Foreign Investment in China

China foreign investment lawyers

MEH.

For weeks now, our China foreign investment lawyers have been getting a steady stream of emails regarding China’s now approved new law on foreign investments. Those emails can very roughly be divided into two camps:

  1. Those (mostly from our own clients) asking us what it will mean.
  2. Those (mostly from China Law Blog readers) using this law as proof that we either “exaggerate how unfair China treats foreign companies” or that we “have become way too cynical about China.”

This post strives to answer both email strains.

The new law sounds good but the devil will be in the details and like everything else related to China laws the details will be in its enforcement. But right off the bat, you can color me highly skeptical.

China has never treated foreign companies remotely the same way it treats domestic companies. China’s entire economic system is based on this and, if anything, things have mostly gotten worse for foreign companies in the last 5-10 years. Why should things all of a sudden change now? Because China is under tremendous pressure from both the United States and its own declining economy to stimulate foreign investment.

But China — like pretty much every country in the world — does not like being told what to do by a foreign power or even by a declining economy. This, coupled with China’s long history of failed promises to open up more to foreign businesses, makes me doubt it is really serious this time either. And reading between the lines of how this law got approved and even when it will actually become law make me doubt China’s enthusiasm even more.

In China approves new foreign investment law designed to level domestic playing field for overseas investors, The South China Morning Post highlights the following red flags:

  • “Beijing rushed the legislation through the country’s largely ceremonial legislature in an effort to fend off complaints from the United States and Europe about unfair trade practices. The new law was first introduced as a draft in 2015, but its progress picked up markedly from the middle of last year to address issues identified by Washington as part of the US-China trade war.”
  • “At the same time, the wording of the law, which will replace three foreign capital laws – the Law on Sino-Foreign Equity Joint Ventures, the Law on Sino-Foreign Contractual Joint Ventures and the Law on Foreign-Capital Enterprises – passed between 1979 and 1990 in the early years of China’s process of reform and opening up, is quite general, leaving many details to be addressed in other regulations and implementation procedures.”

In other words, this is an effort China started in 2015, but now it all of a sudden (under the pressures mentioned) above, has decided to embrace. Enthusiasm matters because without enthusiasm there will be no enforcement. Heck, this law is not even set to go into force until 2020 and it needs all sorts of supporting rules and regulations in the meantime. Enthusiasm matters because without the enactment of the supporting rules and regulations there will be little to nothing to enforce.

The SCMP article ends with an amazing quote from “He Weifang, an outspoken law professor at Peking University” who questions whether China’s existing government structure will adequately enforce the new law:

“We need democratic supervision and justice to ensure enforcement if there are any regulations issued later. Enforcement really relies on structural changes and an independent judicial system. So, I cannot say that I will be more optimistic when more regulations come out,” he said.

“It would be even worse if we lack the implementation mechanism after we enact a law, because the outside world will not trust you no matter what law you enact in the future. We need checks and balances to ensure enforcement, otherwise, all well-intentioned enactment of laws will end in vain.”

He is, of course, 100% right.

Addressing the cynicism question, all I can do is quote what an audience member once said at a China event I attended: “For those of us who have been dealing with China for more than a decade and have therefore been involuntarily trained to ignore the smoke and just wait for the fire, can you please just tell me what you have seen that has actually changed with ….” This proposed law is smoke that may or may not ever become fire and even if it does become fire, it may be nothing more than a match that soon blows out.

Is this new law an effort to improve the chances of a China trade deal? How strong will this law be if there is no trade deal? How strong will it be if there is a trade deal?

At this point, the best strategy is probably just to wait and see.

China Joint Venture lawyer

This is part 5 of our series on China Joint Ventures. We are writing this series now because our China lawyers are seeing a record number of potential joint ventures, due largely to China’s declining economy, the belief that truly foreign companies will not be well-treated in China, and a desire to try to “share the risk” of all this uncertainty. In part 1 of this series, China Joint Ventures: The Long Version, we talked about fake and exploitive joint ventures. In part 2, we assumed your Chinese counterpart is legitimate and wants to do a legitimate JV with your company and we discussed how to make sure you are truly on the same page with your China joint venture counterpart(s)  regarding what will go into the joint venture and how it will operate once formed. In part 3 we discussed some of the things you need in your joint venture agreement if you are to reap benefits from your China joint venture. In part 4, we discussed why the China corporate attorneys at our firm both love and hate China joint ventures.

In this part 5, we discuss what is probably the biggest and the most common mistake we see foreign companies make when going into a China Joint Venture: believing they have control over the joint venture when in fact they do not. We also explain how to avoid this mistake.

Way back in 2008, co-blogger Steve Dickinson was the legal columnist for one of China’s most prominent English language business publications. As part of his regular monthly gig, Steve submitted an article on how to avoid joint venture mistakes. The censors rejected it and we have always assumed they did so because it would have been detrimental to Chinese companies seeking joint ventures that would greatly favor them.

AmCham Beijing did not have such constraints and it published the article Avoiding Mistakes in Chinese Joint Ventures. It provides a roadmap for avoiding what is probably the biggest and most common mistake that gives Chinese joint ventures such a bad name.

The article starts out by noting that with “the exception of some market sectors, China is remarkably open to foreign investment, and in the past several years WFOEs [Wholly Foreign Owned Entities] have become the most common vehicle for foreign investment, partly due to investor skittishness as stories about past problems with Chinese EJV [Equity Joint Venture] partners made the rounds.”

The article then goes on to note how “thoroughly vetting your joint venture partner” will “dramatically increase your likelihood of success,” but states that most China joint ventures fail because the foreign partner made the “fundamental mistake” of believing its 51% ownership gave it effective control over the joint venture:

Foreign investors too often assume Chinese joint venture companies are managed according to a common Western model, under which a board of directors has controlling power over the company. Since the board is elected by a majority vote of company owners, most foreign investors will strive to obtain a 51% ownership interest in the EJV. As majority owner, the investor then assumes he has the right to elect the entire board, and thus effectively control the company.

After winning the struggle for percentage ownership, as a concession, the foreign investor will frequently allow the local side to appoint the representative director and the company general manager.

Unintentionally, this concession cedes effective power. As a result, the investor’s struggle for board control is rendered meaningless. Frequently the Chinese side intentionally angles to ensure this outcome. We know of cases where an EJV partner concedes on the percentage ownership issue in return for control over the two key management positions in the company.

In order to exercise effective control over a joint venture in China, investors must avoid this mistake. It is necessary to have control over the day-to-day management of the joint venture company.

The article then sets out the following basics for maintaining control over your Chinese Joint Venture:

The power to appoint and remove the JV’s representative. The side that appoints the representative director will have significant control over operations. The usual practice of conceding the power to appoint a key officer or director to another investor is a mistake.

The power to appoint and remove the general manager of the joint venture company. It must be made clear that the general manager is an employee of the joint venture company who is employed entirely at the discretion of the representative director. The common practice of appointing the same person as both representative director and general manager is a mistake.

Control over the company seal, or “chop.” The person who controls the registered company seal has the power to make binding contracts on behalf of the joint venture company and to deal with the company’s banks and other key service providers. The power over that seal should be carefully guarded. Ceding control over it as a matter of convenience is a mistake. There is a long, documented history of this seemingly minor consideration dooming EJVs.

The Chinese side to a joint venture usually will refuse to agree to any of the above three control measures by claiming it is more efficient to have them control day-to-day management of the company. The Chinese side will also often claim they cannot use their political connections unless their own people are the representative director and general manager. You should see these justifications for exactly what they are: red herrings used to disguise the Chinese company’s efforts to gain operational control over the joint venture company.

Relinquishing these three control mechanisms to your Chinese joint venture partner will almost invariably cause you long-term problems because once your Chinese JV partner has these controls you will essentially have relinquished all power to influence your own joint venture. When this happens, your best bet will usually be to either reduce your investment to a minority share or abandon it altogether. Once power over operations is out of your hands, it becomes very difficult to run a successful partnership in China.

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

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

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

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

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

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

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

2. The information must have economic value.

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

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

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

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

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

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

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

 

 

 

 

China joint venture lawyers

This is part 4 of our series on China Joint Ventures. We are writing this series now because our China lawyers are seeing a record number of potential joint ventures, due largely to China’s declining economy, the belief that truly foreign companies will not be well-treated in China, and a desire to try to “share the risk” of all this uncertainty. In part one of this series, China Joint Ventures: The Long Version, we talked about fake and exploitive joint ventures. In part 2, we assumed your Chinese counterpart is legitimate and wants to do a legitimate JV with your company and we discussed how to make sure you are truly on the same page with your China joint venture counterpart(s)  regarding what will go into the joint venture and how it will operate once formed. In part 3 we discussed some of the things you need in your joint venture agreement if you are to reap benefits from your China joint venture. In this part 4, we discuss why the China corporate attorneys at our firm both love and hate China joint ventures.

For better or worse, our law firm has developed quite a reputation for not liking joint ventures and so it is not uncommon for us to get calls from potential clients that start with them saying they know we don’t like joint ventures and then explaining why their doing a joint venture is either necessary or will be different from the ones we write about. Are we losing joint venture legal work because of this reputation or do we get more such work because people believe that if we give their joint venture the go-ahead it really is as good as they think it is. Though we will never know, we can at least try to clear the air. So just to be clear: we like appropriate or necessary China joint ventures but we think it a mistake to consider a joint venture as the default method for entering China.

Of all the China legal work my law firm does, setting up and dismantling joint ventures is probably my favorite. I like it because each joint venture is so different and yet all are intellectually challenging. I also like them because they tend to be one of our most lucrative corporate matters we do. We charge a flat fee for about half our China work, but we always charge hourly for joint ventures because setting up a China joint venture can range from fast and easy to difficult and contentious.

Few joint ventures are fast and easy. A joint venture consists of two independent businesses — one foreign and one Chinese — going into business together. That alone ought to tell you how difficult they can be. The most difficult questions usually center around control. Which of the two companies will control what? What really needs to be done to ensure control? What can be done to ensure neither company goes out of control?

Just to be clear, we love forming joint ventures, but only when they truly do make sense and well over half the time we end up counseling our clients against doing the joint venture. Just today I had the following conversation with a potential client (modified ever so slightly for dramatic effect):

Me: I am not clear from your email about what exactly you want to do with your Chinese manufacturer but it sounds like you want to enter into a joint venture with them and that will almost certainly be a bad idea.

Potential Client: Well, we do want to further solidify our relationship with them and we have been thinking a joint venture might be one way to do that. So why do you think it is such a bad idea.

Me: Jokingly, did I say I thought it a bad idea? I think it’s a great idea and here’s why. You will pay us anywhere from $15,000 to $85,000 now to set it up — the more you pay us the less likely it is to actually happen. And then the odds are good that in 3-4 years you will pay us another $50,000 or so to shut it down.

I hope I am doing a good job pitching this to you. Do you want to move forward?

Potential Client: I’ll take two.

Me: Perfect.

Our China lawyers also love taking apart China joint ventures that have gone wrong, and again, not for because it is in any way a good thing for our clients, who usually are in dire straits when they come to us with their joint venture problems, but because resolving joint venture disputes is like a championship chess game, but at our hourly rate.

The problem with China joint ventures is not China-specific; it is joint venture specific. Joint ventures simply tend too to be a bad way to conduct business. Our international lawyers have seen this up close and personal with Russian joint ventures, Vietnamese joint ventures, Mexican joint ventures, Korean joint ventures, Japanese joint ventures, even a Gambian joint venture. Marketing genius Seth Godin beautifully explains why this is the case in his post, “Why joint ventures fail so often“:

There are two reasons joint ventures fail. The joint part and the venture part.

All ventures are risky, because they involve change and the unknown. We set off on a venture in search of something, or to make something happen –- inherent in the idea of a venture is failure. It’s natural, then, for fearful people on both sides of a joint venture to back off when it gets scary. When given a choice between a risk and sure thing, many people pick the sure thing. So any venture begins with some question marks.

The joint part, though, is where the real problem arises. Pushing through the dip is the only way for a venture of any kind to succeed. The dip separates projects that begin from projects that finish. It’s easy and hopeful and exciting to start something, but challenging and often painful to finish it. When the project is a joint one, the pressure to push through the dip often dissipates. “Well, we only have a bit at stake here, so work on something else, something where we have to take all the blame.”

Because there isn’t one boss, one deliverable, one person pushing the project relentlessly, it stalls.

Every joint venture involves meetings, and meetings are the pressure relief valve. Meetings give us the ability to stall and to point fingers, to obfuscate and confuse. If a problem arises, if a difficulty needs to be overcome, it’s much easier to bury it at a meeting than it is to deal with it.

In my experience, you’re far better off with a licensing deal than a joint venture. One side buys the right to use an asset that belongs to the other. The initial transaction is more difficult (and apparently risky) at the start, but then the door is open to success. It’s a venture that belongs to one party, someone with a lot at stake and an incentive to make it work.

Only one person in charge at a time.

Godin is 100% right.

 

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

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

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

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

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

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

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

Just saying….

China lawyersChina craves stability. High unemployment can cause instability.

Today’s South China Morning Post, in an article entitled, China’s small businesses forced to cut back on staff just to survive as economic mood sours amid trade war, talks about how China’s slowing economy is leading to government concerns about joblessness:

With the Chinese economy slowing, concern has increased among Chinese policymakers about the outlook for employment, since ensuring a sufficient number of new jobs is seen as a necessary ingredient in maintaining social stability in the country. Employment was the top priority the Politburo set last July when it shifted its economic policy focus to stabilizing growth, leading the government to enact a series of policies to counter rising joblessness. This series will explore the employment challenges faced by different segments of the Chinese economy. The first installment examines the issues confronting small to medium-sized enterprises.

Chinese President Xi Jinping warned on January 21 that the Communist Party needed to pay particular attention to the risks to social stability from rising economic problems, as evidence increasingly suggests that the nation’s employment situation is deteriorating rapidly, particularly among small and medium-sized businesses.

The article goes on to talk about Chinese companies laying off workers but it does not talk about foreign companies doing the same, though of course they are as well, but perhaps more quietly. Our China lawyers are hearing from our clients with WFOEs in China that local government officials are stopping by essentially to make sure no layoffs are coming and if they are, that they are informed in advance.

Our China lawyers have been representing foreign companies in China for more than twenty years and that means we have gone through all sorts of economic and business cycles, including many downturns, though probably none as scary as this one. One of the things we have learned from past downturns is that China really really really does not want foreign companies to layoff or terminate employees during economic downturns and that alone should impact your layoff and termination decisions.

China is going through tough times right now and foreign companies that reduce employment will not be viewed kindly. Before you terminate any employee you should weigh the economic benefits of the termination against the possible detriment in your company’s local standing. If you must terminate any employee, by far the best (safest) way in these troubling times is via a mutual termination that includes a settlement. A private settlement is way less likely to be noticed by your local government and way less likely to cause major concern. For more on employee settlements, check out Terminating a China Employee: Why Mutual Termination is so Often the Key and China Employee Mutual Terminations: The Dos and the Don’ts.

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

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

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

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

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

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

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

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

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

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

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

China Joint Ventures

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

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

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

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

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

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

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

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

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

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

Huawei indictments for IP theftThe re-opening of the U.S. government has brought with it a renewed assault on Chinese telecoms manufacturer Huawei and its U.S. subsidiary. On January 28, the U.S. Department of Justice unsealed two indictments against Huawei. The first indictment concerns ongoing claims against Huawei and its CFO, Meng Wanzhou, for allegedly violating U.S. sanctions against Iran. This indictment can be found here.

The second and more interesting indictment concerns alleged trade secret theft conducted by Huawei’s U.S. subsidiary under the direction of Huawei China. The trade secrets indictment can be found here. 

The factual portion of both indictments makes for interesting reading. In particular, the trade secrets indictment should be read by any company that engages in technology based business relations with China. This is because the practices described in the indictment do not apply solely to Huawei. If you want a primer on “how they do IP theft” this is where to start. Note that if Chinese companies do in the United States what is described in this indictment consider what Chinese companies do in China.

Let’s say you have set up a WFOE in China to manufacture a critical chemical. The composition of the chemical and its method of manufacture are trade secrets. You have resisted the demands of your Chinese customers to set up a joint venture in China. You have resisted the demands of your Chinese customers to license your technology to a Chinese entity. The only Chinese persons with access to your technology are your Chinese employees. Since those employees are insiders, not outsiders, your technology is safe. Right? Unfortunately, the answer is no.

What can happen to the Chinese employees of your WFOE in China is exactly what allegedly happened to the Chinese employees of Huawei’s U.S. subsidiary. The local Chinese government will give your employees a detailed list of exactly what your employees must take from the WFOE and the timeframe in which they must complete the task. Though your Chinese employees may formally work for your WFOE, the Chinese government is essentially their ultimate “boss,” in the same way Huawei China is alleged to have been the ultimate boss of the employees of their U.S. subsidiary.

What though if your WFOE employee is an honest person and resists following the local government’s instructions? Or perhaps the employee is not so honest but resists simply because he or she does not want to risk losing his or her job if caught. The local government responds: your spouse works as a nurse in the local hospital and it would be too bad if she lost her job. Your father lives on a pension from the local government and it would be too bad if he lost his pension. Your daughter is applying for admission to the local high school and it would be too bad if she is denied entry. On the other hand, if you provide what we [the local government] have requested, we will ensure none of this happens. Moreover, you and your family will receive benefits. If you lose your job, we will find you another job. Don’t worry about it. Just do what you are told and help YOUR country. The pressure to comply is overwhelming and your Chinese employee complies. Your employee really has no choice.

This is the practice in China. Most WFOE managers in IP sensitive industries with whom I have worked in China understand this and so they do not even try to control their employees on IP because they know who is their real boss. They instead set up a costly system in which none of their Chinese employees is given  access to the WFOE’s IP sensitive information. This makes operations difficult and oftentimes the system’s rules are violated and access to IP is granted. When that happens, the technology gets taken because the pressure from the government never stops, in the same way the pressure from Huawei China is alleged to have never stopped against Huawei’s . U.S. employees. This is what is often meant by “forced technology transfer.”

What then should companies that do business in China or with China take away from these two Huawei indictments? Note first of all that neither focus on security issues related to the Huawei equipment that has led the United States and other countries to ban Huawei 5G telecom equipment. That claim is specific to Huawei and the type of equipment it manufactures.

These indictments are focused on how Huawei conducts business. The U.S. Department of Justice (DOJ) is claiming is Huawei intentionally and as a matter of company policy violated U.S. law. For example, in the trade secrets indictment, the DOJ claims Huawei China directed its U.S. employees to steal trade secrets from T-Mobile and when the U.S. employees did not succeed at doing this, Huawei China dispatched a Chinese based engineer to complete the job. The indictment goes on to allege that when Huawei got caught taking T-Mobile’s IP, Huawei submitted an internal report lying about what happened. Huawei’s technology theft is alleged to have been part of a Huawei China program that paid its employees bonuses for stealing intellectual property.

The DOJ claims Huawei stole T-Mobile trade secrets and violated the Iran sanctions and by doing so it overturned the underpinnings of the U.S. legal system and the world legal order. The DOJ’s press release on the trade secrets case makes this clear:

“The charges unsealed today clearly allege that Huawei intentionally conspired to steal the intellectual property of an American company in an attempt to undermine the free and fair global marketplace,” said FBI Director Wray. “To the detriment of American ingenuity, Huawei continually disregarded the laws of the United States in the hopes of gaining an unfair economic advantage. As the volume of these charges prove, the FBI will not tolerate corrupt businesses that violate the laws that allow American companies and the United States to thrive.”

“This indictment shines a bright light on Huawei’s flagrant abuse of the law – especially its efforts to steal valuable intellectual property . . . to gain unfair advantage in the global marketplace . . .”

The U.S. charges are directed at the impact Huawei’s actions have had on both the United States and the rest of the world. The U.S. seeks to expand its claims against Huawei to go beyond the device security concern to a more general concern with how Huawei (and other Chinese businesses and, most importantly, China itself) violates the laws and regulations underpinning the modern free trade system. This is an ambitious goal that will extend beyond Huawei as a company and even beyond IP enforcement as a specific issue. The trade secret indictment complains of actions that go beyond U.S. jurisdiction. The indictments against Huawei read as a global campaign against how Huawei and China do business.

We should therefore expect additional DOJ enforcement actions against Chinese companies. Ms. Meng’s arrest in Canada should not be seen as an isolated case. Worldwide arrests and extradition proceedings and civil and criminal litigation against Chinese companies and their executives will become more common and not just in the United States. We also will see such actions brought by Canada and Germany and Japan and Australia and Spain and England and others as well. The DOJ and the FBI and governments and private companies from around the world will work together to implement this program. These enforcement and litigation programs will extend to various other Chinese companies. The charges against Huawei should be seen as the first, not the last.

Most U.S. companies previously were reluctant to take this sort of aggressive action against China IP theft because of concerns doing so would impact their business in China. They feared a “tit for tat” response by the Chinese government. With the deterioration of US-China relations, this concern seems to be melting away and decades of pent-up resentment against China’s IP practices could well spill out in a cascade of claims from the US and the EU and others.

Welcome to the New Normal.

UPDATE: It took less than 24 hours to prove out the above. See FBI charges second Apple employee with stealing autonomous car secrets.

 

Closing a China WFOE
Closing a China WFOE: Just fading away is a bad idea.

For reasons that ought to be apparent to anyone who reads the news, our China lawyers have of late been getting a whole host of emails from foreign companies looking to shut down or just flee from their China WFOEs. Reduced to their essence, these emails usually focus on one of the following questions:

  1. How do I do it correctly?
  2. If I don’t do it correctly, what are the possible repercussions? Will I be safe in China?

We will answer both questions in this post.

PRC law requires all corporations (foreign and domestic) follow a formal de-registration procedure be followed. When a WFOE is simply abandoned, the annual registration procedures and tax filings will not be conducted. As a result, the business license of the WFOE will be revoked (吊销). Abandoned WFOEs typically have their licenses revoked for failing to complete their annual registration requirements (such as the annual audit and payment of fees) or for failing to file their annual tax return and paying the taxes due. In most cases, the revocation is for both.

When a license is revoked, the following is required:

  • The WFOE must immediately cease doing business. All websites and other public announcements where the company offers to do business in China must be taken down.
  • The official company seals must be collected and deposited with the licensing authority.
  • All taxes and fees owed to the national and local governments must be paid.
  • All salary owed to employees must be paid.
  • The WFOE’s legal representative and directors must immediately liquidate the company in accordance with China’s Company Law and local procedure. All company assets must be used to pay creditors in accordance with the liquidation procedure. Use of the company assets for any other purpose is a crime.

Though liquidation can be used to equitably extinguish the debts of normal creditors, it is usually impossible to formally liquidate a WFOE if it owes taxes or employee salaries.

Failing to properly liquidate a WFOE results in penalties imposed on the management and the shareholder(s) of the company. The legal representative and the other directors (but not the general manager) are personally liable for any damages caused to creditors by the WFOE’s failure to comply with China’s WFOE liquidation requirements.

For improperly liquidated WFOEs, the first step by the Chinese government is to put all potentially liable parties on a “black list.” This includes the legal representative, the directors and the shareholders. Though the general manager is technically not liable, the name of the general manager often goes on the blacklist as well and we have seen instances where random high level employees make it on the list too. This blacklist goes to all SAIC (State Administration for Industry and Commerce) offices in China and to the PRC border control authority. Being placed on this blacklist usually means the following:

  • The legal representative will not be permitted to act as a director, manager or supervisor of a Chinese company for three years from the date of the WFOE’s revocation.
  • The shareholders of the WFOE will not be permitted to invest in another Chinese company for three years from the date of the WFOE’s revocation.
  • The name of the WFOE cannot be used for a period of three years from the date of revocation.

The above is happens when the WFOE does not owe any taxes, fees, salaries or debts. If the abandoned WFOE owes any taxes, fees, salaries or debts, the situation is far more serious. In this situation, the PRC authorities may criminally prosecute the legal representative and the directors of the company for having failed to make the required payments. Failing to pay taxes is a crime in China and failing to properly liquidate is also a crime when that failure involves not properly paying creditors as provided by China’s WFOE liquidation rules.

Even if no crime has been committed, it is nearly impossible for a person or entity put on the blacklist to engage in investment or company management in China and it is also common for Chinese border authorities to refuse entry to the named person. If a crime has been committed, China will usually allow the person to enter China and then immediately arrest him or her for remand to the local authorities for prosecution. Our China attorneys have heard of many instances where key WFOE personnel were held hostage by their China creditors until their debts were fully paid. See How to Avoid Being Detained in China.

Fortunately, the process for proper WFOE de-registration and liquidation has become more systematic and easier to handle in China. For WFOEs that have paid their fees, do not owe taxes, and have paid their employees and their creditors, de-registration and liquidation is now a relatively straightforward process.

Bottom Line: If you need to shut down your China WFOE, follow the rules. If you ever want to set foot in China again, there is no alternative.