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 film lawyerLast Tuesday, U.S. Trade Representative (and Trump appointee) Robert Lighthizer released a statement explaining that his office would seek to impose a second round of tariffs on Chinese imports, this time 10% tariffs on an additional $200B in imports. The first round of tariffs, which went into effect on Friday, July 6, imposed tariffs on $34B in imports, and was quickly matched by China’s imposition of tariffs on $34B in US exports to China.

The USTR is justifying its actions on the basis of the 200-page Section 301 report which detailed a wide range of allegedly unfair trading practices by the Chinese government, including forced technology transfer, theft of IP and technology, improper government subsidization, and lack of reciprocity.

It is difficult to find anyone outside China who disagrees with the substance of the Section 301 report, but it is difficult to find anyone outside the Trump administration who understands – let alone agrees with – the country’s blithe entry into a trade war. Ramesh Ponnuru, a senior editor at National Review (hardly a bastion of liberal thought), wrote a cheeky opinion piece in Bloomberg laying out what he saw as Trump’s Four Rules for Conducting a Trade War:

  1. Assume that you will win it effortlessly.
  2. Make sure your tariffs are designed to inflict maximum damage on your own country’s companies.
  3. Take on as many countries simultaneously as you can.
  4. Don’t feel that you have to make your negotiating demands clear.

The USTR has released a tentative list of 6,031 product categories that, in aggregate, allegedly represent $200B worth of Chinese imports. Included on this list, to the chagrin of almost everyone in the entertainment industry, is the following category: “Motion-picture film of a width of 35 mm or more, exposed and developed, whether or not incorporating sound track.” The list also includes motion picture films of a width less than 35mm, but it is silent as to whether this would extend to movies on digital media, which is how the vast majority of films are distributed these days. See Rule (4) above.

Industry observers have been trying to figure out what, if anything, this means to the Chinese film industry, the US film industry, and the interaction between the two. From an economic standpoint, putting tariffs on motion picture imports from China is solely a symbolic gesture. China would love to be exporting films in such quantities that these tariffs would hurt, but as we wrote in What Does the Chinese Film Industry Get From Hollywood?, Chinese films simply don’t do business in the U.S. In the past 10 years, the highest-grossing Chinese films in the U.S. have been The Grandmaster (2013, $6.6M), The Mermaid (2016, $3.2M), and Wolf Warrior 2 (2017, $2.7M).

Meanwhile, multiple U.S. films each year gross more than $100M in China.

Putting all this together, it seems possible (if not likely) that the Trump administration is simply baiting the Chinese government to retaliate against the liberal redoubt of Hollywood. See Rule (2) above. China would love to see Chinese films dominate the Chinese box office, and they certainly don’t care about protecting American business interests. But they also don’t want to do Trump’s dirty work for him.

At this point, all options are open to the Chinese government, and they have even more political cover to take whatever action they like. My guess is that the Chinese won’t do anything except use the threat of tariffs as an excuse to postpone the already-interminable negotiations over the revised film quota and profit-sharing arrangements. I’d do the same thing in their place. How could they possibly reach an agreement on film imports with the threat of retaliatory action hanging over the entire process? This way, the Chinese can have their cake and eat it too.

Of course, it’s also possible the Trump administration didn’t think about any of this too deeply and everyone is reading in complexity where there is none. Being There, anyone?

China company chop

It is always a good idea to have your Chinese counter-party “chop” or “seal” your China contracts with their official China company chop. It has been more than five years since we blogged about what constitutes an official China company chop and it seems like our China lawyers are getting an uptick in requests for us to explain how to discern what is and is not an official China company chop. This post is a response to those emails and a necessary update to our previous posts on China company chops.

Every contract with a Chinese company must be executed by a person at the Chinese company with authority and it must be chopped with the official company chop (sometimes also referred to as a company seal). However, there are many types of company chops. Which one should be used? How do you know if the company chop is real? What does a real China company chop look like? What does Chinese law require of a China company chop? What are some examples of fake company chops?

An official Chinese company chop on a contract says the Chinese company itself has authorized the contract. This means that the company cannot later claim that whomever signed it was not authorized to do so and so the contract should be deemed invalid.

The rules/requirements for Chinese company chops are different in every city, so there is oftentimes no way to know whether a company’s chop is a proper, legally registered and authorized company chop just by looking at it. For this reason, the Chinese courts have decided that they generally do not care and if the document is chopped with something that purports to be the company chop and if the signer of the document is either the legal representative of the Chinese company or a person with apparent authority to act on behalf of the Chinese company based on his or her business card the Chinese courts will usually not invalidate the contract based on a technical argument related to the validity of the company chop or the authority of the signer.

What this means in real life is that if you ever sue a Chinese company for breach of contract and the Chinese company tries to claim that the chop on your contract is not really theirs and its President (per his or her business card) did not have authority to sign on behalf of the company, it will almost certainly lose. Nonetheless, what this also means is that you will have one more litigation hurdle you must jump and on which you could conceivably fall. What if it is a mid-level manager who signs your contract and not the President? Your prevailing on your breach of contract litigation now looks less certain.

Since there are so many kinds of company chops, it is best to insist on the standard round company chop using red ink. Some of these company chops are numbered and some are not. This varies by district and is not an indicator of validity. The newish oval company chops in black and purple are not common and should be avoided for companies that want to take the cautious approach. Unfortunately, some districts have moved to using these oval company chops and so it can be a good idea to determine whether you are in one of these districts. Nonetheless, none of our China attorneys have personally dealt with a Chinese company that did not have access to a standard round company chop with a star in the middle.

The only way you can be virtually certain about the authenticity of a Chinese company chop is to do expensive and time consuming and difficult in-person due diligence. You can visit the head office of your Chinese counter-party and inspect the company chop there and then compare that company chop to the company chop used on previous contracts executed by the company and provided to you during your visit. For this sort of visit to be helpful, you need to be fluent in Chinese and know enough about Chinese law and business to be able to discern whether the older contracts you are being shown are real or not. As you can imagine, this sort of in person due diligence is not ordinarily done, other than on really big money transactions.

Better yet, you send a China attorney to confirm with the government that the company chop that will be used on your contract is actually the company’s real company chop. But this method too is usually reserved for only big money transactions because because getting an attorney to run to the local MOFCOM office is not going to be cheap or easy.

Our firm’s China lawyers are occasionally engaged to do one or even both of the two company chop verifiers described above, but for verifying company chops for more typical China contracts we usually suggest foreign companies do the following:

Ask the Chinese party to provide you with the following four pieces of information:

  1. The signatory’s title, in Chinese and in English
  2. The signatory’s name in Chinese characters.
  3. A scanned copy of the signatory’s business card, in Chinese and English [unless you already have a copy
  4. A copy of the Chinese company’s business license

Armed with this, our China lawyers cannot guarantee anyone that the company chop is indeed authentic, but we can at that point let our clients know whether we are comfortable or not with the chop. By this point we have almost certainly already done basic due diligence on the Chinese company and so we already know it is a legitimate company and so once we get the above information relevant to the company chop, it is the incredibly rare instance when we express discomfort.

The bottom line on China company chops is that so long as the company chop looks authentic and so long as the person signing the contract or document has apparent authority to act on behalf of the Chinese company, that is all that is normally required. Due to the variations from district to district regarding Chinese company chops, on all but really large transactions, it will usually not make economic sense for you to do much more than to get your experienced China lawyer (who must be fluent in Mandarin) the four pieces of information listed above and have them give the company chop a relatively quick perusal.

To a certain extent, China company chops are somewhat overrated. The big issue is whether you are dealing with a person in the Chinese company with authority to bind the company. Are you even dealing with the company and not some rogue employee or third party? Does the company even exist, using the name they have given you? Those are the real issues, and they require real work to resolve. The notion that “the company chop is everything” is no longer a wholly accurate representation of the current state of law in China. Finally, any company chop can be faked. So even if you know what the genuine chop looks like, you do not know whether the one you are looking at IS that chop or is rather a fake.

However, insisting that that any legal document be chopped is still required in China so the basic best practices described above should be used for all your China contracts.

Got it?

 

 

Chinese companies overseasEight years ago, I wrote a post Top Ten Reasons Chinese Companies Fail In The U.S. A few weeks ago I got a fascinating email from someone in response to that post.

The below is that email. But before you read this email, let me make very clear that many Chinese companies do a very good job operating in the United States and my publishing this email is NOT intended to stand for the proposition that Chinese companies even tend to act as per the below.

Rather, I am publishing this email to show very starkly how operating in a foreign country without being mindful of the legal and cultural differences between your home country and the foreign country can lead to disastrous results. This is the theme or at least the sub-theme of many (most?) of the blog posts we write and in response to those we often get comments and emails expressing surprise at the disconnects. This post just goes to show that “what goes around comes around” and just as American and European companies so often stumble when doing business in China, so too do Chinese companies stumble when doing business overseas.

With all these provisos, here then is the email [substantially modified to protect both the person who sent it to me and those who still work at this company].

 

I am writing to you in response to the blog post from eight years ago, Top Ten Reasons Chinese Companies Fail In The United States. I wanted to relate my experience working for a Chinese company. I had a senior level position at this US company and after working there for 10+ years was purchased by a Chinese company. About a year later, the China home office brought in a a new plant manager from China to run things in the United States. This person’s English was very poor and this caused problems as the employees spoke only English or Spanish.

Almost immediately, he began to complain about the work ethic of the Hispanic workers, which I have to tell you had never ever been a problem.

Then the company began to enact draconian measures, such as firing workers for minor mistakes — like being a few minutes late or taking too long in the bathroom. They then moved to begin to replace the office staff with people who spoke Mandarin. This was done by hiring recent Chinese university graduates. This did not work out very well either because when one of the recent Chinese hires would ask too often about their vis sponsorships (which they usually did) they would be told that they would not be sponsored and either fired or left.

Production line employees were spied on and people from the HR department would walk the floor with cameras while telling the employees that any infraction would lead to termination. When any of us “management leftovers” would try to explain that they could not operate a company in the US like they did in China, we were glared out and ignored. Many times we were told that the workers “were lazy and ten times worse than those in China who knew their place.” They even took away the water coolers to save money by forcing the workers to get their water from the bathroom sinks. When one of us “management leftovers” said something bout this we were told not to “worry about it because ‘these people’ are used to drinking water like this from where they come from.”

Not surprisingly, production levels plummeted as skilled and unskilled workers alike either quit or were fired in an effort to intimidate the others into working faster. The blame for this began to fall on us “management leftovers.” Turnover by this point had reached triple digits among the production workers. People would show up and quit the next day complaining that they felt like they were working in a prison. By this point I was working 12 hours at the office and then coming home, eating dinner, and working another 4-6 hours on the computer doing reports and constantly having to explain to the home office why production goals were not being met. .

Management too by this point were dropping like flies and because word had already spread widely about our company, finding replacements was difficult/impossible. When I left the company after not being able to take it any more, I gave a full report to the HR people but that of course led nowhere.

The company is still spiraling down with turnover at an all time high. I have heard that the home office finally sent people from China to find out “the truth,” only to be told that all of the trouble had been caused by the “management leftovers” who did not know how to run the place. I even heard one manager was physically threatened not to reveal things to the home office. The lawsuits are coming next.

So yes, when I read your post I knew exactly what you were talking about.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

a. An exact date when funds must be paid.

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

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

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

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

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

Some of the following issues arise from this:

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

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

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

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

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

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

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

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

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

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

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

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

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

incoterms, FOB, FCA, CIF, ECWInternational shipping terms are way more complicated and important than most realize and international companies and lawyers seem to constantly get them wrong. My law firm has had multiple cases where BOTH sides of a dispute had chosen the absolute worst shipping terms possible for themselves. In these situations, each side makes various arguments as to why the other side’s choice of shipping terms should prevail.

A few weeks ago, my Uber driver on a very long ride in Spain was a logistics coordinator who was lost that job during Spain’s financial crisis. Desperately wanting to improve my Spanish, I asked him all sorts of questions regarding logistics and at one point he mentioned that “almost nobody except the Germans” understands what shipping terms mean. He then laughingly regaled me with stories where companies from all over the world were dead-on wrong (to their detriment) about what they thought they had agreed to by way of shipping terms.

If you purchase product from China, you typically should not use FOB as your shipping term. Use FCA or CIF or even EXW instead. Get a copy of Incoterms and learn what the above shipping terms mean and use them exactly as specified. Do not use the UCC: Incoterms only. Do not edit the terms.

In 2015, there was a massive explosion at the Tianjin Port with supply chain losses of approximately $9 billion. Who bore the loss of that destruction. The product sellers or the product buyers? Did any insurance company pay for the losses? Or did they escape the obligation to pay because in fact no insurance covered the items sitting in the port waiting for delivery? Sure, incidents as big as the Tianjin port explosion are rare, but there are all sorts of other things that can make shipping terms determinative, ranging from sanctions to theft to tariffs.

If you are a foreign company that purchases product from China pursuant to a contract manufacturing arrangement your  completed product is probably packed into a container at the factory in China, then transported from the factory to the port by truck. The container sits in a processing yard at the port for a week or so and then is finally loaded onto a ship.

A lot can go wrong in this process. Consider risk of loss. Who gets paid if the container is lost? What if the truck carrying the container to the port has an accident and the entire shipment is destroyed? What if the container is stolen from the port? What if there is an explosion at the port and the container is destroyed? What if the ship sinks in a storm in the Gulf of Alaska? What if the container is offloaded and the same misadventures happen before the container is delivered to you, the buyer, at your facility in North America or Europe or Australia?

Your shipping terms will typically determine risk of loss. International shipping terms have been carefully developed over many years and they are embodied by Incoterms. What is Incoterms? I will let Wikipedia explain:

The Incoterms or International Commercial Terms are a series of pre-defined commercial terms published by the International Chamber of Commerce (ICC) relating to international commercial law. They are widely used in international commercial transactions or procurement processes and their use is encouraged by trade councils, courts and international lawyers.[1] A series of three-letter trade terms related to common contractual sales practices, the Incoterms rules are intended primarily to clearly communicate the tasks, costs, and risks associated with the global or international transportation and delivery of goods. Incoterms inform sales contracts defining respective obligations, costs, and risks involved in the delivery of goods from the seller to the buyer, but they do not themselves conclude a contract, determine the price payable, currency or credit terms, govern contract law or define where title to goods transfers.

The Incoterms rules are accepted by governments, legal authorities, and practitioners worldwide for the interpretation of most commonly used terms in international trade. They are intended to reduce or remove altogether uncertainties arising from different interpretation of the rules in different countries. As such they are regularly incorporated into sales contracts[2] worldwide.

“Incoterms” is a registered trademark of the ICC.

Incoterms cover virtually all important issues related to international shipping of goods and selecting a single Incoterms shipping term typically will resolve all important issues related to a shipment. For this reason, every buyer and seller who will be involved with international shipping must decide what term will be used and then comply with the selected term.

The choice of shipping terms determines who bears the risk of loss transfer. Many U.S. buyers make the mistake of choosing Free On Board (FOB) as their shipping term. They chose FOB to ensure the price of the product does not include the price of insurance and freight to ship the product from China to the U.S.

When they chose FOB, these inexperienced buyers do not usually realize they are not accounting for risk of loss. Under FOB, risk of loss passes only after the product has been loaded onto the vessel (crosses the rail). Since risk of loss transfers when the product crosses the rail, the buyer purchases insurance that covers the product at that point. Now ask yourself: who has the risk of loss from when the product leaves the factory until it is loaded onto the ship? The answer of course is that the factory has the risk of loss.

But Chinese factories almost never purchase insurance for the brief period between when the product leaves their factory and is loaded on the vessel. The Chinese factory just assumes the buyer has purchased insurance as if the risk transfers when the carrier takes delivery. But this is not true.

This means that during the period between delivery to the carrier and loading on the vessel, the risk of loss for the product is uninsured. If the buyer is aware that the product in uninsured, that is a risk that the buyer willingly assumes. The problem is that hardly any buyers understand that they are taking this risk with product they already have paid for — at least in part. Many Chinese factories demand full payment at the time the product is put into the control of the carrier. They do not want to wait until the product is loaded on the vessel since they can never be sure when this will happen.

The solution to this problem is simple. Use the right shipping term. As the drafters of Incoterms clearly state, for modern shipping by sea, the FOB term should never be used. The proper term is Free Carrier (FCA). Under FCA terms, risk of loss passes when the shipment is put into the custody of the carrier. It does not matter where the carrier takes delivery. It may be at the factory or it may be at the port. Since the buyer can be certain where risk of loss passes, the buyer can be certain it has obtained the appropriate insurance. The issue of insurance is not left to the seller. The responsibility and benefit of insurance rests on the buyer where it belongs.

Another problem our international lawyers often see are buyers that seek to create their own shipping terms. We see contracts where buyers provide that the shipping term will be FOB but risk of loss transfers only after the product is delivered, inspected and accepted. But because FOB means risk of loss transfers when the shipment is loaded on the vessel, this self-created language makes no sense. There is no shipping term that provides for transferring risk of loss under these terms and these buyers confused risk of loss with acceptance of the goods, two unrelated concepts. By providing internally incoherent contract language the buyers harm themselves. If the shipment is lost, will the insurance company pay? If it pays, will it pay the factory or the buyer? Who knows? If you want expensive litigation create your own shipping terms!

Bottom Line: Failing to use standard Incoterms shipment terms in the standard way will decrease predictability, Choose the right Incoterms shipment term for your situation and don’t modify it.

United States tariff exception
Happier times….

Well, that escalated quickly!

The U.S.-China trade war is back on.

President Trump last week announced that the U.S. will impose 25% tariffs on about $50 billion worth of Chinese imports, ostensibly to punish China for its “systematic theft” of U.S. intellectual property and/or to reduce America’s trade deficit with China. China immediately fired back by announcing it would  impose 25% tariffs on about $50 billion worth of U.S exports to China in two stages.

Here are the two lists of Chinese products the U.S. has targeted, primarily machinery and industrial parts from industries such as aerospace, robotics, automotive, industrial machinery, and information and communications technology. These 1,102 product lines theoretically benefit from the Chinese government’s “Made In China 2025” industrial plan to become a global leader in certain new and advanced technology industries.

China also issued two lists targeting U.S. products ranging from salmon to soybeans, Harley Davidsons to electric cars, orange juice to whiskey. China’s first list targets 545 product categories covering about $34 billion in U.S. exports to China and its second list targets another 114 product categories covering about $16 billion. Many of the U.S. products selected for extra tariffs are from Trump-voting red states that have benefitted from huge volumes of agricultural exports to China.

July 6 is currently the deadline for when China and the U.S. will start imposing the proposed tariffs on the first list of imported products. Given President Trump’s track record of flip-flopping on China trade issues, it is not entirely clear whether these tariffs on Chinese imports will actually be imposed.

So, what can and should U.S. companies do if they are caught in the cross-fire of this escalating trade war, either because they import goods from China that will be subject to U.S. tariffs or because they exporting U.S. goods to China that will be subject to Chinese tariffs?

For the U.S. tariffs, U.S. companies likely will be able to request that specific products be excluded from the tariffs on Chinese products. This process likely will be similar to the exclusion request process used for the recently imposed “national security” tariffs on steel (25% tariffs) and aluminum (10% tariffs). In the past few months, the U.S. Department of Commerce has been flooded with nearly 20,000 requests to have products excluded from these tariffs. Separate requests must be submitted for each product a company wants excluded.

An exclusion request typically includes the following:

  1. Identify the product you want excluded. The U.S. list of targeted products is identified by the Harmonized Tariff Schedule (HTS) number that is used to declare the product when imported into the United States. A company needs to identify the commercial name of the product, the HTS number for the product, and any other industry designation of the product under a recognized standard or certification (for example: ASTM, DIN).
  2. A description of the product based on physical characteristics (for example: chemical composition, metallurgical properties, dimensions) so your product can be distinguished from other products that would still be covered by the tariffs. A significant concern in considering exclusion requests is whether granting a specific exclusion request will create a loophole many other products can also use.
  3. The basis for requesting an exclusion. Is the steel/aluminum/other product unavailable from a domestic U.S. supplier and thus imports are needed to fill a demand no U.S. supplier can fill. Are there certain qualification requirements only the import supplier can satisfy? Have you been put on allocation by domestic suppliers?
  4. The names and locations of any producers of the product in the United States and in foreign countries.
  5. Total U.S. consumption of the product by quantity and value for each year for the past three to five years (2013 – 2017) and projected annual consumption for the next few years (2018- 2020), with an explanation of the basis for the projection.
  6. Total U.S. production of the product (or possible substitutes) for each of the past three to five years.
  7. Discussion of why the U.S. products (or substitute products) cannot be used in place of the imported products.
  8. A good story why your company deserves the exclusion it is requesting. This typically includes the history of your company (e.g., fifth generation family-owned), the products produced by your company, the strategic significance of your company’s products, the number of workers in your company, and your company’s annual sales.

On the Chinese side, U.S companies exporting to China likely will have a similar process to try to get a special waiver to get their products excluded from the Chinese tariffs listed U.S. imports into China. The Chinese exclusion process will likely not be as formalized as the U.S. process but it likely will require a Chinese company to submit the exclusion request and to provide the above listed items to explain why the U.S. products deserve to be exempted from the tariffs.

A U.S. exclusion process will likely proceed fairly slowly because there are so many exclusion requests already in the pipeline for the steel and aluminum tariffs, though a successful exclusion request likely will result in a refund of any tariffs paid. Waiting for a tariff refund is not the best thing in the world, but requesting such a refund will be the best path for many.

 

China high techWell yeah.

I mean this title does sound pretty obvious doesn’t it?

But this was definitely not always the case. Way back in early  2006, I can remember tentatively writing a post with the same title as this one — China is Booming: Go There for Growth and getting emails and calls from people saying that China would never be more than a low cost manufacturing center and from reporters all but demanding what information I had to support my bold claim.

And I can remember not having much hard information at all. For at that time, pretty much all of the work my firm’s China lawyers were doing was for companies doing business with China for its low costs. Few believed anyone other than a Coca Cola or a McDonalds could profit from China and it was believed that profits for even the largest companies would take years if not decades to realize.

Fast forward to today where our legal work is roughly evenly divided into the following thirds:

1.  Helping foreign companies with the legal issues that stem from China manufacturing. And even the legal side of that has changed dramatically. See China Manufacturing: Cha-Cha-Changing….

2. Helping foreign companies profit from doing business in China. That still involves a lot of WFOE formations and Joint Venture, but starting only a few years ago, it now involves at least as many licensing and distribution and e-commerce deals.

3. Helping foreign and Chinese companies navigate deals in foreign countries.

And in all three areas, our work increasingly involves the highest of high tech: biotechnology, autonomous driving, fintech, artificial intelligence, blockchain, cryptocurrencies, battery tech, and the Internet of Things, none of which were on most people’s radar back in 2006. Heck, back then, viewing China as anything more than a cheap place to make socks or rubber duckies was truly not all that common.

Things change and things have changed. What are you seeing out there?

China movie contracts
Photo by George Baird

Over the past couple weeks, the Chinese Internet has been abuzz with chatter about how Chinese movie stars allegedly underreport income via a dual-contract system in which only one contract is disclosed to the tax authorities.

The ruckus started when television personality Cui Yongyuan uploaded a redacted actor employment contract apparently for Chinese A-list actress Fan Bingbing’s work on the upcoming Bruce Willis film Unbreakable Spirit. (Initial reports stated, incorrectly, that the contract was for Fan’s work on the upcoming Feng Xiaogang film Cell Phone 2.)

Cui complained that Fan was massively overpaid – nearly $1.6M for only four days’ work – and her contract was bad for the Chinese film industry. The contract also detailed some of Fan’s allegedly egocentric contractual demands: screenplay rewrites, her own hairstylist and voice artist, luxury car service, a $200+ daily food allowance, and a requirement that the studio also hire her personal makeup artist at more than $12,000/month. Here in the United States, The Smoking Gun and other websites have posted so many celebrity contracts that we are inured to such terms, but Chinese netizens went berserk. Some penned impassioned defenses of Fan; others bemoaned the country’s skewed priorities.

Cui was just getting started. The next day he published a second redacted contract, this one for $7.8M, and intimated that the two contracts were so-called “yin-yang contracts” for Fan Bingbing: a form of tax evasion under which the smaller contract is reported to the tax authorities as income, and the other is unreported and therefore tax-free income.

At this point the Chinese tax authorities got involved and announced they would be investigating various Chinese film companies and also Fan Bingbing’s own production company. Shares in most of China’s major film companies promptly took a dive, presumably on the assumption that accounting flim-flam was rampant.

Meanwhile, the supposed evidence of Fan’s financial misdeeds unraveled nearly from the beginning. Cui conceded that the second contract had no connection to Fan Bingbing and in fact he had no evidence of any tax evasion on her part. Fan has vehemently denied the allegations of a second contract, and has threatened to sue Cui for damage to her reputation. It’s enough to make your head spin.

Actor compensation is an increasingly touchy subject in China, as the government more control over the film industry while also wanting to exert “soft power” through its cultural exports. With the possible exception of Olympic champions, movie stars probably represent China’s most bankable and least controversial form of soft power. But if the stars shine too brightly (or get paid too much), then the optics start to look bad, especially internally. For this reason, last fall the China Alliance of Radio Film and Television passed guidelines (almost certainly at the behest of the Chinese government) seeking to limit actors’ pay in two ways: capping acting fees at 40% of a project’s budget, and capping any one actor’s fee at 70% of the casting budget.

At this point the only thing that seems (relatively) clear is that Fan Bingbing received $1.6M for four days’ work on Unbreakable Spirit. But let’s imagine for a moment that Fan did receive a separate, larger payment via a second contract. There’s no proof this occurred, but even if it did there’s nothing illegal about it, unless the recipient never reported it. Indeed, all of the criticisms leveled against Fan thus far are similarly uncompelling. Consider:

  1. Fan is being paid too much for her acting services. It’s not difficult to muster a convincing argument that as a policy matter celebrities should not be paid more than, say, teachers or scientists. But the producers of Unbreakable Spirit are the ones who have to pay Fan, not the public, and they have obviously made the calculation that Fan is worth it. She is one of the most popular actresses in China, and they’re not running a charity. Why shouldn’t Fan get as much money as possible for her role? Fame (and the attendant paychecks) can be fleeting, and it’s hard to begrudge anyone who demands to be paid what the market says they’re worth. Especially a female actor, in this age of #metoo. If Unbreakable Spirit were an American film no one would think twice about Fan’s compensation.
  2. The contract is with Fan’s company, not her personally. The vast majority of actors in Hollywood are hired through their own companies, usually LLCs called loanout companies. The main reasons for this are to limit liability and to gain preferential tax treatment. The situation in China is similar. Nothing illegal about it.
  3. Fan (might have) signed two contracts for the same film. Fan has her own production company and it’s quite common for big stars to work as actual or de facto producers on a film. That is: they use their fame, connections, and/or money to help get the film financed, made, and distributed. If someone not  an actor did that, they’d be paid as a producer. Nothing illegal or even unusual about having a second contract for different services.
  4. If she signed two contracts, Fan was paid much more for producing than for acting. Actors take lower fees all the time for various reasons. Maybe they love the movie and take less just to get the movie made. Maybe they believe in the movie and will take less upfront for a piece of the profits (or even revenues, as pioneered by Jack Nicholson in 1989’s Batman). Maybe they’re also directing and producing the film and effectively want to invest their sweat equity in the film. It’s also possible Chinese filmmakers may also be trying to avoid the 2017 rule limiting actor compensation. Such a workaround is arguably a gray area but seems difficult to police, especially with talent that legitimately provides more than just acting services. Who should decide the actual value of their acting services?
  5. Fan’s contract requests are outrageous. By Hollywood standards, Fan’s requests for Unbreakable Spirit are neither outrageous nor particularly diva-like; I’ve received bigger, less rational asks from actors who are much less famous. It’s almost expected for an actor (or their agent) to push the envelope and see how much they can get, not least because it establishes a benchmark for the actor’s next picture. And sometimes a seemingly outrageous request has a legitimate purpose, as most famously embodied by Van Halen’s prohibition of brown M&Ms.

Even if Fan Bingbing hasn’t done a single thing wrong (which is very possible), it wouldn’t be surprising to learn that tax evasion is rampant in the film business. Tax evasion is like a national sport in China. Mainland factories regularly misreport income by having payments go to a Hong Kong or Taiwanese holding company. So-called “independent contractors” in China rarely report their income because they and their foreign employer are both operating illegally. And the billion-dollar daigou business is profitable largely through tax and customs fraud.

But if Chinese celebrities are committing tax evasion through two contracts, it’s because they’re not reporting income, not because there’s anything wrong with the two-contract model.