Basics of China Business Law

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 Employment LawyersBecause China is not an employment-at-will jurisdiction, mutual termination is usually the safest path for a China employer that has chosen to terminate one of its China employees. In a mutual termination, it is critical the employer gets a termination agreement that resolves all outstanding matters with the relevant employee and that explicitly releases the employer from all employee claims. If used correctly, mutual terminations can be a useful tool when dealing with a China employee. In this post, I discuss a few dos and don’ts you should keep in mind during a mutual termination process.

First, do take control of the discussion and do not turn it into an endless negotiation. Usually the employee will accept a quick payout when you initiate the termination process. But occasionally a disgruntled or difficult employee who has NO intention of settling may want to drag you into an endless discussion regarding termination. For example, our China employment lawyers have seen instances where after reviewing a proposed mutual termination agreement the employee comes back with a few requests for minor modifications to the agreement but then refuses to sign the agreement and also refuses to give a reason for not signing the agreement. Then when the employer follows up, the employee says: “wait a minute, you should pay me an additional month’s salary for not giving me sufficient notice of my termination.” Generally speaking, with a mutual termination, the employer is not obligated to pay an additional month’s salary in lieu of notice so the employer is not required to grant such a request. But suppose the employer is okay with paying a little extra to try to cleanly end the employment relationship and the employee in response to this says “I need more time to review.” At this point (or even before this), you know the employee is not going to accept the mutual termination and you also know the employee is not acting in a reasonable manner. You should not expect the employee to change and you should forget about terminating on mutually agreed terms and you should start thinking about other options. Must you terminate this employee? And if yes, what legal grounds do you have for a unilateral termination?

Our employment lawyers also sometimes have to deal with an employee who is willing to leave but sees his or her termination as a great way to “make” a lot of money. This employee often will ask for more in severance but not specify how much more they want. How should you negotiate with this sort of employee? The short answer is you don’t. Unless you are willing to pay more, the severance amount you initially proposed to the employee should be your only offer. In other words, you as the employer should be prepared to say “take it or leave it” when the moment comes.

But do listen to legitimate concerns or comments from your employee. Taking control is not playing hard ball. The goal of a mutual termination is to end things with the employee in a way that is reasonable and fair to both sides. Even though we craft our employee termination agreements in a clear, concise and reasonable fashion, it is not uncommon for employees to raise legitimate concerns that should be addressed. For example, an employee may want her employer to make the severance payment sooner than the employer has initially proposed. As long as it’s feasible for the employer to pay by the date requested by the employee and as long as this will get the employee to execute the mutual termination agreement right away, the employer should accept. Sometimes the employee may propose some minor revisions to the Chinese text which will make them feel good, for instance, adding a few words to emphasize that the employer initiated the termination process. As long as the employee’s proposed revision does not change the meaning of the terms and is otherwise harmless, you should accept. It is up to you and your China employment attorneys to distinguish between an employee’s genuine, good-faith concerns and stalling or revenge tactics.

Next, do not get bogged down on the reasons for the mutual termination. Employees are human beings and it is hard to predict exactly how they will react to their termination. They may get upset or disappointed or they may be happy to move on with their lives with a generous severance payment. You should avoid “touchy” subjects as much as you can.  For example, if you anticipate the employee will dispute their having performed unsatisfactorily (and most do), don’t mention it. “It was not a good match” often works well in this scenario. Do not indicate to the employee that there may be something she can do to make you change your mind about her termination. To put it another way, do not start the process unless and until you are certain about terminating the employee and unless and until you know pretty much exactly what you are going to tell them.

Much of the time our China employment lawyers rehearse with our employer clients how to handle the termination. It is that important.

 

China WFOE lawyerIf you are an American company doing business in China, you don’t need me to tell you how so many things have changed for you over the last year or so, and so I won’t.

But I do need to tell you — somewhat urgently — that if you are operating in China without a legal Chinese entity, you need to stop. Like right now.

Back in March, we did a post, Doing Business in China with Deportation or Worse Hanging Over Your Head in which we discussed how “China has like never before been tracking down foreign companies (especially U.S. companies) that are operating in China without having a business entity (a WFOE or a Joint Venture) that allows them to legally do so. See also Donald Trump and Your China Business: Double Down, Ditch It or Die and Donald Trump and Your China Business: Double Down, Ditch It or Die, Part 2. Our thesis — based on what we were seeing on the WFOE front and on other crackdowns involving even things like bar fightsvisasexpat taxescannabis, and employment law — was that China was toughening up enforcement against foreigners and foreign companies in China on all fronts, but especially against Americans and American companies as a sort of a slow and not terribly public retaliation against President Trump.

With all the talk now about US tariffs against China, legal enforcement in China against American companies operating in China without a WFOE has gone into hyperdrive. One of our readers, herself a China lawyer, recently wrote me to let me know how ridiculous she thought I was for believing Beijing would “quietly” go after American companies. My response to her was that we had no idea whether China’s stepped up legal enforcement is being directed from Beijing or is more in the nature of a slow and quiet and yet widespread uprising against the United States being mounted by government officials throughout China.

We can debate who is leading this enforcement charge and even the reasons for it, but to me the most important thing is that if you are an American company and you are not in full compliance with Chinese law you are at greater risk now than you have ever been. If you are doing business in China, especially if you are doing business there “through” a Chinese citizen you are paying, you need to think long and hard about your China company formation options.

Whenever we write about how China is getting tougher with such and such a law, we invariably get emails and/or comments saying how idiotic and/or unfair we are for criticizing China for enforcing its laws. Just so the record is clear, we have not said that and we are not saying that; we are as neutrally as possible merely writing on what we are seeing and we would be more than happy to leave it to the legal philosophers to put these sort of real-life China business and legal issues into some larger context.

In addition to the stepped up enforcement of China’s WFOE requirements, we are also seeing a massive uptick in American companies forming Hong Kong Companies or consulting WFOEs in ill-advised efforts to get legal. So let me use this blog post to once again make clear, forming a company in Hong Kong does not do a thing to make your business operations legal in Mainland China:

Nor will forming a company in Macau or Taiwan or Singapore. If you are doing business in the PRC/Mainland China, you need a PRC legal entity, such as a WFOE or a Joint Venture. See Having A Hong Kong Business Does NOT Make You Legal in Mainland China. See also A Hong Kong Company Is NOT a Mainland China Company and a Hong Kong Trademark is NOT a Mainland China Trademark. If it were otherwise, virtually nobody would go through the agony and the costs of forming a WFOE; they would instead pay some accountant in Hong Kong about USD$1,000 and have an HK company in less than a week. Please, please, please do not fool yourself into believing otherwise!

In fact, the more you get on the grid in China without actually doing everything the right way in China, the more you make your illegality more obvious and easier to spot. See Quasi-Legal In China. Not the Place You Want to Be andQuasi-Legal in China. Not the Place You Want to Be, Part II.

We are also hearing from many American (and some European companies as well, but we’ll save that for a subsequent post) companies that formed their WFOE in China the “fast and easy way.” Some less than reputable WFOE formation companies will tout how they can form China WFOEs quickly and cheaply and for only around USD $15,000 in minimum capital. What these WFOE formation companies typically then do is form your company as a consulting WFOE in an “easy” China city. Please don’t fall for this. If your WFOE is not going to be in the consulting business, it cannot legally operate as a WFOE in China and it will get shut down. See How To Form a China WFOE. Scope Really Really Matters, Part II. And if your WFOE is going to be operating in Xi’an you do not want it to be formed in Shenzhen, for just a whole host of reasons.

If you are not complying with Chinese laws it is important you move quickly to get into compliance. But it is also important that in moving quickly you not expose yourself to even more and potentially greater problems. To borrow from a famous legal quote, you should move to get legal in China with all deliberate speed.

China company formation done wrong is not going to be your answer.

What are you seeing out there?

china employee due diligencePeople lie.

Especially on job applications.

A widely cited US study from 2017 found that 85% of applicants lied on their job application. Another study from 2015 found that only 56% of job applicants had lied, but either way, the number is huge.

Why do job candidates lie? For most, it’s a combination of two things: they think their lie will help their candidacy (especially if they think resumes are being screened by a computer), and they don’t think anyone will do a background check. The most common lies are about job skills, followed closely by lies about job responsibilities. An estimated 15% of candidates list jobs that they never held (George O’Leary or Marilee Jones, anyone?).

China is no different from the US in this regard, and in many ways it is worse because Western companies are unable or unwilling to perform due diligence on job applicants. Seeing a market opportunity, I started my own company in 2009 to help Western companies with their China hiring, with a particular emphasis on background checks and screenings. And boy, do they need the help.

Overall, we reject 72% of all candidates for dishonesty, usually for not having the ability they said they did. We have found that salespeople and general managers lie 80% of the time; engineers lie 65% of the time; and people working in finance lie 59% of the time. They lie because they think they can get away with it.

One candidate said he recently left his company when a headhunter called. We found out he was fired three years ago and his detailed stories regarding his accomplishments over the last three years were all fantasy.

Candidates often give us a cell phone number for a former boss that turns out to be the phone number of their friend pretending to be the boss. And even if we get the right number for the boss, Chinese bosses are usually unwilling to speak ill of a former employee even when it’s justified. Our strategy is to take detailed interview notes with the job candidate, and then ask their former boss to confirm the who, what and where of important projects. We often learn that the boss, or someone other than the candidate, actually managed the project in question.

Ronald Reagan is credited with popularizing the Russian proverb “trust, but verify” during his 1980s negotiations with Mikhail Gorbachev. The phrase is ambiguous, but is generally agreed to mean that people should earn your trust, rather than be assumed trustworthy until proven otherwise. I wish the latter was a good business strategy in China but it is not. China has many wonderful people and fantastic job candidates. But it also has a lot of people willing to lie and cheat to get ahead, and they are often the ones who get the interviews.

What are you doing to ensure you hire the “right” candidates?

*This post was written by Jim Nelson, President of SHI Group Recruitment, a China-based employee recruitment agency that focuses on helping Western companies find and hire good employees in China.

China employment lawyersOur China employment lawyers conducted more than double the number of employer audits in the last year as in the year before and it would not surprise us a bit if the next year sees a similar increase. Foreign company employers in China continue to face growing heat for all sorts of reasons, including the following: The government in Beijing views its compact with its citizenry as including taking care of employees.

  1. Many local governments view their compact with their citizenry as including taking care of employees.
  2. There is a lot of pressure on both Beijing and on local governments — from both employees and from competitor businesses — to make sure foreign companies are abiding by all of China’s laws, including all of its employment laws.
  3. There is massive pressure on both Beijing and on local governments — from both employees and from competitor businesses — to make sure American companies are abiding by all of China’s laws, including all of its employment laws. If Trump’s next round of tariffs goes into effect, this pressure will only increase.
  4. China’s employment laws and rules just keep getting more complicated, more pro-employee, and more localized. See China Employment Law: Local and Not So Simple.

An HR audit can range from just reviewing documents off-site to having a bilingual Chinese-English employment attorney go to your facility(ies) for an on-site document review and to interview key personnel. Employer audits begin with a document-based review, and nearly always continue with revising (and/or creating brand new) company employment documents and contracts and meeting with Chinese government officials to remedy problems found.

What sorts of foreign companies should undergo such an audit and how often? Pretty much any foreign company with employees and once a year is typical. By any foreign company, I meant to include WFOEs, Rep Offices and Joint Ventures. Rep Offices and Joint Ventures? Absolutely. If anything an audit for these sorts of China entities is more important than for a WFOE.

Let me explain.

An American company has set up a representative office in China. The American company and the rep office then rely heavily on a third party labor dispatch agency such as FESCO or CIIC to employ and manage the employees. This makes sense, since the Rep Office cannot directly employ anyone in China. In this sort of labor agency arrangement, the labor agency is the employer of record and it is the one on the hook for all employment law violations. This, however, does not mean the American company/Rep Office need not be concerned about whether their HR program is in good shape or whether what the labor dispatch agency does is adequate. If anything, our employer audits usually find more problems with third party hiring agencies than with WFOEs. And when you think about it, this should not be all that surprising.

The problem with third party hiring agencies is that they care way more about their own company than about your company. Their goal is to protect themselves, not you. Do their employment contracts include provisions requiring “their” employees  not reveal your trade secrets? Do their employment contracts include provisions preventing “their” employees from going off and competing against you the day after they quit working for your company or get fired? Unless you make sure their employment contracts include such provisions they almost certainly do not. And unless you make sure every new/subsequent employment contract includes such provisions they almost certainly will not.

Another big problem we see with third party agency employment contracts is that they are rarely kept up to date. The problem here is that when a foreign company that uses a labor dispatch company changes its terms of employment with all or some or even one of its third party “employees” it seldom communicates this change to the labor dispatch agency. This means the official employment contract between the third party agency and its employee(s) does not get updated.

The same holds true for the rules and regulations used to set out the employee conduct that will be deemed inappropriate and will therefore be punished? If you are using whatever your third party hiring agency has provided you, do the rules and regulations actually make sense for your business? Are those rules and regulations being modified to reflect changes in your business? Has everyone who does work for you signed the right set of rules and regulations? It is not uncommon for us to find situations where third party employees have signed on to rules and regulations for various different foreign companies that use the third party hiring agency — without ever having signed the rules and regulations of the foreign company for whom the employee is actually doing the work.

Next situation. The foreign company has a joint venture in China. The foreign company’s Chinese joint venture partner supplies all the employment documents. Did you review them before they were signed by the Joint Venture employees or did you just assume that your Joint Venture partner would take care of all that?

I am going to be blunt here. For two very important reasons, you really should carefully your Joint Venture employment contracts. The first and most important reason is that your interests and the interests of your China Joint Venture partner are not the same. Your Joint Venture partner has incentive to hire his or her sons and daughters and cousins and nieces and nephews and to do the same with those to whom he or she owes a financial or moral or social debt (see e.g. guanxi).

The second reason is that Chinese companies are not under nearly the same employment law scrutiny as foreign (especially American) companies and so they typically do not take employment issues as seriously as foreign companies (especially American companies) should. And yet, Joint Venture entities (especially those with an American Joint Venture partner and especially those in certain industries) will be viewed by both the various governments in China and by its own employees as being a foreign company.  When our China employment lawyers conduct HR audits of China Joint Venture entities, we nearly always find a lot more problems than with our HR audits of WFOEs.

First off, the employment documents (to the extent there are any and far too often there are not) are in only Chinese and the foreign partner has either never seen them or does not understand them. It is never pleasant having to tell a client whose Joint Venture has never once made a profit that its Joint Venture has 300 employees, not the 200 it believed. Or that 15 of its employees are, for whatever reason (relatives of the Chinese JV partner?), being paid double what others in the same position in the company are making. Or that all or most of the employees are getting a portion of their salaries in cash so as to reduce required employer social benefit contributions and employer (and employee) taxes. Not only does this mean the JV has unrecorded debt, it also means the American side will face a huge problem if it ever wants to shut down the JV or do some other sort of business in China. This is just the tip of the iceberg in terms of the employment problems Joint Venture HR audits reveal.

Not surprisingly, our China employment lawyers also advocate employer audits as an essential element of the due diligence on any M&A deal. Our employer audits in those situations often find that the employment documents of the company to be acquired — especially the employment contracts and the employer rules and regulations — were prepared a long time ago and are now outdated. It is also quite common to see a situation where the acquired company started in one city and then grew to include a number of additional cities and yet its employment contracts and its rules and regulations were never localized to reflect its multi-city reality. Even in the rare instance when the acquired company’s employment documents are in good order, the new employer almost always wants to introduce some changes — perhaps a new bonus program to encourage certain employees from the acquired company to stay on after the deal. An employer audit helps identify what is in place and what makes sense to change.

So as you can see, China employment audits should not be limited to just WFOEs.

 

China NNN attorneyBy a wide margin, the most popular China contract my law firm writes is the China NNN Agreement. These are basic and important agreements no matter what your industry. We write these to protect against disclosure, competition, and circumvention. For more on what goes into our China NNN Agreements, check out our most read post, imaginatively entitled China NNN Agreements.

Unfortunately, not everyone uses my law firm’s China lawyers for their NNN Agreements and I say this for reasons beyond our not capturing the fees for those. I say this because our China attorneys receive a steady stream of emails from Western companies that want to retain us to sue on their existing NDA or NNN Agreement and after we review those agreements, we decline to take their case because their agreements are just not good enough. In fact, our firm has never taken on a breach of an NDA or breach of an NNN because we have yet to see such an agreement written by someone else that was strong enough to warrant litigation and because nobody has ever sought to sue on any of those we wrote.

Note. I am not saying that no other law firm can write a proper NNN Agreement for China. I am not saying that at all. I am merely saying — not surprisingly — that in situations where a Chinese company has signed an NDA or an NNN Agreement and then someone wants to sue on it, we have not liked the agreement on which they want to sue. Get it?

What then is so wrong with the NDAs and the NNNs my law firm sees and does not like? All sorts of things. The most common problem is that the agreement was not written for China at all. It is just a Western-style NDA used either as-is or cobbled together to try to look like it is for China. For why this does not work, check out Why Your NDA is WORSE Than Nothing for China. Probably the second most common problem we see is the situation where the Western company has an NNN that is 98 percent good, but then has a bad provision through which its Chinese counter-party can drive a truck. In these situations, I ask the Western company how the horrible provision came about and invariably their response is that the Chinese company would not sign the NNN Agreement without it and nobody told them how bad it would be for them to put that provision into the NNN Agreement.

WARNING. There are all sorts of ways a Chinese company can quickly and efficiently eviscerate a perfectly fine NNN Agreement with what can appear to be a minor change. For this reason alone, it is always a bad idea to get an NNN Agreement from your lawyer and then not go back to him or her with any proposed changes. When any of my firm’s lawyers draft NNN Agreements we make very clear that we see our role as handling the NNN transaction from beginning to end. See e.g., China NNN Agreements: How to Get Them Properly Signed and Executed.

I thought of all of the above recently when communicating with one of the best and most experienced attorneys I know. We were discussing “the old days” in China legal and how different they were and then we started talking about how in so many ways little as changed. On that front, this lawyer wrote me the following regarding NNN Agreements and IP theft [stripped of any identifiers and cleaned up substantially]:

Back in the 90’s I worked on a deal with a Chinese company that was entering the cellular phone business. The other side was ___________[Company X] from the United States. Company X insisted on a well-crafted, highly effective NNN Agreement. The Chinese side refused to sign this though, so Company X went home and said it would not come back until the agreement was executed. I asked the Chinese side why it would not sign the agreement. They said: “We won’t sign because we are doing this project to acquire the technology for ourselves. We are not going to disclose to someone else.” That is when I learned that non-use is more important than non-disclosure in these agreements. I told the Chinese side that if they didn’t sign Company X will not be back. The Chinese company eventually signed, but I also was sure to tell Company X that from the moment the paper document was signed, it would need to monitor what its Chinese counter-party was doing with its IP. Nothing really much has changed since those days except Chinese companies have become far more clever and they no longer  make it clear from the start what they are planning to do. But as you and I both know, that does not mean anything else about these deals and what is needed in these agreements has changed.

Yup. What are you seeing out there?

china attorneys
Love is a many splintered thing.

Our China attorneys often hear something like the following from our clients:

“I am not worried about this deal/contract/transaction with this Chinese company because” [choose one or more]:

  • The owner and I are great friends.
  • I trust the owner implicitly.
  • There is no way they [the Chinese company] would do this because it would destroy their business.

I start one of my “how to protect your IP from China” speeches with the following:

“Big companies in China want to steal your IP. Small companies in China want to steal your IP. Private companies in China want to steal your IP. Public companies (and SOEs) s in China want to steal your IP. Oh, and that company whose owner you like so much and whose son’s or daughter’s wedding you attended, that company also wants to steal your IP.”

So how then do our China lawyers respond to the client who insists “it’s all good” with their China counter-party and there’s no need for protection [choose one]?

  1. You are wrong about your friendship with the owner. He is a liar and a thief.
  2. You are wrong to trust the owner. He is a liar and a thief.
  3. You are wrong about the economics. They will . . . because they only think short term?
  4. None of the above.

None of the above is the correct answer because our China lawyers do not have any special knowledge about the Chinese counter-party or its owner(s) and so we have no way to refute what our clients are telling us about them. On top of this, we have seen plenty of instances where an American or a European company has had a fantastic relationship with its Chinese counter-party for decades.

No, what we say is that even if all they are saying about their Chinese counter-party is true, there are still substantial risks. And then we tell them about the countless instances where we have seen things go badly wrong even when the American or European company was entirely right in trusting their Chinese counter-party or the economics of the situation.

But how can that be?

Because the foreign company that believes trust or economics solves all when doing business with a Chinese company is ignoring the following:

Just because you are friends with the owner or just because the owner can be trusted or just because it would not make economic sense for the company to cross you, this does not apply to 1) the company’s employees, 2) the company’s vendors/suppliers; 3) the company’s subsequent owners, or to a 4) changed economic situation.

The risk is often not the owner of the company, but everyone else who gets access to your IP or your trade secrets. These are the sort of things our China lawyers see all the time:

  1. Everything is going great with the Chinese company and then the son or someone else takes over for and everything completely changes. Our China lawyers must have dealt with this at least a dozen times.
  2. Everything is going great with the Chinese company and then the General Manager of the Chinese company or someone else goes off and starts a competitor of the Chinese company and this new competitor steals our client’s IP or trade secrets and starts competing with our client. Our China lawyers must have seen this at least two dozen times. See Inside a Heist of American Chip Designs, as China Bids for Tech Power.
  3. Everything is going great with the Chinese company and then a vendor or a supplier of the Chinese company starts competing with the Chinese company by using our client’s IP or trade secret.
  4. Everything is going great with the Chinese company but then the economics of the industry change and the Chinese company can now make a lot more money by stealing our client’s IP or trade secrets and so it does.

For these four reasons (and more), my firm’s China lawyers (and pretty much every other China attorney we know) virtually always insist on our clients having enforceable contracts with the Chinese companies with which they are doing business. We draft these contracts to cover ownership changes and to cover employees and vendors and suppliers and changing economic situations. For more on what is needed to have an enforceable China contract, check out China Contracts: Make Them Enforceable Or Don’t Bother and China Contracts That Work.

Because this only makes sense.

And of course there is more. Beyond the contract, you need the registrations required to protect your product/technology/IP. This often means registering your trademark in China in English and in Chinese, registering the copyright in your software and anything else that applies in the PRC and maybe Taiwan elsewhere and registering a design patent in China. These will give you protection against those beyond just the Chinese company with which you are doing business. I will write more on these things in my next post.

Your thoughts?

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.