foreign businesses in China

Co-blogger Steve Dickinson and I will be giving a presentation at AmCham (Beijing) on September 24, from noon until 2 p.m.  AmCham just posted this event but I do not think its posting (which we did not review before it went live) is quite clear enough on what we will be discussing.

So I will try to get clear on that right here and now.

China is obviously going through a lot of changes — when is it not?  It should go without saying that those changes are impacting foreign businesses that do business in China or with China.  Steve and I are constantly talking with each other and with our clients and others about how China’s changes are impacting and might impact foreign businesses involved with China.

Since Steve is based in China and I am based in Seattle, we necessarily talk with different people and we necessarily have a different perspective.  So our plan for this upcoming event is to talk about what each of us are seeing/hearing from our own individual perspectives and then comment just a bit on what the other person is seeing/hearing.  We are each going to independently come up with and discuss the five big trends that we see impacting foreign businesses in China or doing business with China.  Honestly, neither of us will know the other’s list until it is presented live at AmCham.  I swear it.

We plan to speak for a combined 30 minutes or so and then open it up for questions.

I’m hoping you-all can stop by with questions.  Go here to read more and to register.

With the recent U.S. filing in the WTO accusing China of failing to provide adequate protection of foreign Intellectual Property Rights, we are headed for another China/U.S. disinformation campaign on an important issue. Many foreign companies doing business in China get caught up in the confusion of the political rhetoric and conclude there is no hope for protection of their IP rights in China.

This is a mistake because China actually provides effective intellectual property protection in the patent, trademark and trade secrecy areas. These are the areas that are relevant to the vast majority of foreign businesses in China. The problem addressed by the U.S. WTO filing concerns pirated DVDs and media downloads. This is still a major problem in China, but it is not relevant to the IP issues that confront most foreign businesses in the country.

Many foreign businesses mistakenly conclude IP protection is hopeless in China. As a result, many do not come to China, and others who do fail to take any measures to protect themselves because they feel the process is futile and a waste of time and money.

I have been arguing for years that the IPR protection situation in China has substantially improved. However, when I make these statements, I am often challenged. In addition to the negative press and government reports, my clients often point to the situation on the ground. Take Shanghai for example. Within five minutes of the door to my apartment there are five pushcarts doing a brisk business in pirated DVDs and software. When I get off the subway on Nan Jing Road to walk to my office, I am immediately accosted by vendors selling pirated watches, bags and pens. My clients say: Isn’t this proof that China is ‘flooded with pirated products’ as the U.S. reports state? If giant foreign companies cannot protect their product from such pirating, what hope is there for a small or medium size foreign firm? Isn’t despair at a solution the only reasonable conclusion?

These surface impressions are completely irrelevant and misleading to the vast majority of foreign businesses operating in China. China has done an excellent job in establishing laws and creating an enforcement system for IPR protection. Largely for reasons of market structure and the technology of distribution, in the areas of patent, trademark and trade secret protection, the protection system has made substantial progress. Though there is substantial infringement in these areas in China, much progress is being made in combating such infringement and the registration, court and enforcement system has been reasonably effective.

On the other hand, in the area of protection of media distributed on DVDs and downloadable on the internet, progress in China has not been good at all. Again, largely for reasons of market structure and the technology of distribution, there has been little measurable impact on reducing infringement in this area.

Now, let’s go back to our scene on the streets of Shanghai. Why do I say that this obvious IPR piracy is not an issue for the vast majority of foreign businesses? What about all those folks who are selling pirated foreign brands (other than DVDs) on the street. First of all, these pirates have been driven from the retail outlets and are forced to sell their products on the street. They are not even permitted to operate pushcarts. Second, look carefully at to whom they are selling. They never approach a Chinese citizen. They only approach foreigners. This is because only foreigners are willing to purchase their inferior products. Chinese consumers are not that gullible. If you travel to Qingdao or Guangzhou or other cities with a low number of Western expats and tourists, you will find that street vendors selling pirated goods do not exist. This is because there are not enough foreign customers who want the product. It simply is not true that China is “awash in pirated goods.” In fact, this is a problem unique to cities with large foreign and expat populations. It therefore is simply irrelevant to foreign businesses operating in China.

Pirated DVDs, however, are available all over China and are purchased regularly by Chinese consumers who would never knowingly purchase a pirated luxury product like a coat or bag. The same stigma concerning prestige and quality simply does not apply to entertainment and software DVDs. Very little progress has been made in preventing the sales of such items over the past several years, in spite of major campaigns by the Chinese government. In this respect, the U.S. presentation of the situation on the ground is actually quite accurate. However, the vast majority of foreign companies are not selling a product in China that can be reduced to a DVD or internet download. Therefore, even though this issue is a major problem, it is simply not relevant to most companies doing business in China. It is a mistake to assume that China’s poor record in preventing infringement of media and software DVDs extends to the more common IPR areas of patent, trademark and trade secrecy.

For most foreign businesses, their important intellectual property rights (IPR) fall in the areas of patent, trademark and trade secrets. These IP rights can be quite effectively protected in China. However, the Chinese system, like the U.S. system, is a self-help program. Do not expect either the Chinese government or a foreign embassy to do the job for you.  You must do it yourself. This means making the proper filings and entering into the required agreements. It also means investing the time and money to locate infringers and then prosecute them aggressively. This process is a tough one. Unlike many other developing countries, however, aggressive protection of IP rights can succeed in China.

The greatest mistake is to do nothing.

The last week or so, we did a couple of “big picture” posts on China’s future. The first, “The Rise of Great Nations/What China Wants,” discussed how China seeks to shape its future as a great power. The second, “China And Yao Ming Rising?” discussed how China sees itself among nations now and its future. Both posts highlighted China’s rising confidence.

In a post entitled, “China Steps Up,” [No Longer Online] the Diligence China Blog analyzed how China’s increasingly confident view of itself will likely impact foreign businesses in China, and I found the following two points particularly salient:

If you’re not first, you’re last. Ok, I apologize for the Will Ferrell, Ricky Bobby reference, but the Middle Kingdom has always had issues when it comes to playing nicely with others. They pay lip service to the ‘joining the community of nations’ line that we all love, but China considers parity to be a milestone on the way to its true destiny. One aspect of China’s 4000 year cultural history is the notion that China stands between Heaven and the Barbarians of the Underworld. Guess which one you are? Look for Chinese companies to get more competitive as they prepare to go head-to-head with western MNCs. The Lenovo gambit has been a limited success, but HuaWei is looking like a winner. Chinese MNCs are going to go international in the developing markets first, and try to climb the value chain.

Will it make China market entry easier or more difficult? Maybe it’s counterintuitive, but a confident China will be easier to deal with. China seems to feel that it is coming into its own, and that its policy of “learning from the foreigners” is working out just fine. WTO has been a big hit for China, and we can expect Beijing to honor the treaty obligations for as long as the WTO stands. But SOEs [state owned entities] will be protected. Anyone looking for foreign involvement in TV, telecom, education or other culturally sensitive industries is in for a long wait. Entry will get easier but exit may be trickier. Look for China to be increasingly sensitive about profit repatriation and changes in corporate ownership. If you don’t have an exit strategy, you ought to drop a line to your international lawyer and start looking at a range of scenarios.

Much as I like the part about dropping “a line to your international lawyer,” I do not see China instituting new laws restricting profit repatriation. However, I do see China increasing enforcement of its existing laws relating to foreign business as I have already seen this happening in many areas (I received yet another call last week from a foreign consulting company in BIG trouble for doing business in China without having registered a WFOE to do so) and I see this only continuing to pick up. In China IP Protection Rising — Just As Predicted, we wrote about China’s stepped up legal enforcement of intellectual property rights and in URGENT ALERT: Register Your Company In China NOW, we wrote on how the government has mounted a crackdown on foreign businesses operating illegally.

I am skeptical China is going to toughen its corporate ownership rules beyond the M&A (mergers and acquisition), but I do agree with Diligence China in predicting Chinese companies will increasingly be developing their overseas business, particularly in emerging market countries like Vietnam.

China’s recently stepped up effort to root out foreign companies doing business in China without being registered to do so has caused a rash of China consultants to retain the China lawyers in my firm.

From our work in forming China WFOEs for these consultants, we have learned that many China consultants are falling dangerously short in various other legal aspects of their business as well. Indeed, if we were to single out the foreign businesses in China most often guilty of underestimating their legal risks, it would be China consultants. China consultants seem to have been in China so long that they have lost sight of the fact that when push comes to shove (or as we lawyers like to say, when a deep and easy pocket needs to be found) they are the American/European/Australian company that is going to need to answer for what happened. These China hands also fail to recognize how much China has changed in the last decade and that doing business in China today is just not the same as it was five years ago. Not even close. If you are a Western consultant hired by a Western company to assist in China, you must realize that if something goes wrong for your client you will be your client’s first choice for legal redress.

What can go wrong? And what can you as a China Consultant do to prevent or ameliorate it? Overall corporate planning to protect your personal assets is an absolutely necessary first step. Beyond that however, and more specifically to China, you can do a lot to protect your client and thereby protect yourself.

We have seen the biggest problems with sourcing consultants that assist in finding Chinese manufacturers. A typical sourcing project, might go like this:

  1. Western company retains a product sourcing consultant to find the best Chinese widget manufacturer in terms of cost/quality/dependability.
  2. Consultant requests and secures sample widget from manufacturer.
  3. Consultant meets with countless Chinese manufacturers in search of the best one.
  4. Consultant recommends company Z in China to manufacture 100 million widgets.
  5. Consultant is to be paid a percentage of the manufacturing costs.
  6. Company Z starts manufacturing the widgets.

By this point, I am guessing the sourcing consultants reading this are saying, “yes,” while the China attorneys out there are already apoplectic. Let’s deconstruct this hypothetical project and note where the consultant has potentially harmed the client and needlessly taken on huge liabilities for itself.

  • The sourcing consultant agreed to find “the best” widget manufacturer. Is that best in China or best in the world? What if the widget manufacturer charges one hundred dollars a widget for the 100 million widgets, but your client’s competitor finds another widget manufacturer who will do it for ninety dollars. Are you liable for the difference? Even worse, what if your client’s competitor gets the same Chinese widget manufacturer to do 100 million widgets for ten dollars less? Do you really think a US jury is going to believe you were doing your best when your fee was a percentage of the final costs? Are you responsible for the Chinese manufacturer’s late deliveries? For the Chinese manufacturer’s bad product?  Is it clear exactly what your percentage is going to be based and have you set things up so that your client cannot just go around you? The Solution: Use a well-crafted written contract to make clear exactly what you will and will not do. Put in a non-circumvention provision to make sure you get paid.
  • If you take a sample to China and start showing it to potential manufacturers without FIRST putting in place various safeguards, you are courting disaster. The sample could be used for counterfeiting. We had a consultant call one of our China lawyers in a panic after returning from China to learn that one of the manufacturers to which he had shown a sample had already started manufacturing the product for someone else using the consultant client’s trademark which it had gleaned from the Internet. The Solution: Never show a sample or product plan or reveal your trade name(s) without first making the Chinese manufacturer sign a China-centric NNN Agreement (essentially a hopped up NDA that protects against competition, circumvention and disclosure). Chinese manufacturers tend to be quite familiar with NNN agreements and if you give them a simple and reasonable one, in Chinese, they will sign it.
  • You the consultant must do more than simply negotiate the price and delivery dates or you should at least make clear in writing that these are your only tasks. Typically, product sourcing consultants oversee the OEM contract with the manufacturer and by doing so, they face major liability issues if that contract is not up to snuff. You are the “China guy” and your client is counting on you to guide it through China’s business minefields. You are the one who is supposed to know anything and everything about what it takes to do business in China. Equally importantly, with the manufacturing of its product, your client is probably turning over to the manufacturer all sorts of critical intellectual property. Your client probably thinks that its existing patents, trademarks and copyrights will protect it in China, but a court will expect you as the China expert to know better. The Solution: Put in writing with your client that you will not be providing it with legal advice and that it will need to retain its own lawyer to draft the OEM agreement with the Chinese manufacturer. Put in writing that it is your client’s responsibility to protect its intellectual property in China and that to do so, it must register its IP in China, either through a lawyer with whom you connect them or independently).

Just remember that your client sees you as the expert at doing business in China and it is looking to you for help in all areas and if you fall short in any way, you are at risk for a lawsuit.

China consultant, protect thyself.