Basics of China Business Law

China employment discrimination lawyers

A few weeks ago, China’s Ministry of Human Resources and Social Security and its Ministry of Education (and seven other departments) released a notice regarding women’s employment. Here is a quick overview of this important notice.

The notice makes clear that gender discrimination during recruitment or in hiring is prohibited. Employers are generally prohibited from limiting the gender of candidates, giving preference to any gender, or refusing to hire women. Employers are also not allowed to engage in any of the following:

  1. Asking a job candidate her marital/childbirth status,
  2. Requiring a pregnancy test as part of an employee’s entry medical examination,
  3. Restricting childbearing as a condition of employment, or
  4. Applying a higher recruitment standard to female candidates.

If an employer is suspected of gender discrimination during the recruitment process (usually because someone has filed a complaint or reported it to the authorities), the authorities will interview/talk/meet with the employer and conduct what can be a large-scale employer investigation. Then if the gender discrimination allegations are confirmed, the employer will be ordered to take corrective measures.

An employer that refuses to talk or meet or otherwise communicate with the authorities or refuses to correct its violation after being ordered to do so, will have its information published and be “named and ashamed” via the media. Women who believe they are/were victims of gender discrimination may bring a lawsuit based on violations of their equal employment rights and if they are eligible they will receive legal aid and judicial assistance in bringing those claims.

Chinese employment authorities will “actively” audit the contents of employee recruitment information and issue orders to violators to correct job ads that contain gender-discriminatory content. If an employer publishes job postings with gender-discriminatory content, it will be ordered to make corrections according to law and if it refuses to do so, it will be fined “no less than RMB 10,000 but no more than RMB 50,000.” These violations and will go on the employer’s “human resources market integrity record” and can subject the employer to punishments for being a “serious dishonest employer.”

This notice should not change much for savvy foreign employers, but it should change everything for those not on top of their China hiring and employment game. What I mean by this is that companies that have always had their China employment lawyers monitor and audit their hiring practices and employment policies will likely not need to change much if anything. This notice will definitely bring changes, but smart employers were likely already avoiding most if not all of what will now lead to punishment, simply because discrimination on the basis of gender has never made sense and has always had its inherent risks.

But foreign companies that have ignored such things and failed to have a China employment lawyer audit and monitor their hiring documents (including their help wanted ads) and their treatment of female employees need to change things and fast. If you have employees in China or are seeking to hire employees in China you need to check NOW whether you are complying with all applicable laws. And if you are contemplating terminating a female employee who is pregnant, nursing or on maternity leave you had better be very careful in going down that path. As we wrote in Terminating China employees just got tougher the authorities are cracking down hard on employers that violate the laws on protecting female employees and — as is always the case — foreign employers are their favorite targets. If you are not positive that your China employment and hiring programs have been honed to perfection, you should get cracking now.

China WFOE formation lawyers

One of the first tasks in forming a WFOE in China is to determine what entity will be the shareholder of the WFOE. It is possible for an individual or individuals to own a China WFOE, but for various reasons, our China WFOE formation lawyers nearly always discourage that.

The basic analysis runs as follows:

1. Direct ownership of a WFOE by the foreign operating company parent company is most common for single owner WFOEs.

2. For clients that either do not want their company to be easily identified with the WFOE or for various other reasons do not want their company to own the WFOE, forming or using a Special Purpose Vehicle (SPV) — a separate holding company not directly linked to the main company — is possible.

When considering an SPV for owning a China WFOE, the following considerations can be important:

a. Over the past decade, the Chinese government has become suspicious of SPVs. At one point, it even moved to prohibit SPVs for WFOE formations. However, with the adoption of the new WFOE formation rules in 2017, the Chinese government now permits using SPVs. So current Chinese government rules are neutral on this issue.

b. In the past, one reason investors used an SPV was to hide the true identity of the owners of the WFOE. Under China’s new WFOE formation rules, the investor must provide a complete organizational chart that details ownership of the shareholder(s) and that identifies the actual controlling person. It it therefore impossible to conceal ownership. Accordingly, SPVs are no longer useful to conceal actual ownership from the Chinese government.

c. SPVs continue to be used where there are several investors in the WFOE. Often these investors are resident in different jurisdictions. In that case, it is common to take all these investors into a single SPV. The SPV is then the single shareholder of the WFOE. Issues such as management, distribution of profits and purchase and sale of ownership interests are handled at the SPV level. In many cases, the SPV is formed in a tax haven such as Hong Kong to allow distribution of profits free of tax. These considerations do not apply in a single shareholder setting.

d. In terms of limiting upstream shareholder liability, there is little to no benefit in using an SPV. The WFOE will be a limited liability legal entity. The limitation of liability rules apply in China in somewhat the same way as in the United States, Australia, Canada and the EU (including the UK). The financial liability of the WFOE is limited to the amount of investment. Liability beyond the investment amount generally occurs only in the case of illegal acts. In China this liability would generally be as follows:

  • The shareholder will be held liable if it does not contribute required capital to the China WFOE and that failure results in the WFOE not paying its taxes, employee salaries, or in a fraud against creditors.
  • A WFOE’s director will be liable for instructing the WFOE to commit an illegal act. Examples of illegal acts are tax fraud or commission of a significant safety violation.
  • Directors and the shareholder will be liable if the WFOE terminates business and does not liquidate pursuant to Chinese company law. An improper WFOE shutdown leads to both the investors and the directors being placed on a black list and prohibited from engaging in other investments or business in China. Individual directors should not travel to China since they may be detained. See Shutting Down a China WFOE: Don’t Go There.

The above three basis for liability are all very real, but creating an SPV does not noticeably reduce any of these risks. This is because most of the liability risk falls on the individual directors, not on the shareholder. Second, the Chinese government will use the org chart/actual controlling person information to “pierce the corporate veil” to assign liability to what the Chinese government determines in its own discretion is/are the actual party/parties in interest.

Other basis for liability arising from WFOE operations are so rare that they can in most instances be discounted. On the other hand, the three basis for liability set forth above are common and care must be taken to avoid these sorts of liability situations.

3. There are sometimes tax or other operational or accounting reasons for create an SPV for China WFOE ownership. In considering whether to do an SPV, a cost-benefit analysis makes sense. Most of our clients find using an SPV to own their China WFOE more trouble than it is worth. However, each situation is different and there are definitely times where SPV ownership of a China WFOE makes good sense.

China confidentiality agreements trade secret agreementsAs part of our China company formation work, our China lawyers help our clients with their employment matters that arise before, during and after their China entity (usually a WFOE) is formed. Among other things, we draft the employment documents needed for a newly established WFOE. When a WFOE is up and running, it needs employee agreements in place for all its employees and we usually recommend what we call an “Initial Employment Package,” which includes the following for each employee:

  1. Employment Contracts
  2. Rules and Regulations
  3. Trade Secrecy and Intellectual Property Protection Agreements and
  4. Sign Off Agreements (acknowledging each employee’s receipt of the Rules and Regulations)

These China employment packages also often include Non-compete Agreements and Education/Training Reimbursement Agreements as well.

One of the common questions we get from both existing and prospective clients is why they need their employees to sign a trade secrecy agreement at all and in this post I briefly explain why our China employment lawyers always recommend having such an agreement.

Consider this scenario. A China employer hires an employee and gives the employee access to some or all of the company’s trade secrets. The employee then leaves employment and takes the material with her. What can the employer do? Suppose the employee never signed either a trade secrecy agreement or a non-competition agreement.

Since the theft of trade secrets is a both a crime in China and gives rise to a civil claim, the lack of a signed trade secrecy agreement does not bar the employer from suing the employee and/or reporting her to the police. But to succeed on either front there must be clear evidence that the employee took something and that what the employee took was in fact a trade secret. And that is where things can get difficult. Very difficult. For information to qualify as a trade secret in China, all of the following must be true:

1. The information is technical or business information unknown to the public.

2. The information must have economic value.

3. The owner of the trade secret undertook reasonable measures to maintain its confidentiality.

Are you certain you will be able to prove all of the above about everything you do not want your employees taking with them? In our experience, this usually ranges from difficult to impossible simply because most companies are not terribly careful about preserving their secrets.

Though it is possible to bring a trade secret lawsuit in the absence of an agreement protecting confidential information, a trade secrecy agreement almost invariably makes that lawsuit faster, cheaper and — most importantly — better. This is because if your trade secrecy agreement says not to steal X, Y and Z and an employee steals X, Y or Z, you can sue that employee for what should be a relatively clearcut breach of contract, rather than having to prove out everything related to trade secrets, as mentioned above. You will not need to prove that what was taken was a trade secret because your trade secrecy agreement with your employee will make clear what the employee can and cannot use outside your company, regardless of whether it is or is not a trade secret.

Trade secrecy agreements also make clear to your employees what is okay and what isn’t and they let your employee know that you can sue and win if they violate it. And by doing so, they greatly decrease the risk of an employee walking out the door with your trade secrets — as defined by you, not by complicated regulations and a random Chinese court.

One of the things our employer audits consistently reveal is that even companies that require trade secrecy agreements often (like about 90 percent of the time) fail to get all of their employees to sign these. We have learned this from our employer audits and we have learned this from companies that come to us after one of their employees has taken their trade secrets and joined a competitor or started their own competing business.

China employers should also have a clearly documented secrecy/confidentiality policy that sets forth how they handle and protect their confidential information. This coupled with a trade secrecy agreement will give the employer the maximum legal benefits and protections.

Bottom line: Make sure all your employees execute an English/Chinese trade secrecy agreement at the beginning of their employment and make sure your rules and regulations deal appropriately with your trade secrets as well.

 

 

 

Five Keys to a Good China ContractI hate when someone claims China does not enforce contracts — that just happened. I hate this because it is mostly just not true. Yes, if you are seeking to protect your cutting-edge semiconductors based on a a contract enforceable in China, your odds are not good. But if, on the other hand, you are seeking to enforce a run of the mill manufacturing contract or service contract or whatever, if your contract was drafted with China in mind, you ought to be just fine. Believe it or not, but the World Bank ranks China as better for getting a contract enforced than the United States.

What are the keys to a China contract that works? The following:

  1. You generally want your contract with Chinese companies to provide for disputes to be resolved in China, either in a Chinese court or before a China-based arbitral body. Your choice of venue will depend on the nature of your contract. China does not enforce most foreign court judgments. See e.g. China Enforces United States Judgment: This Changes Pretty Much Nothing. China’s courts do (technically anyway) enforce most foreign country arbitrations, but it does not always do this and getting a Chinese court to do this is rarely quick or easy.
  2. You generally want your contract with Chinese companies to use Chinese as its official language. See Dual Language China Contracts: Don’t Get Fooled! Of course, if you are going to do this, you need to be darn sure that your lawyer both fully understands the Chinese in your contract and is fully capable of translating that contract into English for you.
  3. You generally want your contract with Chinese companies to call for application of Chinese law. If you are going to have your contract in Chinese and your disputes before a Chinese trier of fact, this only makes sense.
  4. You usually should have a provision calling for contract damages. This provision can act as a heavy hammer against your Chineses counterpart. See On the Importance of Contract Damages in China Contracts.
  5. Make certain the name (in Chinese) of your Chinese counterpart is 100% accurate and completely corresponds with its official company name. And while you are at it, it is good to have your Chinese counterpart stamp/seal the contract as well. See China Company Chops: The Basics.

That’s it. Go forth and prosper.

China employment lawyersAmending a major term (position/pay) of your China employee’s employment contract involves considerable risk and therefore requires substantial care.

Let’s consider a fairly recent case in Jiangsu province. The employee was hired as a senior engineer for product design and development. The employee made roughly RMB 7,000 per month before leaving his job. Several years into his employment, the employer essentially suspended the employee from his original position as the company was going through structural changes. Right after providing the employee with his suspension notice, the employer stopped giving the employee his original product design and development work tasks and instead instructed the employee to “stand by” at an empty desk at the HR department. The employee also had his salary reduced. About three months after receiving the suspension notice, the employee resigned, suing for severance pay based on his employer having failed to provide him with normal labor conditions by refusing to allow him to engage in his normal work.

The case went through labor arbitration and courts at two levels. The appellate court first recognized that the employee had the right to terminate the employment contract and ordered the employer pay the employee damages for having failed to provide him the labor protections and conditions set forth in the employment contract. The court ruled that because the employment contract provided for the employee to have the position of senior engineer, having the employee stand by at an empty desk at the HR department, reducing the employee’s salary, and not giving the employee any work constituted an abuse of its right of personnel management and entitled the employee to damages for weakening the employee’s professional skills and demeaning him.

The court rejected the employer’s argument that the employee had implicitly agreed to amend his employment contract by not making any objections within one month following notice of his suspension. The court ruled that the employer was entitled to manage its own personnel according to its business needs but it had abused that right by acting unreasonably. The court ordered the employer to pay the employee severance for the termination. Because the employee had worked for the employer for 16 years before his resignation, the court awarded the 16 months’ salary as severance.

What lessons are to be learned here? The safest way to amend an employment contract is via a mutual agreement. Employees nearly always consider unilateral changes to their job duties, position or remuneration to be a big deal and China’s labor authorities and courts typically feel likewise. Not only will mutual amendments lead to far fewer lawsuits and greatly decreased liability risks, a well-crafted employment contract amendment also ensures both sides are on the same page with what is being amended (and what is not). There are few things more frustrating for our China employment lawyers than being called after an employment contract amendment rather than before. As for our clients, I can tell you that amending an employment contract typically takes our China employment lawyers a few hours, while defending against an angry employee whose contract has been unilaterally amended typically takes us tens of hours.

From a physiological standpoint, working with an employee to amend their employment contract also gives the employee a voice in the process and makes them feel more empowered. Mutual amendments are considerably more likely to achieve an outcome acceptable to both parties and less likely to result in confrontations and disputes and high costs. If the employer and the employee are unable to reach agreement on amending the contract, the employer should consider whether it might make sense to reach a mutual termination agreement with the employee so the parties can part ways amicably.

The case I wrote about above involved a Chinese company and its Chinese employee, but it highlights how this economic downturn is heightening protections for Chinese employees across the board. In Terminating Your China Employees Just Got Tougher, I wrote about how the Chinese government and its courts are taking a tough line regarding how foreign employees treat their Chinese employees. As a foreign employer, you should always just assume China’s tribunals will be even tougher against you for whatever you do involving your Chinese employees. These are tough times for foreign employers in China and the costs of getting even the smallest things wrong have gone up.

Just saying….

China employment lawyersUnilaterally terminating a female employee in China, especially one who is pregnant, nearly always leads to the terminated employee bringing some sort of legal action. Though there are a few legally permissible grounds for an employer unilaterally terminating a pregnant employee without having to pay severance, those grounds are few and far between and the burden will always be on the employer to prove such ground: e.g., the employee failed to satisfy her conditions of employment during her probation period. Yet if everything from step one to the termination is done right, it is possible to legally terminate a pregnant employee during her termination.

A fairly recent case in Guangzhou illustrates this. The employee and the employer entered into a three-year fixed-term employment contract with a six-month probation period. The employer provided the employee with a document that set forth the recruitment requirements and provided that the employee would be considered to have failed to meet her recruitment requirements if she were late for work three times or more during her probation period. The employee signed off on this document and then right after starting her job informed the employer she was pregnant. Before the end of her probation period, the employer issued a notice to the employee terminating the employment relationship for being late for work four times during her probation period. The employee brought a labor arbitration claim demanding reinstatement. The employee argued she was only late a few minutes late each time and she had completed her work tasks and the employer violated the law protecting female employees. The employee lost at labor arbitration and appealed to the court and lost there again.

The court noted that the real issue was not whether the employer was aware that the employee was pregnant at the time of her termination, but rather whether the employer was justified in terminating the employee for failing to meet the recruitment requirements during her probation period. The attendance records proved the employee was late four times during her probation period and the employer was able to prove that it had provided the recruitment conditions to this employee in writing at the time of her hiring. The court held that for these reasons the employer had the right to terminate the employment contract and the employer’s requirements did not violate any mandatory law and therefore the termination was not unlawful. The court rejected the employee’s argument that the employer’s decision was unfair because other employees who were late more than three times were not terminated. The court also did not side with the employee on her claim that she had been terminated just because she was pregnant.

This case shows it is possible to terminate a pregnant employee without having to pay severance and without having to provide advance (30 days) notice, provided the employer can show there is a legally permissible ground for the termination decision.

It is possible to terminate a probationary employee for failing to meet recruitment requirements provided the employer is able to prove why the employee did not meet its requirements. For this to work, it is important the employer have a clear writing setting out its probationary employee’s conditions of employment and it get the employee to review and acknowledge receipt of such conditions. Furthermore, if a termination becomes necessary, the employer needs to have another clear writing documenting exactly how the employee failed to meet the specified conditions or requirements during the probation period. Note that the termination notice must contain the reason for the termination and the notice must be in writing.

The employer prevailed in this case because it met all these legal requirements. Would it have turned out differently had the termination happened after the employee had completed her probation period? The employer would have needed to rely on another legally permissible ground for the termination: e.g., employee’s serious breach of the employer’s rules and regulations. It would then depend on more factors, such as what the employer’s rules and regulations say regarding employee discipline in general and regarding the specific behavior at issue.

Nonetheless, this particular employer’s decision seems a bit harsh and even though it ultimately won, it no doubt lost substantial time and money defending itself in costly labor arbitration and litigation and now it is known to the outside world as the company who fired a pregnant employee just because she was late for work by a few minutes on a few occasions. Had this been my client I would have recommended against it instituting such draconian employment conditions in the first place and I would have most certainly recommended trying to quietly and expeditiously settle the claims before they blew up into full blown legal proceedings.

As a general matter, you should not implement an employer policy that you do not intend to strictly enforce. Also, for certain eligible positions it can make good sense to designate the employee to work flexible hours so he or she can focus on getting the job done and not worrying about being at the office from 9 to 6. These sort of nascent problems are what our China employment lawyers look for in our employer audits because in China — like most everywhere else — an ounce [gram] of prevention is worth a pound [kilo] of cure.

 

China Joint Venture LawyerThis is part 3 of our series on China Joint Ventures. We are writing this series now because our China lawyers are seeing a record number of potential joint ventures, due largely to China’s declining economy, the belief that truly foreign companies will not be well-treated in China, and a desire to try to “share the risk” of all this uncertainty. In part one of this series, China Joint Ventures: The Long Version, we talked about fake and exploitive joint ventures. In part 2, we assumed your Chinese counterpart is legitimate and wants to do a legitimate JV with your company and we discussed how to make sure you are truly on the same page with your China joint venture counterpart(s)  regarding what will go into the joint venture and how it will operate once formed.In this post, we discuss some of the things you need in your joint venture agreement if you are to reap benefits from your China joint venture.

Just as a quick aside: there is a 99.99% chance you will never see a dollar from your joint venture if you use your joint venture partner’s attorney or even any attorney chosen for you by your joint venture partner or you use no attorney at all. If you don’t realize this after reading the below, I don’t even know what more to say.

Many China joint ventures fail because the foreign partner made the fundamental mistake of believing its 51% (or more) ownership of the joint venture gave it effective control over the joint venture. Foreign investors too often assume Chinese joint venture companies are managed according to the common Western corporate model under which a board of directors has controlling power over the company. Since the board is elected by a majority vote of company owners, most foreign investors strive to obtain a 51% ownership interest in their China joint venture. As the majority owner, the foreign investor just assumes it has the right to elect the entire board, and thus effectively control the joint venture company.

After winning the struggle for percentage ownership the foreign investor will frequently give the Chinese side the authority to appoint the joint venture’s Representative Director and the company General Manager. But  this concession cedes effective power and effectively renders the foreign investor’s struggle for board control is rendered meaningless. The Chinese side will intentionally angle to ensure this outcome, usually by offering to concede majority ownership to the foreign investor in return for control over these two key management positions in the joint venture company. If you want to exercise effective control over a China joint venture, you must avoid this mistake. If you do not, you will not have control over the joint venture’s day-to-day management.

For you to maintain control over your Chinese joint venture you need the following:

  • The power to appoint and remove the JV’s Representative Director. The party that appoints the joint venture’s Representative Director will have significant control over operations. The usual practice of conceding the power to appoint a key officer or director to the Chinese side is a mistake if you want to maintain control over your China Joint Venture.
  • The power to appoint and remove the JV’s General Manager. The General Manager is an employee of the joint venture company and that person is employed entirely at the discretion of the JV’s Representative Director. The common practice of appointing the same person as both Representative Director and General Manager is usually a mistake.
  • Control over the company seal, or “chop.” The person who controls the registered joint venture company’s seal has the power to make binding contracts on behalf of the joint venture company and to deal with the company’s banks and other key service providers. For these reasons, the power over that seal should be carefully guarded. Ceding control over it as a matter of convenience is a mistake. There is a long, documented history of this seemingly minor consideration dooming China Joint Ventures.

The Chinese side to a joint venture will usually refuse to agree to these three measures by claiming it is more efficient to have the Chinese side control day-to-day management of the company. The Chinese side will also often claim they cannot bring their political connections, or their guanxi, into play unless their own people act as the joint venture’s Representative Director and General Manager. These claims usually are used to disguise the Chinese company’s efforts to gain operational control over the company and your relinquishing these three control mechanisms to your Chinese counterpart will likely be problematic for you.

Once these three control mechanisms are entirely under the control of your Chinese joint venture partner, you will likely quickly learn that you have relinquished all power to run the JV and bad things will likely result. What sorts of bad things? The most common is that you will never see any money from the joint venture. Ever. This occurs because with its control over your Joint Venture your Chinese counterpart can always make sure the joint venture never makes a profit, but his or her company always does.

How can this be achieved? We often see this done by using one of the following two tactics:

  1. Suppose your Chinese JV partner can make the JV hiring and firing decisions. Now suppose your JV should have 200 employees but your JV partner hires 350 employees, thereby wiping out any profit for the JV. Why though would your JV partner do this and how does your JV partner benefit from doing so? Many reasons. The extra 150 employees can be some combination of 1) relatives who do or do not kick back a good portion of their grossly inflated earnings to your JV partner, 2) strangers who do kick back a substantial portion of their grossly inflated earnings, and 3) friends and relatives of Chinese government officials who are hired to increase your Chinese JV counterpart’s standing and thereby benefit your JV counterpart and his own companies, 4) friends and relatives of whomever else your Chinese JV counterpart wishes to increase his or her or its standing.
  2. Your Chinese JV counterpart chooses to buy (possibly inferior) products and services at inflated prices from his or her own companies, including from the company that is your JV partner.

In our next post we will explain why the China joint venture lawyers at our firm both love and hate them and what you can do if you are stuck in a bad one.

China Joint Ventures

This is part 2 of our series on China Joint Ventures. We are writing this series now because our China lawyers are seeing a record number of potential joint ventures, due largely to China’s declining economy, the belief that truly foreign companies will not be well-treated in China, and a desire to try to “share the risk” of all this uncertainty. In part one of this series, China Joint Ventures: The Long Version, we talked about fake and exploitive joint ventures.

In this post, we are going to assume that your Chinese counterpart is legitimate and truly wants to do a legitimate JV with your company. But just because there is good potential for a profitable China Joint Venture and you are working with a putative China joint venture partner that is sincere and honest does not mean doing the joint venture will make sense. Before you do a joint venture with anyone you should make sure the two (or more) of you are truly on the same page regarding what will go into the joint venture and how it will operate once formed.

There is an old Chinese saying that applies to any sort of partnership without a meeting of the minds: “same bed, different dreams” (同床异梦). I applied this saying to China Joint Ventures (I was certainly not the first to do so) in a Wall Street Journal article I wrote back in 2007, titled, Joint Venture Jeopardy:

The much-publicized legal fight between French beverage maker Groupe Danone and its Chinese partner, Wahaha, calls to mind an ancient Chinese proverb often used to describe a bad marriage: “Same bed, different dreams.” Danone accuses Wahaha of breaking contracts and setting up competitor companies; Wahaha denies the allegations. The case is a highly visible test of China’s commitment to rule of law in matters involving foreign business. Whatever the outcome, China’s joint ventures increasingly look like unfruitful unions.

How can you avoid a bad joint venture marriage? By putting your dreams to the test before you wed.

China joint ventures are notorious for their high failure rate. Foreign companies too often rush into China joint ventures without ever discussing their respective dreams with their China joint venture partner. The sooner you seek to discern whether you and your potential China joint venture partner share the same dreams, the sooner you will know whether it makes sense for you to keep spending time and money trying to do the joint venture deal.

To help our clients determine whether they have found their dream JV partner, we have compiled a list of questions they should ask their potential Chinese joint venture partner to determine whether there is sufficient commonality to press forward with their joint venture deal.

  • What are you seeking to accomplish with our joint venture?
  • What will you do for and with our joint venture?
  • What will your company do to advance the business of our joint venture
  • What do you want our company to do to advance the business of our joint venture?
  • Who will make business decisions for our joint venture?
  • What mechanisms will we use for reaching JV decisions?
  • Who will control what of our JV?
  • Who will make what decisions for our JV?
  • What will you contribute to our joint venture, both now and in the future? Property? Technology? Intellectual property? Money? Know-how? Employees?
  • What do you expect us to contribute to our joint venture, both now and in the future? Property? Technology? Intellectual property? Money? Know-how? Employees?
  • If our joint venture loses money, who will be responsible for putting more money in?
  • How will we resolve our disputes? The common Chinese company response will be something like “we will work out any issues among ourselves and if that fails, we will have a special meeting to try to resolve everything. This answer is meaningless. You need an answer that explains exactly how day to day disputes will be resolved so your joint venture does not collapse
  • Can either of us use confidential JV information for our own business?
  • Can our own businesses compete with our JV?
  • Can our own businesses do business with the JV? What is that going to look like?
  • How and when will the joint venture end?
  • What if one of us wants to buy the other one out?
  • How do we end the JV?

If you get answers you like to the above, you keep moving forward. If you get too many answers you do not like to the above, you move on.

In our next post, we will talk about how to structure a China JV so you do not lose your shirt.

China Joint Ventures

With China’s economy in a downturn and so much uncertainty regarding the future of US/China (and even EU/China) relations, our China lawyers have of late been seeing a massive uptick in companies looking to do China joint ventures “to share in the risk.” When done right, China joint ventures do share risk. But when done wrong they actually increase the risk, but only for the non-Chinese company. This is part one in a series of posts intended to help you spot China joint venture risks and avoid them.

The first thing you should know is that Chinese companies will often use the false promise of a joint venture to entice foreign companies to provide them with the foreign company’s technology. This South China Morning Post article, US entrepreneurs make a choice: rewards of doing business in China often outweigh risks of losing trade secrets, nicely explains the technology/joint venture interlay.

Our China lawyers have seen countless exploitive “joint ventures” but most of them start in the same way. The Chinese company convinces a foreign company to do a joint venture and then gets the foreign company to contribute money, technology, or know-how to the joint venture. The Chinese company is put in charge of setting up the joint venture because that only makes sense, right? Wrong.

Instead of actually setting up a joint venture that gives the foreign company an actual ownership stake in the joint venture company, the Chinese side takes the assets from the foreign company but never forms a joint venture. The Chinese company will then either go silent or — if it still needs the foreign company — it will provide it with fake documents showing the joint venture was in fact formed with the foreign company having ownership in it. The foreign company believes it owns part of the China joint venture even though it does not.

Eventually (usually many years later) the foreign company starts getting frustrated about never receiving any money or even news from the joint venture and contacts a China lawyer for help. Our law firm has handled at least a dozen of these matters where our ten minute search revealed there never was a joint venture. The good news is that this sort of thing never happens to foreign companies that use their own qualified China lawyer, as opposed to their joint venture partner’s lawyer or a lawyer not familiar with China. The bad news is that there is usually nothing that can economically be done to help a foreign company in this sort of situation.

In some circumstances it may be possible to sue individuals and companies outside China for fraud but for that to work you need for the foreign country to have subject matter and personal jurisdiction and you need to be able to serve process on the defendants under the Hague Convention and, perhaps most importantly, have some means of collecting on any judgment awarded. Foreign courts generally will deny jurisdiction in a case involving ownership of a Chinese company and even if they did, Chinese courts are not likely to enforce whatever judgment that foreign court renders. All this combines to mean that in most instances the duped party has no good recourse.

 

international litigation lawyersEuler Hermes, the German credit insurance company, recently released its bankruptcy filing projections for 2019 here. The Report states that bankruptcies worldwide increased by 10% in 2018 and it projects an additional 6% increase for 2019.

What surprised me is that the increase in bankruptcies worldwide stems almost solely from an increase in formal bankruptcy proceedings in China. The 10% increase worldwide for 2018 was due almost entirely to a 60% increase in China bankruptcies. In 2019, the projection is for a worldwide increase of 6%, with China once again by far the highest in the world with a projected 20% increase.

This compares unfavorably with the relative stability of China’s East Asian neighbors: Japan, Korea, Taiwan and Hong Kong, which are all projected to have a 2% or less growth in bankruptcies in 2019. China also compares unfavorably with the 0% growth in bankruptcies projected for the United States and Germany, China’s two primary European and North American economic competitors.

What is fueling China’s tremendous increase in formal bankruptcies? The Report cites two factors:

“The [ projected 20% increase] will result on one hand from the on-going softening and adjustments of the Chinese economy, notably in regards to credit growth, Belt and Road Initiative and international trade issues, and on the other hand from the increasing inclination to use insolvency procedures, in particular by the authorities, in order to clean the ‘zombie’ state-owned enterprises (exceeding 20,000 cases according to some studies).”

Weakness in China’s economy in generally well known and undisputed. See The Top Ten Issues for China’s Economy and China’s Economic Slowdown and YOUR Business. I am going to focus here on the issue of “zombie” state-owned enterprises. The zombie SOEs are smaller enterprises owned by provincial and lower level Chinese governments that have been money losers for decades. The central government has been pushing to shut down these SOEs for many years, but the local governments have resisted, primarily to prevent job losses and the resulting social unrest.

The Euler Hermes Report suggests the Chinese central government will increase pressure against these zombie SOES in 2019 by taking even more aggressive steps to forestall local government insistence that non-performing SOEs be kept on artificial life support. We should therefore expect a wave of SOE closings in 2019. Some will make use of formal bankruptcy proceedings. If past practice is an indicator, even more will simply disappear. In both 2018 and already in 2019, the international litigators at my law firm have handled a massive increase in matters where a foreign company has paid its Chinese manufacturer for product only to get nothing (or almost nothing) in return and then to learn that the manufacturer no longer exists. See China Business Scam Week, Part 2: Bricks for Products. You must be on your guard for this sort of thing, starting NOW. See China’s Economic Slowdown and YOUR Business.

This slew of China bankruptcies and disappearing companies is an important issue for foreign companies doing business in China or with China. Many foreign business people believe the risk of a sudden closure of a supplier is limited to privately owned Chinese companies. Many foreign companies falsely believe the Chinese government will protect SOEs from any form of economic downturn and, therefore, SOEs are “safer” than their private competitors.

But as the Euler Hermes Report shows, this belief is not based on the facts. Chinese government policy is to protect a group of about 200 “state champion” SOEs. Virtually all other SOEs (without regard to which type of government is the owner) do not benefit from Beijing’s protection and these other SOEs are fair game for closure. China’s central government periodically imposes a program designed to clean up the balance sheet and close non-performing (zombie) SOEs. This type of clean up program is projected for 2019.

What does this mean for foreign buyers? First, it means that long term suppliers of critical products and materials will suddenly disappear without notice, leading to predictable chaos in the supply chain. Second, it means the affected Chinese SOE then has a very strong incentive to make a final fraudulent sale in order to extract a profit from one or more foreign buyers. This profit is then pocketed by the managers who then disappear. This type of scheme has been employed almost as standard procedure in the past and there is no reason not to expect this type of fraud will be used during the 2019 SOE clean up campaign. We wrote about the need to watch out for this sort of scam in China Business Scam Week, Part 2: Bricks for Products:

These things happen with companies that want to make a few final sales before they file for bankruptcy or just shut down and disappear. Just imagine the profits to be made from three $350,000 sales for which no product is ever provided. So just imagine the incentive for the owners of the Chinese manufacturing company to sell and not supply to foreign companies right before (or sometimes even right after) they shut their doors for good.

The China lawyers in my law firm call this the bricks for product scam because the first time we ever saw it was more than a decade ago when a U.S.-Norwegian fish company bought about a million dollars in fish from a Chinese company and every container consisted of a thin layer of fish wrapped around a core of bricks. The local SEOE company that sent the fish for bricks had shut down and its managers had fled town and were nowhere to be found. Or at least that is what the local government told us. In that case (as in most that we see), there were plenty of warning signs, all of which were ignored.

The standard technique is to offer a discount for a larger than usual sale amount and then deliver nothing or almost nothing. Sometimes nothing at all is shipped. In other cases, a fraudulent shipment is made: a container full of bricks, barrels full of water or sand, or a refrigerated container full of rotten fish or fruit. By the time the foreign company discovers the fraud, the Chinese company (often a local SOE) has already been liquidated and its owners/managers have disappeared. Much of the time, little can be done.

However, if the Chinese company formally declares bankruptcy (which does happen) and if it has some assets left (which also does happen) and if you have a China-centric manufacturing contract (see On SMEs Trusting China Manufacturers. Don’t. Just Don’t.) you at least have a chance at getting some or all of your money back. Even better, of course, is to delay payment until after you have confirmed delivery of conforming product.

Bottom Line: The message of this post is that the danger of paying and getting nothing from your Chinese supplier comes from BOTH private companies and from SOEs. Based on my own experience, I see the SOEs as a greater danger. When you get an offer from a Chinese supplier that seems “too good to be true,” it is. Extreme care is required.