Doing Business in China: Idiosyncratic Laws, Unwritten Customs, Unfamiliar Partners

Doing Business in China: Idiosyncratic Laws, Unwritten Customs, Unfamiliar Partners

For U.S. companies, China is rich with business opportunity but fraught with business risk. American companies seeking to cross this border need to invest time and energy in due diligence to avoid costly mistakes and possibly crippling loss of intellectual property. Apple learned this lesson in a headline-grabbing case that ended in a $60 million settlement last July over the sale of the iPad® mobile device in China.

Blindly entering into a joint venture without vetting your Chinese business partner, or failing to recognize the idiosyncratic nature of Chinese law and the sometimes “unwritten” Chinese customs that will creep into your transaction, will almost certainly bring a bad result.

That was the message from Andrea Charters, vice president and associate general counsel for Rosetta Stone, Inc., the Arlington, Va.-based language software-as-a-service company, and Dan Harris, founding member of Harris & Moure, PLLC, a boutique international law firm with attorneys in Seattle, Washington, and Qingdao, China, and publisher of the China Law Blog. Charters and Harris led a Webinar presented by LexisNexis®, mapping a course for American companies through the risks and benefits of doing business in China.

Charters kicked off program with the in-house lawyer’s perspective. Doing business in China, she said, means weighing the business opportunity in the context of the Chinese legal environment and the inherent risk of an unfamiliar market.

In initially evaluating the opportunity, “you need to take a look at proportionality,” she said. What proportion of the Chinese population is likely to purchase your product? While the Chinese population represents a vast number, “a lot of those people are not in the market for what your company is selling,” she added.

Having decided that the opportunity justifies the risk and expenditure of human capital required for the necessary due diligence, the next step is to evaluate the regulatory burden and follow a few critical rules for doing business in China: choosing the right Chinese business partner, identifying the interests you want to protect, properly structuring the deal, crafting the proper dispute resolution clause and employee contracts, and tackling the critical issues of IP registration– properly protecting your company’s patents, copyrights, trademarks and intellectual property.

Vet With Vigilance

Selection of your Chinese business partner, she said, is a pivotal choice. The partner holds the keys to market access and can navigate unfamiliar regulatory requirements. But partnering without vetting is dangerous, and a company should “expect to invest in getting to know your counter-party very seriously.” Do not go into a relationship without knowledge, she said.

Carefully consider deal structure. Charters noted that some industries require partial or even complete Chinese ownership of a venture. Companies may achieve the right structure by establishing so-called “variable interest entity” (VIE) structures in which an entity established in China is fully or partially owned by a non-Chinese company, through certain contractual or services arrangements. Structures may incorporate call options, proxy agreements, services agreements, loan equity pledges and other forms of contractual assurance to potential business partners. She suggested using Nexis® to scope out the latest developments on the business landscape and Lexis® to research the securities filings made by other companies in which they report their deal structures, in order to gain insight into how companies are structuring their transactions. VIEs, she added, are not necessarily the answer and in fact may be invalidated by the Chinese government.

A critical concern is identifying what your company needs to protect. Business assets, contractual relationships (with customers, suppliers, landlords, and employees), and, in particular, intellectual property, need to be in the forefront. Failing to protect intellectual property in one jurisdiction can jeopardize IP rights worldwide. Harris noted that deal structure is often a critical consideration when deciding how to protect a company’s intellectual property given the sometimes predatory environment in China. Joint ventures being inherently risky, companies should explore other structures. Can the intellectual property be licensed? Can the client go it alone and avoid a joint venture?

Companies need to vet their potential employees too. “You need to get to know the people you’re hiring in China,” Charters said. American companies will be surprised to learn that a written employment contract is the norm for all Chinese employees―otherwise, Harris explained, a company is required to pay two years’ salary to an employee it terminates. The contract should identify confidential information. China has sophisticated trade secret laws and Chinese courts will rule favorably for employers on confidentiality and trade secret cases. “Chinese courts do not look favorably on Chinese employees that seal IP,” Harris said. But to prevail on a trade secret claim the information must have commercial value and the company must have made reasonable effort to protect it. And―especially critical for R&D employees―the contract must provide that intellectual property developed by employees belongs to the company.

IP: A Constant Target

American companies accustomed to U.S. laws respecting intellectual property will find themselves navigating a minefield in China. Apple’s settlement in July 2012 with Proview Technology is a prominent example. In China, Harris said, you can “plan on someone making a play for your intellectual property.”

“If it is in the best interest of a Chinese company to take your IP it almost certainly will try to do so and the Chinese government to a large extent just goes along with this,” Harris said. He said at least half of Chinese contracts are written to make it clear that the Chinese company’s overriding goal is to take its business partner’s intellectual property and “then move on and cancel the deal.”

Moreover, Chinese courts are not comfortable with large damages claims and tend not to award lost profits, Harris noted, citing a case in which Nike won a “big victory” against a Chinese company selling “fake Nikes.” That award was $75,000. “Count on hometown favoritism operating against you,” he said. “It behooves you to act like every Chinese company is a threat to your IP.”

What can American lawyers expect when negotiating a deal in China? Harris laid out a few basic tactics. The Chinese side, he said, will urge that something be done in a particular way because “it is the law in China.” Why? To persuade the company to sign over its intellectual property, Harris said. He said that when he asks a Chinese counterpart to cite the law, “not once has the Chinese party come back with a real cite because there is no such law.” When a Chinese party refuses to sign a nondisclosure agreement, he advised, back away. “They intend to steal your IP.”

Other advice:

• Put all contractual provisions in writing. “Oral doesn’t cut it, email doesn’t cut it,” Harris said.

• Use one “official” language for the contract, but always translate the contract into Chinese to avoid disputes over terms later.

• Contracts with Chinese companies need to be written in “excruciating detail,” said Harris. American contract norms like “reasonable quality” and implied covenants are meaningless in China. An example of a dispute over product quality ended with this remark: “Well if they wanted bags with strong handles, they should have bought the $4 bags instead of the $3 bags.”

• Use liquidated damages. Chinese courts tend to enforce them. While the amount of liquidated damages may not be truly sufficient compensation for a breach, it provides an effective “hammer” for enforcement of contract terms. Do not select the United States as the forum for dispute resolution because, Harris said, Chinese courts will not enforce a U.S. judgment.

• Always have your contract with a Chinese counterparty sealed. Without the seal, the counterparty has room to argue that the party signing lacked the authority to do so. In addition, insisting on the seal signifies to the Chinese counterparty that the contract negotiator is savvy in Chinese customs and contract law and, Harris noted, “if they are inclined to get one over on you, this will make them run away for all the right reasons.”

• Often the Chinese courts are the best venue for your dispute, he said. Chinese companies understand them, understand the risk, and Chinese courts have more power than arbitrators, Harris noted. If a company elects arbitration, companies need to consider venue. Chinese companies never agree to arbitration in the United States. Alternatives are Vancouver, Toronto, Singapore, and Hong Kong. Specify the language to be used for the arbitration.

• Contracts with distributors, joint venturers, and licensees must be clear with respect to ownership of intellectual property. A party owning more than 50% of a joint venture does not necessarily control the entity, Harris cautioned. Rather, control derives from being able to name the managing director of the entity. Thus, a joint venture may acquire control of intellectual property, and may transfer the intellectual property out of the joint venture, divesting the American company of its valuable asset.

• All intellectual property should be registered. “If you haven’t done the proper IP registration, you pretty much have zero chance of protecting your IP,” Harris said. And, he noted, with regard to trademarks, “China is a first to file country, not a first to use company.” Therefore, the fact that a company is using a trademark affords it no protection if the trademark is not registered.

Key Takeaways:

1. Know your business partner. Invest the energy to know your counterparty in any Chinese business venture.

2. Identify the key proprietary information that your company needs to protect, and structure all contracts with joint ventures, employees, licensees, distributors, and others with an eye toward shielding these valuable assets from misappropriation.

3. Be wary of threats to your company’s intellectual property. Retain expert guidance for navigating the cultural and legal differences between China and the United States. Do not assume that protections that are taken for granted in the U.S. will exist in China.

Listen to the recording of the Webinar: Working With China: Essentials for In-House Counsel Protecting Intellectual Property, Negotiating Deals and Drafting Employee Contracts