrial policy has no impact on the rest of the world because the product cannot be exported.

The real issue here is that CATL is investing huge sums in manufacturing a product with a less than rosy future. CATL makes old generation versions of lithium cobalt oxide batteries. Though lithium is readily available, cobalt is rare and expensive. More importantly, it is well known in the EV world that lithium cobalt batteries do not have the energy density to compete with petroleum based engine systems and other battery types are already being developed to replace lithium cobalt. Though lithium remains a constant, other metals such as manganese, nickel and even iron are being developed as alternatives to cobalt.

Though CATL appears to have a large R&D department, it does not seem to engage in its own cutting edge research related to developing the new generation of EV batteries. R&D for CATL is confined to two areas: a) additional cost cutting and b) assimilating existing battery technology developed outside China. As CATL continues cutting its prices, its ability to do cutting edge research and development will likely be further constrained.

So what’s the real take away here? CATL and other Chinese EV battery makers do not need help on the investment and production side. They have that covered. But they need access to evolving battery technologies to achieve increased energy density, reduced material costs, reduced weight and increased safety. In other words, we should expect them to fall back on another standard Chinese industrial policy strategy: assimilation of foreign developed technology.

What I expect to see in the next decade of electric vehicles in China is an avid interest in foreign technology in all related fields, centering on power supply (batteries/rechargers) and on vehicle technology. Chinese companies will use all the standard techniques that we have discussed on this blog to try to acquire foreign technologies that are already rampant in the auto tech and other high tech industries: The question is not so much what the Chinese companies will attempt to achieve; the question is whether foreign developers of these critical technologies will give them away or demand adequate compensation.

For more on the “giving away” intellectual property to China versus getting adequately compensated for it, check out the following:

And for more on China IP issues directly related to the automative industry, check out China IP Challenges for Automotive Suppliers.

China joint venture schemesThis is part 3 in our series of posts detailing the current methods Chinese companies use 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 into 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. And in this part 3, we explain how Chinese companies use Joint Ventures (real, fake and non-existent) to get at foreign technology without paying for it.

Chinese companies dangle the formation of a joint venture as a means to view (and then use) foreign company intellectual property. Just to be clear, I am not saying all China joint venture proposals are made solely to get a free look at foreign technology. As dubious as our China lawyers are about most (but not all) China joint ventures, plenty of them are legitimately proposed and formed. Here I am not so much talking about real joint ventures as I am about proposing a joint venture with no real intent to form one and doing that to get at your IP.

The Chinese side wanting a free look at your IP will normally propose forming a joint venture in China for developing and marketing a product. In these cases, however, even if a well formed Chinese joint venture would be commercially reasonable, this is not the case when a free look joint venture scheme is being employed. Normally, the type of joint venture proposed by the Chinese side is not permissible or practical under Chinese law and business conditions. In these situations, it is normally best to accomplish the commercial objectives of the U.S. side through a well drafted license agreement rather than by creating a JV company.

As a quick aside, if you want to learn more about China joint ventures, I suggest you read China Joint Ventures: The 101 and China Joint Ventures: Testing the Dream.

The basic issues related to Chinese companies using a Chinese joint venture to garner a free look at your IP are as follows:

1. Forming a JV means forming a separate legal entity pursuant to the PRC Sino-Foreign Joint Venture law. This means establishing a separate company with a separate address, separate facilities and separate officers, directors and employees. It is rare that the Chinese side really intends to do this.

2. When the entity is formed, the stock must be issued to both investors. All of the stock must be issued to the foreign side on the date the JV entity is formed; here can be no waiting for issuance of the stock. Issuance of the stock cannot be triggered by some event such as authentication of the technology or government approvals.

3. The Chinese side normally will offer the foreign company share ownership in the Joint Venture in exchange for the foreign company licensing the foreign technology to the joint venture and for general cooperation in the future. The Chinese side does not require the foreign side to contribute cash or to contribute the technology to the JV company. The proposal is that the U.S. side will get “something for nothing.” It will get ownership in the China Joint Venture without having to pay anything for it, beyond licensing its technology to the Joint Venture and getting licensing fees for that. Of course, no successful business gives something for nothing. In China, however, this would also not be legally permissible.

China does not allow “sweat equity” or equity issued based on some separate benefit conferred on the Chinese entity (say, preferred investment in a foreign company). Stock must be issued for cash or for a hard asset like equipment. A license to technology does not qualify as equity in a China joint venture. For technology, the investment only counts if the technology is formally contributed to the JV entity as an asset. Since a license is revokable, a license is not treated as an asset under China Joint Venture law. Even where technology is contributed as an asset, the value of the technology must be independently appraised and normally the contribution of IP by the U.S. side is limited to a maximum of 15% of the foreign company’s total investment in the Joint Venture.

This means the Chinese company that is offering the above “something for nothing” terms is doing so as a ploy to convince the foreign side to drop its guard and reveal confidential technical and business information. The argument by the Chinese side to facilitate this intellectual property look-see is: “We will be partners soon, so why hide anything from us.” But since the terms of the JV are not legally permissible you really won’t be partners soon and the result of this ruse is either that the JV never forms and the Chinese side blames this on the government (always beware of force majeure clauses in Chinese contracts) or the JV is legally formed but never actually does any business.

4. It takes at least three months to form a JV company and it often takes six months or more. Forming a Joint Venture in China is expensive and time consuming and this timing and expense should be taken into account in the business plan. And as noted above, it is entirely possible the Chinese government will not approve the formation of your JV company, especially if — as described above — the equity structure is not allowed. Often, however, the Chinese side will draw the joint venture formation process out for a year or more. During this entire period, the Chinese side is working to extract confidential information from the foreign side. One standard trick at this stage is for the Chinese side to say that it is bringing other “big player” investors into the JV company and these new investors are skeptical and need to see proof of the technology before they will invest. Of course, these big players will assist in taking the JV public in China, resulting in a major returns for the foreign side. So in a case where the foreign side is not required even to pay for its shares in the JV, this becomes “something for nothing” squared. Like all good con games, this one too plays on greed.

5. If the Chinese side scheme involves actually forming a Joint Venture, rest assured that you will own less than 51% of it. And with your less than 51% JV ownership, you will have no control over the JV and no meaningful rights of any kind. Many (most?) foreign investors believe that their ownership in a Chinese JV entity will allow them to exercise at least some control over the operations of the entity, but exactly the opposite is true. China has no effective minority shareholder protections. The management of the JV will simply ignore the “rights” of any minority investor, including the “rights” of the foreign investor. So, in the end, the foreign investor in a Chinese JV has less power and control than a foreign party that simply licenses its technology to the Chinese side.

6. Nearly all commercial reasons for doing a JV in a technology development and sale project can be duplicated with more certainty via licensing. For example, a license can be drafted where the JV entity pays a royalty that provides exactly the same economic benefit as a percentage ownership in the JV entity. If the foreign side truly believes in the prospect of a PRC IPO (even though these are incredibly rare), the license agreement can be drafted to provide for the Chinese company licensee to pay a royalty in the event of a sale of the Chinese entity that will provide the exact same financial return to the foreign licensor that it would have gotten had it had an equity interest in the Chinese entity. For more on China technology licensing agreements, check out China Technology and Trademark Licensing Agreements: The Extreme BasicsChina Technology Licensing Agreements: The Questions We Ask, and China Licensing Agreements – Look Before You Leap,

7. The control benefits of a license can be considerable. As noted above, if the foreign entity is a less than 51% owner in a JV company, the foreign entity basically has no remedy at all if the Chinese side does not perform. There may be remedies on paper, but Chinese company law is defective in this area and minority shareholders pretty much have no effective rights. On the other hand, a well-drafted license gives the licensor very powerful rights. If the Chinese side does not perform, the licensor can both terminate the license and sue the Chinese side for damages. This is exactly why Chinese entities prefer the JV approach and why they avoid licenses.

Bottom Line: In considering cooperation with a Chinese company, a standard technology transfer agreement/license is nearly always better than forming a PRC joint venture entity.

China Memorandum of UnderstandingThis is part 2 in what will be series of posts detailing the current methods Chinese companies use 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 into a foreign company to convince the foreign company to give the Chinese company access to the foreign company’s IP.

This first post generated a number of posts by various people on Linkedin along with a slew of comments, including complaints. The complaints about our post fell into two categories: those who said foreign companies do the same thing and those who said we would not be complaining about these tactics were they not being done by Chinese companies. Our response to these two complaints is that they are both true and irrelevant. This is a blog about China, so what did you expect?

Today’s post describes how Chinese companies use Memorandums of Understanding (MOUs) as a trap for gaining access to foreign company IP.

I will though first start with the standard problems our China attorneys see with MOUs, which include the following:

1. The foreign company negotiates and signs the MOU before they speak to an attorney who knows and understands China. In most cases the foreign company does not speak with an attorney at all before signing an MOU. In some cases though, they speak only with their in-country (not China) investment counsel. These attorneys focus on the domestic (not China related) investment issues and they usually do an excellent job. However, they know little to nothing about China, so the China side of the MOU is not properly reviewed before it is signed.

2. The Chinese side will nearly always draft the MOU. This virtually always means the Chinese side is using an attorney who knows and understands Chinese laws relating to MOUs. Where the MOU is drafted by the Chinese side, it normally is drafted as a formal, binding agreement with dispute resolution and penalties for default included. This is of course exactly the opposite of what is required for an MOU. The MOU must be written as a non-binding document, with no dispute resolution and no penalties. See In China, Treat A Memorandum Of Understanding Like A Binding Contract.

3. The MOU usually provides for two sets of terms to ensure the success of the free look scheme. First, it will propose a large investment, but with non-standard investment terms that require the foreign side to reveal technical information not normally in an investment project. Second, it will suggest forms of cooperation that are illegal under Chinese law.

The U.S. side assumes the Chinese side simply does not understand how investment works in the U.S. but does understand Chinese law and therefore would not be proposing a China business structure that is either illegal or impractical. Both assumptions are incorrect and what the Chinese side does here is done intentionally as part of its free look scheme.

4. The MOU will normally be open ended and vague in terms of the time for completing the various steps required to complete the project. This is a major mistake. In any project working with a Chinese company, it is essential to set clear and strict deadlines and to be willing. Most MOU documents contemplate eventually drafting a definitive agreement. The date for drafting and execution should be set for 30 days, 60 at the very most. The reason for setting a tight deadline is because the foreign party must be prepared to deal with the standard Chinese approach to drafting the definitive agreement, which goes like this:

a. The Chinese will offer no input. If the foreign side provides an outline or a term sheet, the Chinese side will simply state that it looks “OK,” with no further response and thus force the foreign company to do all the drafting of the definitive agreement. This document is then submitted to the Chinese side early, giving the Chinese side ample time to respond. But, the foreign side hears nothing.

b. As the deadline for completing the definitive agreement approaches, the foreign side begins to get concerned about the deal collapsing due to a failure to agree on a final definitive agreement. The Chinese side then responds, usually 4-7 days before the deadline. Note that it does not matter whether the deadline is 30, 60 or 90 days; the Chinese side will respond hard against the deadline, with the hope that the pressure of the deadline will soften the resolve of the foreign company in holding to its terms.

The Chinese side’s right up against the deadline response will usually provide for changes in the definitive agreement that completely reverse the terms of the MOU and any subsequent term sheet. No explanation is ever given for these massive changes. The foreign side often will simply capitulate and the Chinese side prevails. In other cases, the foreign side will respond and there is a tense period of last minute and significant revisions to the definitive agreement. Again, the Chinese side’s strategy is that the last minute negotiations will force the foreign side to make drafting mistakes that will prove beneficial to the Chinese side.

4. The result is either that a) the parties ultimately draft a definitive agreement so flawed that it is never implemented or b) after months of unproductive negotiation, the parties walk away. But during this period, the Chinese side will have been working to gain access to technology of the foreign party. Walking away is exactly what the Chinese side planned from the start and impossible terms guarantees this in the end. The Chinese party succeeds in obtaining the free look, with no risk that it will be burdened with making a substantial investment or working with the foreign party at any time in the future.

You can prevent this by doing the following:

1. Do not enter into a binding MOU. A simple term sheet is best. Even using the MOU term exposes the foreign entity to risk in China.

2. Separate the investment from any cooperation project. Do the investment on a very short time frame pursuant to a standard Western-style investment agreement. Do not tie the investment to future cooperation in China. Do not do the investment in installments. Require the Chinese side invest the entire amount in a very short time frame. Limit due diligence to the financial condition of your company. Do not allow any due diligence on your technology or your trade secrets or your business plans.

3. If there will be future cooperation, require all discussions on future cooperation occur only after the full amount of the investment has been received.

Of course, a Chinese company planning to employ an MOU free look scheme will not agree to these terms above. But, that tells you what you need to know and if the Chinese side will not agree, you should probably send them on their way.