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Quick Question Friday, China Law Answers, Part XVIII

By Dan Harris on Posted in Basics of China Business Law, China Business

China and the Middle Income TrapBecause of this blog, our China lawyers get a fairly steady stream of China law questions from readers, mostly via emails but occasionally via blog comments or phone calls as well. If we were to conduct research on all the questions we get asked and then comprehensively answer them, we would become overwhelmed. So what we usually do is provide a super fast general answer and, when it is easy to do so, a link or two to a blog post that provides some additional guidance. We figure we might as well post some of these on here as well. On Fridays, like today.

One of the more common questions our China lawyers get asked is whether it is “safe” for someone to go to China. Usually the question is something like the following:

I was a manager/managing director/general director/sole employee with such and such WFOE/Rep Office/JV a couple of years ago when the company just up and left China without closing it down properly. Is it now safe for me to go back to China? What could happen to me if I do go?

What’s often so interesting about these questions is that they are coming from someone who thought at the time of the company closing that he or she would never be returning to China. And now they are all but forced to do so with their new company or even in a governmental capacity.

My standard answer is anything but comforting, and it is usually is something like the following:

Our China attorneys can spend all kinds of hours researching the laws on this but in the end, it is probably just going to come down to whether you are on any lists or not, either with Beijing or with the city in which your entity was located. And if you are on just a list for the city in which your entity, it is impossible to quantify your risk if you do not go to that city. We do not have a good way to determine on what lists, if any, you might be. And as for what will happen to you if you are “picked up,” we don’t really know that either, because we have heard of people cutting pretty good deals and being able to return without problems and we have also heard of people having to pay all back taxes, plus interest, plus penalties. About all that I can tell you is that if it were me I would not be going.

See Closing Down a China Company, You Can Run But You Can’t Hide, Part 2 and Closing Down a China WFOE: You Can Run But You Can’t Hide (Part 1).

What have you seen out there?

China Company Formations: Are You The 10%?

By Dan Harris on Posted in Basics of China Business Law

China WFOE formationChina is cracking down on foreign companies doing business in China without a company. This is causing many companies that probably should have formed a China company years ago, to seek to form one now. With this increase in “last-minute” company formations, we are getting a (probably) disproportionate number of calls from companies whose China company formations were botched.

Let me begin by noting that there are many very good entity formation companies that help foreign companies form China WFOEs and Representative Offices. Unfortunately, there are also many really bad and even dishonest such companies. It is not always easy to spot the incompetents and the crooks, but generally, if they do the following, the odds are good that they are either bad or incompetent (or both):

  1. Act as though every China company formation is the same. See How to Form a WFOE in China.
  2. Assure you that they can form a WFOE in two months (no matter what). Forming A China WFOE. How Long Will That Be Going On?
  3. Brag about how low they can get your registered capital. How to Form a WFOE in China: The New Minimum Capital Requirements
  4. Act as though they have some “special” ability to get things done in China because they are “well-connected” or have “guanxi.” See China Guanxi: You Don’t Have It.
  5. Push you into forming a Representative Office and not a WFOE, without really analyzing what you need .See The China Representative Office (RO). Got WFOE?
  6. Push you into forming a WFOE and not a Representative Office, without really analyzing what you need.
  7. Push you into forming any China company at all, without first determining whether you have other better options. See How to Form a WFOE in China, Part 12: Do You Really Even Need One?

Unfortunately, I am noting an increase in companies contacting our China lawyers after having their China company formations have been botched, in the following two very different situations:

  1. The companies are reaching out to us because their company formation is “taking forever” or because it was rejected.
  2. The companies are contacting us to represent them on something like employee contracts or vendor contracts and in our discussions with them, we learn that the company was set up improperly in China.

The problems we see are all over the map, some of which can be solved and some of which cannot. When we get one that cannot be solved, we suggest that the potential client literally start all over with its China company formation or shut down and cease doing business in China. We see problems with company scope, ownership, directorships, and even with the wrong sort of company having been formed.

Many years ago, in I wrote about my firm having referred out a relatively routine domestic matter for one of our clients because we did not think we were the right firm for the project:

We told them we do not handle such matters and we gave them a short list of excellent attorneys that do. The client expressed surprise at our unwillingness to take on their matter and remarked on how this area of law is “so easy.” I told them that it is “easy” 90% of the time, but difficult the other 10% of the time and that we only knew enough to be able to know half the time when we would be delving into the other 10%. In other words, we would probably have a 5% error rate and that precluded us from taking on such matters.

Yesterday, the client called to thank us because its matter was one of the ten percent. Though both the client and I had assumed the client needed A, it turned out that it was actually in the 1% that actually would be much better off going with B.

In that post, I emphasized how the percentages above were guesstimates used to make the point that many things lawyers do appear to be and in fact are fairly routine. But for any given project there is usually the ten percent, and it is that ten percent that can cause the problem.

Our China lawyers tend to see a large number of the” ten percent” because nobody calls us to say, “I just did this and it all worked out fine, can you help me?” Our typical call is more like “I have this problem with the Chinese government. Can you help me?”

Forming a company in China is a great example of the 90-10 rule, both because many are not aware of the 10% that lurks within and because the problems that arise from this lack of awareness can be huge.

Ninety percent of the time (another guesstimate), forming a WFOE or an RO in China is not that complex. But it is the ten percent that will kill you.

Here are some of the ten percent issues relating to China company formation on which we have been called:

  • A company that had been locally approved for its WFOE to do XYZ was being shut down by Beijing 15 months after its formation because WFOEs cannot do XYZ in China. The “funny” thing about what this company was doing was that if it had defined its scope a bit differently in its WFOE application, it would have been legal and it very likely would not have been shut down.
  • A company that formed a Representative Office in China and then was told around three months later that it was operating completely illegally and would need to shut down. The company clearly should not have been set up as a Rep Office and when I asked why they had done so, they told me it was because it was cheaper than opening a WFOE. They had never consulted an attorney on the differences between Rep Offices and WFOEs; they had simply told an entity formation company to form a Rep Office. The twist on this is that we are now getting many calls from companies that were formed as Rep Offices (legally) looking to form a WFOE because their operating costs (because they are a Rep Office) have become so high for them.
  • Countless calls from companies whose WFOE or RO application has been declined or gotten stuck in the system. We consider these people lucky because what has happened to them beats getting approved locally and then getting shut down by Beijing. For them we formulate a plan to reinvigorate their existing application or to start all over. Once a company starts having approval problems, a red flag gets attached to them and so even if they completely clean up their act, they will be subject to increased Chinese government scrutiny. For this reason, we often recommend starting all over, using a new foreign company as the ownership entity. This is not always possible with Rep Offices because they require ownership by a company that has been existence for at least two years and even certain kinds of WFOEs (advertising for example) that also require prior longevity.

Are you the ten percent? How do you know?

Four Best Books on China Business

By Dan Harris on Posted in China Business, Recommended Reading

Best China Business BooksClub China (KLM Airline’s China focused website) came out today with a list of the four best books on China business. It describes its list as follows:

Are you planning your China business venture? Or have you been in China for years, and find yourself still hungry for knowledge? Our Club China editors have compiled their list of best business books about China. Some have been published fairly recently, others are classic but still immensely popular. Please enjoy our ‘Must-reads about China’.

Its list consists of only four books, all but one of which (the One Hour China Book being the exception) I have read and recommend very highly. I am writing this post on an airplane (heading to New York to speak on China tomorrow at Cardozo Law School and having someone on the ground fill in the links) with marginal internet, but I have a nagging feeling, actually a certainty, that though my list would most emphatically include the three books I have read, it would also most emphatically include some more. So to me this list is not necessarily THE four books you must read or even the best four books for those looking for more information on doing business in China or with China, but rather, four great books for that purpose (I have heard nothing but good things regarding the One Hour China Book).

So without further ado, I give you the KLM list, with my own comments following the quote.

China CEO. By Juan Antonio Fernandez and Laurie Underwood. KLM has this to say about China CEO:

There is nothing like learning about business successes and failures from the very people that experienced them….Twenty top executives and eight experienced consultants based in China offer their first-hand, front-line advice….China CEO is full of such sound advice about subjects like managing Chinese employees, leaderships styles and negotiating with the Chinese Government.

Way back in 2009, in a short article I wrote for Forbes Magazine, entitled Best 10 Books on China, I listed China CEO and had this to say about it: China CEO is a technical collection of interviews with CEOs on how to conduct business in China.

One Billion Customers, by James McGregor, of which KLM has this to say:

The author is a former Wall Street Journal China bureau chief who became a successful corporate executive. One Billion Customers … offers compelling narratives of personalities, business deals, and lessons learned….The book offers a great number of interesting case studies, including a rocky joint venture between Morgan Stanley and a Chinese bank; the rise and fall of a Chinese peasant turned billionaire smuggler; Rupert Murdoch’s travails in bringing a satellite TV network to China; and a muck-raking Chinese financial journalist’s battles with both government censorship and the private media’s cozy relationships with advertisers.

I also listed this book in my Forbes article with this to say about it: “How big business gets done in China.”

China’s Super Consumers, by Savio Chan and Michael Zakkour, of which KLM has this to say:

The subtitle of the book Chan and Zakkour wrote says it all: What 1 Billion Customers Want and How to Sell it to Them. It explores the birth of consumerism in China and explains who these super consumers are. The authors explain what’s inside the minds of Chinese consumers, what they buy, where they buy, how they buy, and most importantly why they buy….The authors offer real stories of the kind that entrepreneurs can never get enough of: how was it done, why did it work, where did it fail….The book takes its readers inside the boardrooms of the people who understand Chinese consumers and have had success in the Chinese market.

I reviewed this book when it came out in 2014, and if you will forgive me a bit of bias because it quotes me a couple times on the legal side of doing business in China, I think this book makes for a superb primer on how to do business in China. Back then I described it as “a great book and I highly recommend it for anyone with a product or a service that is being sold or could be sold to China’s consumers. It is also a very good book for any foreign company doing business in China or looking to do so.” I certainly stand by that review now.

The One Hour China Book, by Jonathan Woetzel and Jeffrey Towson, about which KLM has this to say:

If you are more a doer than a reader, this one is for you. In just 132 pages, two Beijing university professors take you on a quick tour of China business life. There are just six stories in this book and they happen to be pretty good. This “quick-read” offers the distilled knowledge of two Beijing university business professors with over 30 years of experience on the ground in China and emerging markets….Each chapter is condensed into a handful of key points/statements which help the reader to understand and remember the underlying mega trend.

That’s it. Those of you on the ground who wish to add additional books to this list, please do so via the comments below. I am still working on a massive “best reading materials on China” list and I continue to welcome suggestions for that as well.

Getting Money out of China: The Movie

By Matthew Dresden on Posted in China Business, China Film Industry

Getting money out of ChinaThe 40th Annual UCLA Entertainment Symposium took place this past weekend, and in recognition of the Chinese film market’s meteoric expansion, the symposium for the first time devoted an entire panel to China. The panel featured three high-powered Chinese film execs: Eric Rong, President of TIK Films, Jay Sun, Chairman and President of Pegasus Media Group, and Simon Sun, Executive Vice President of Le Vision Pictures (USA).

The panelists were uniformly positive about the future of US-China film cooperation and mutual investment, but the most interesting exchange (to me) was when they addressed the question of Chinese currency restrictions. The panelists agreed that getting money out of China was difficult and becoming more so, and commented on two general solutions. First, Chinese companies with substantial cash reserves in China can set up a credit facility with an international bank with a US presence; Rong said that this is what TIK Films’ parent company Hunan TV did with East West Bank (e.g., to finance its big deal with Lionsgate). Second, Chinese companies can set up a Hong Kong company and send money from that company, as Hong Kong dollars are freely convertible; this is what Pegasus does, according to Jay Sun.

These solutions are sophisticated, appropriate and (not surprisingly) in line with how we often advise our entertainment (and other) clients. A word of caution, though: these approaches will only work as long as the Chinese government allows them to work. Yes, Hong Kong doesn’t have currency restrictions, but companies still need to get the money to Hong Kong in the first place, and that  requires pretty much the same approvals as sending money to the US directly. Alternately, Chinese companies can get money to their Hong Kong company by requiring that customers send payments to Hong Kong for goods or services provided in China. This is perfectly acceptable—so long as the Chinese companies have secured prior Chinese government approval for the Hong Kong bank account and report and pay taxes on such payments. I think you can guess how often that happens. The Chinese tax authorities haven’t been overly assiduous about enforcing these restrictions over the past several years, but I would be surprised if that didn’t start to change.

To give you an idea of how often these Hong Kong bank accounts are set up legally, many years ago we represented a very large publicly traded U.S. company that had just bought a China WFOE. All twenty of the WFOE’s major China-based suppliers were getting paid in Hong Kong. Our client did not like this, because it felt it might be seen as facilitating tax evasion. So our client requested that the suppliers provide proof that their Hong Kong bank accounts had been approved by the Chinese government. We got the following responses:

  • 4-5 said, “Are you kidding? Everybody does this and no one gets approval.”
  • 4-5 said “Are you kidding? I’m not going to send you any documents.”
  • 4-5 sent us non-responsive documents they apparently thought we would take to be Chinese government documents allowing them to open a bank account in Hong Kong.
  • The remainder just ignored our request.

Not a single one of them produced a shred of evidence that their Hong Kong bank account had been approved by the Chinese authorities.

Another common method of converting RMB to dollars (not mentioned by the panelists because it isn’t relevant to the financing of major studio films) is the “exception” that allows each Chinese individual to send $50,000 overseas each year. Wealthy Chinese individuals seeking to fund a movie or Broadway show, purchase real estate, or invest in an EB-5 project have taken advantage of this loophole by recruiting a gaggle of people in China to send money on their behalf. This process, known as “smurfing,” has been widely used for years. I’ve met multiple people at the US-China Film Summit who proudly told me their entire business model was based on facilitating these payments. At dinner the other night, an acquaintance told me about a Chinese factory owner he knew who had required 200 of his employees to send $50,000 each to the United States. But smurfing is legally questionable and the Chinese government is claiming down on this as well. As my colleague Steve Dickinson observed in a recent interview with Bloomberg Business, banks are sometimes refusing such transactions by saying they simply don’t have any dollars available.

Long story short, we can expect to see more US-China film deals fall through for lack of funding, and it won’t necessarily be the fault of the Chinese company. Simon Sun referred to a piece in the Los Angeles Times last year (presumably this one) about the large number of US-China deals that had fallen apart because the money never came through. Sun stated that the article was true, but biased – deals have been falling through as long as Hollywood existed – because the legitimate Chinese companies are real (and have real money). I couldn’t agree more. But it’s often hard to tell who’s for real, which makes both due diligence and the way the deal is structured more important than ever.

IP in China’s Entertainment Industry — The Big Issues: an AmCham China Panel, Beijing, Monday March 21st

By China Law Blog on Posted in China Film Industry, Events
Come to AmCham's Media and Entertainment event on March 21 in Beijing

AmCham Media and Entertainment event on March 21 in Beijing

 

AmCham China’s Media & Entertainment Forum is putting on a what is sure to be a great panel in Beijing on Monday March 21, from 12:00 p.m. to 2:00 p.m.: IP in China’s Entertainment Industry — the Big Issues.

AmCham describes the event as follows:

The rapid growth and increasing sophistication of China’s entertainment industry present both challenges and opportunities to foreign businesses. Foreign owners of audiovisual content confront a range of complex IP issues. Many of these are particular to the Chinese market. Come hear our panel of experts discuss the big picture as well as delve deeply into such issues as:

  • How an IP case winds its way through Chinese courts
  • Recent examples of Chinese IP litigation in US courts
  • How takedowns work
  • Format protection
  • When you can (and should) litigate around IP issues
  • Emerging IP trends within China’s entertainment industry”

Mathew Alderson, who heads up our China media and entertainment practice out of our Beijing office and is a co-chair of the AmCham Media and Entertainment Forum, will  be one of three panelists, along with Joel Blank, IP Attaché for China at US the Embassy, Tom Duke, Senior Intellectual Property Liaison Officer at the UK Embassy. Kristian Kender, Managing Director of China Media Management Inc, and the other co-chair of AmCham’s Media and Entertainment Forum, will be the moderator.

Please go here to learn more about the seminar and go here to register

If you’re going to be in Beijing on Monday March 21, you should get along to AmCham for this great panel.

Buying Stock in China’s Publicly Traded Companies: Good Luck With That

By Dan Harris on Posted in China Business

China attorneysI am a China lawyer.

That means I am not a China expert, not a China investment advisor and not a China stock analyst. So when I tell you that I have never invested in a publicly traded Chinese company and I cannot see myself ever investing in a publicly traded Chinese company, you should (and you probably will) completely ignore me and not change your behavior in any respect.

But I am going to ramble about China stocks in this post anyway.

What has spurred this post (and my rambling) is having just read a post on the always superb China Accounting Blog, by Paul Gillis, PhD/CPA Professor at Peking University’s Guanghua School of Management and the person who knows more about China accounting practices than pretty much anybody. Paul’s post cites to and agrees with another blog post, one written by Dan David at GEOInvesting, entitled, EB-5: The SEC Has Done an Amazing Job Protecting Chinese Investors – Will China Return the Favor? The GEOInvesting post bemoans how the United States Security Exchange Commission (SEC) does a great job protecting Chinese investors from getting ripped off in EB-5 investor scams but pretty much nothing to protect US investors in Chinese stocks:

As David points out in his post, the only CEO to be jailed for defrauding US investors was Dickson Lee of L&L Energy. Lee, however, was a US citizen and was arrested on US soil, so Chinese authorities could not protect him.

Perhaps the most egregious case was Ming Zhao of Puda Coal, who faces a $250 million judgment from the SEC for ripping off U.S. shareholders. But Chinese authorities have not helped the SEC to enforce the judgment, and instead elevated Ming Zhao to the Eleventh Standing Committee of the Chinese People’s Consultative Congress. I guess he is viewed as a model comrade.

Now we have the case of ZTE which was recently accused by the Commerce Department of circumventing export restrictions by selling products with sensitive American technologies to Iran, despite having agreed to the export restrictions. The US actions likely make it difficult for American companies to serve as suppliers to ZTE. China has screamed foul, saying the US actions would severely affect the normal operations of Chinese companies.

There was also the recent case where the Bank of China’s New York branch refused to comply with a US court order to turn over customer information related to a counterfeiting case. After facing $50,000 a day fines, the Bank of China relented and turned over the information.

Gillis sees Chinese regulators as “playing US regulators for fools. They are protecting Chinese fraudsters and thereby creating a safe harbor for those who wish to commit fraud against US investors. At the same time, they welcome application of the rule of law in the US to protect Chinese investors. US regulators are letting them have their cake and eat it too.”

Gillis then discusses how the “SEC has been unable to bring Chinese fraudsters to justice; as long as they stay in China they remain outside of the grasp of US regulators. China has shown no interest in prosecuting Chinese fraudsters for crimes committed in China that are clearly crimes in China, apparently on the basis that victims of the crimes were not Chinese. And US regulators have had little success in getting cooperation from Chinese regulators at bringing the fraudsters to justice in the United States.”

But Gillis believes that if the US actually started getting tough with China stock fraudsters, we would start seeing results:

What China is doing is a version of the poker strategy of shooting the angles. In poker, angle shooting is the act of using various underhanded, unfair methods to take advantage of inexperienced opponents. The difference between angle shooting and cheating is simply a matter of degree.

The SEC and PCAOB should take a lesson from the Bank of China case. When the pain was great enough, China backed down and produced the documents. The SEC got a partial victory against the Big Four accounting firms in China when it threatened to ban them because China would not allow the production of documents. I believe that if the SEC/PCAOB can make a credible threat that they will kick Chinese companies off US exchanges they can get China to prosecute fraudsters who rip off US shareholders, to help recover funds, and to properly regulate auditors and listed companies.

Dan David asks one key question: Why is it illegal in the U.S. for fraudsters to steal from Chinese investors, but in China fraudsters are not prosecuted for, stealing from U.S. investors?

Guess what? They are both right. It is very easy for Chinese companies to engage in stock fraud without repercussions. Our China attorneys see this all the time, as hardly a month goes by without someone contacting us to see if we might be interested in pursuing a stock fraud claim against XYZ Chinese company. The problem is that unless XYZ is still operating in the United States (or in Canada, which faces many of the same issues) or purchased American insurance that might cover the fraud claims (which is not likely), these just do not tend to make for great cases, because there is no money pot at the end of the proceedings.

So if you are buying (most) Chinese stocks, you are on your own. In other words, caveat friggin emptor baby. And that (plus the fact that we rarely see a Chinese company with fewer than three sets of books) is why I will not buy Chinese company stocks.

Your thoughts?

Quick Question Friday, China Law Answers, Part XVII

By Dan Harris on Posted in China Business

China and the Middle Income Trap

Because of this blog, our China lawyers get a fairly steady stream of China law questions from readers, mostly via emails but occasionally via blog comments or phone calls as well. If we were to conduct research on all the questions we get asked and then comprehensively answer them, we would become overwhelmed. So what we usually do is provide a super fast general answer and, when it is easy to do so, a link or two to a blog post that provides some additional guidance. We figure we might as well post some of these on here as well. On Fridays, like today.

In the last couple of weeks I gave a rash of interviews (see here and here) which have been picked up by quite a few very popular Chinese and Vietnamese language websites. This has — believe it or not — led many people to send me multi-question emails seeking my views on the housing market in various cities (so far, Vancouver, Los Angeles, New York, and Paris) and whether it will be possible for them to get their money out of China to buy properties, along with emails from realtors asking me (for free of course) to tell them how to help their Chinese buyers get their money out. My response to the emails asking me to determine housing prices (and even to tell them whether they should buy in one city or another) is to say that I have no clue and if I did know the answers, I would charge them a fortune for the advice. As for how to get money out of China, I give the typical lawyer answer: I would need a lot more facts and then I would need to conduct extensive research.

Our China lawyers often get really deep, complex questions, to which my answer is usually, “I have no idea.” These questions usually come via email and they range from someone asking whether such and such industry would be a good investment to whether they should do a deal or buy a product from such and such Chinese company (which 99 times out of 100, I have never heard of), to whether I think China will eventually surpass the United States (to which I like to reply by saying in what?) to where we think China’s economy is headed in the next six months/one year/indefinite period (to which I reply by saying that if I knew I would be an investment advisor, not a China attorney).

My favorite economy-related question of late is the broad-brush one, of which the following is fairly typical (it’s a combination of two very similar e-mails):

I have to write a paper for __________ Community College and so would you please answer the following questions for me:

  1. How does China’s economy compare to the United States? Have their been any changes in the last five years?
  2. Do you see China going past the United States and when?
  3. Is China’s economy better or worse than the United States?
  4. What does China need to do to keep growing so fast?
  5. Does free trade help China?

I responded by 1) not criticizing the incredible vagueness of the questions and 2) simply saying that the questions should be going to an economist, not me.

But about ten minutes ago, I got an email from a friend (an old China hand) who pointed out how we have many times in the past together expressed our skepticism about China’s economy continuing to grow and, most importantly, whether China has what it takes to “escape the middle income trap.” My friend concluded his email by asking me if I thought that what is happening with China’s economy today is “nothing more than China having hit against the middle income ceiling.” My response was, “great question. In fact, such a great question, I am going to answer it on the blog right now.”

So here goes.

Way back in 2010, In China, Malaysia, Korea And The “Middle Income Trap”, I first wrote about the middle income trap, defined as follows:

I just learned a new term today that I know I will be using frequently in the future. The term is “middle income trap” and it crystallizes some of my previously discombobulated thoughts I have had regarding economic development. Let me explain.

This new term (for me) comes from a post by Michael Schuman on Time Magazine’s Curious Capitalist blog, entitled, “Escaping the middle-income trap.” The post focuses on how Malaysia’s economic growth has been so consistently strong since World War II, yet has been slowing over the last few years and of how Malaysia just cannot seem to break into the league of developed nations. Schuman defines this “trap,” as follows:

I returned a few days ago from Kuala Lumpur, the capital of Malaysia, where the talk of the town – well, at least among economists — is the “middle-income trap.” What’s that, you ask? A developing nation gets “trapped” when it reaches a certain, relatively comfortable level of income but can’t seem to take that next big jump into the true big leagues of the world economy, with per capita wealth to match. Every go-go economy in Asia has confronted this “trap,” or is dealing with it now. Breaking out of it, however, is extremely difficult. The reason is that escaping the “trap” requires an entire overhaul of the economic growth model most often used by emerging economies.

The concept behind the “middle-income trap” is quite simple: It’s easier to rise from a low-income to a middle-income economy than it is to jump from a middle-income to a high-income economy. That’s because when you’re really poor, you can use your poverty to your advantage. Cheap wages makes a low-income economy competitive in labor-intensive manufacturing (apparel, shoes and toys, for example). Factories sprout up, creating jobs and increasing incomes. Every rapid-growth economy in Asia jumpstarted its famed gains in human welfare in this way, including Malaysia.

However, that growth model eventually runs out of steam. As incomes increase, so do costs, undermining the competitiveness of the old, low-tech manufacturing industries. Countries (like Malaysia) then move “up the value chain,” into exports of more technologically advanced products, like electronics. But even that’s not enough to avoid the “trap.” To get to that next level – that high-income level – an economy needs to do more than just make stuff by throwing people and money into factories. The economy has to innovate and use labor and capital more productively. That requires an entirely different way of doing business. Instead of just assembling products designed by others, with imported technology, companies must invest more heavily in R&D on their own and employ highly educated and skilled workers to turn those investments into new products and profits. It is a very, very hard shift to achieve. Thus the “trap.”

Schuman went on to write on how South Korea is “probably the best current example of a developing economy making the leap into the realm of the most advanced.” Schuman did not see Malaysia making the leap. Its companies are not innovating. Its private investment is declining and it spends almost nothing on R&D. “If Malaysia is going to break the “trap,” it has to reverse all of these trends.”

Though both Korea and Malaysia relied on exports to generate growth, they did so differently. South Korea created homegrown, internationally competitive industries. “Korea is where it is today because its private companies have been working on getting there for a very long time, backed in full by the financial sector and the government.”

Malaysia, on the other hand, “relied much, much more on foreign investment to drive industrialization. That’s not a bad thing – multinational companies provide an instant shot of capital, jobs, expertise and technology into a poor country. MNCs, however, aren’t going to develop Malaysian products; that has to take place in the labs and offices of Malaysia’s private businesses. But those businessmen have been content to squeeze profits from serving MNCs and maintaining their original, assembly-based business models.”

I concluded this post by comparing Malaysia and Thailand to mid-sized law firms, but I intentionally did not discuss China’s ability to make the leap, mostly because it was during a period when I was worried that doing so would have wall-like (if you catch my drift) repercussions:

Malaysia and Thailand remind me a bit of the mid-size law firm. I can understand hiring the big firm for the big deal or the big case requiring a massive number of associates or legions of highly specialized partners. And I can understand hiring a highly efficient and focused small firm. But I rarely understand hiring the mid-sized firm, which usually tries to price itself along the same lines as the big firms, but without the corresponding depth or expertise. Why bother? And nothing against either Malaysia or Thailand, but I think many businesses have asked themselves this very question.

I returned to the subject again in 2012, in Will China Escape the Middle Income Trap? In this post, I wrote briefly about a hugely influential talk I had recently seen:

I was on a panel this past weekend at the Wharton China Forum 2012 and while there I had the opportunity to listen to a great lecture by world-renowned economist, Augusto Lopez-Claros. I asked Professor Lopez-Claros whether he thought China would be one of the rare countries that breaks through the middle income trap and his answer was a resounding “it’s possible.” He then went on to note how only five countries have really done that and become developed: South Korea, Japan, Singapore, Hong Kong and Chile. I’m not even sure Singapore and Hong Kong are even large enough to count. I am not prepared to say that China will not be able to burst through the middle income trap, but I will say that I think those who just assume that it will are ignoring all sorts of things.

In 2013, I raised the same issue again in Will China Avoid The Middle Income Trap? Four Ways To Make That Likely. That post focused on a Wall Street Journal article listing out the four things Asian countries need to do to escape the middle income trap:

The Wall Street Journal’s Real Time China Blog just came out with a post, entitled, Four Ways Asia Can Avoid the ‘Middle-Income Trap’ setting out what Asia’s emerging economies (“defined by the International Monetary Fund as China, India, Indonesia, Malaysia, the Philippines, Thailand and Vietnam) must do to avoid getting “trapped.” The post is based on an IMF report that came out earlier this week in which IMF economists suggest four ways to avoid that”:

  • Invest in infrastructure. IMF analysis suggests that subpar infrastructure is a key factor that can check an emerging economy’s growth. India, the Philippines and Thailand are particularly exposed in this area and should focus on building new and upgrading existing public transit systems, freight channels, ports and energy infrastructure.
  • Guard against excessive capital inflows. Money flows from abroad can energize an economy and give domestic consumption a boost, but can send an economy south if investors retreat in a hurry. Policy makers should have macro-prudential controls in place to mitigate potential rapid outflows, the IMF said.
  • Boost spending on research and development and post-secondary education. Both are needed to foster the innovation that’s a hallmark of advanced economies. Malaysia and Thailand have the highest college enrollment rates among emerging Asian economies, but China is rapidly catching up, according to IMF data. China far outstrips other developing Asian countries on R&D, with 2009 spending at more than 1.5% of GDP.
  • Get more women into the workforce and raise the retirement age. Aging populations are a problem in much of Asia. Governments can take steps to reduce “dependency ratios” by raising the age when workers are eligible for pensions and encouraging girls to enter university and vocational training.

I ended the post with a series of questions:

It is an interesting list, but I wonder how predictive it really is. If it is accurate, my sense is that China will do quite well over the next 50 years. But is it accurate? Are these four things really enough? And is China doing a good job with the above four things? What about economic reform? What about rule of law? What about IP protection? What about innovation? What do you think?

Just for the fun of it, let’s analyze whether China in fact has done the four things it “needed” to do.

First, China has invested in infrastructure. I do not think this can be disputed. Yes, you can say that they spent too much here and not enough there, but overall, China has invested in infrastructure.

Second, it’s not clear to me what constitutes “excessive capital inflows” and so I do not really know whether China is guilty of that or not.

I do not think China meets the third requirement of research and development. I say this because I am always shocked at the unwillingness of Chinese companies (including the biggest and the best of them) to truly invest in R&D the way American, Japanese or European companies do. Yes, Chinese companies claim to invest in R&D, but what I mostly see is that they spend way too little, are unwilling to bring in the really top people from around the world to help, and then they fail. And after they fail, they shop around and pay for the technology from a non-Chinese company. Now mind you, I am absolutely not complaining about this at all. In fact, I revel in this because one of the fastest growing areas of my law firm is drafting the technology licensing agreements that make these technology transfers possible. And I believe this number three is the most critical component in a country “making the leap” from middle income to developed.

I think China has done a decent job with item number four.

So then back to the big question. Is the state of China’s economy right now going to be a perpetual condition because it is merely the result of China’s not having the “whatevers” in place to allow it to go from being a middle income country to a developed one? Sorry, but you should ask that of an economist.

But what do you think?

 

Getting Money Out of China: The Reality Has Changed

By Dan Harris on Posted in China Business
China is putting foreign currency outflows under a magnifying glass

China is putting foreign currency outflows under a magnifying glass

 

Got a call the other day from a U.S. law firm that frequently uses our China lawyers to consult on litigation matters involving Chinese companies. The law firm was initially calling to see about our serving a Chinese defendant in a products liability action.

First thing we did was to tell them how until recently we had a 100% success rate in serving Chinese companies with process via the Hague Convention, but that our strong sense was that “the rules on that had changed.” We explained how China right now is making great efforts to prevent foreign currency from leaving the country and the possibility of a Chinese company losing a lawsuit outside China meant the possibility of foreign currency needing to leave China. And for that reason, we have over the last few months been encountering China service of process issues where none existed previously.

The above is just one of the many ways the rules of conducting business with China (legal business in the above instance) have changed due to China’s efforts to block or at least slow down a foreign currency exodus.

We first wrote about China’s newish foreign currency restrictions in Getting Money out of China: What the Heck is Going on? In that post (written on January 14), we wrote how “in the last week or so, our China lawyers have probably received more ‘money problem’ calls than in the year before that. And unlike most of these sorts of calls, the problems are brand new to us. It has reached the point that yesterday I told an American company (waiting for a large sum in investment funds to arrive from China) that two weeks ago I would have quickly told him that the Chinese company’s excuse for being unable to send the money was a ruse, but with all that has been going on lately, I have no idea whether that is the case or not.”

We then said that the common theme we were detecting was that “China banks seem to be doing whatever they can to avoid paying anyone in dollars.” We then listed how the following examples we were seeing and hearing about:

1. Chinese investors that have secured all necessary approvals to invest in American companies are not being allowed to actually make that investment. I mentioned this to a China attorney friend who says he has been hearing the same thing. Never heard this one until this month.

2. Chinese citizens who are supposed to be allowed to send up to $50,000 a year out of China, pretty much on questions asked, are not getting that money sent. I feel like every realtor in the United States has called us on this one. The Wall Street Journal wrote on this yesterday. Never heard this one until this month.

3. Money will not be sent to certain countries deemed at high risk for fake transactions unless there is conclusive proof that the transaction is real — in other words a lot more proof than required months ago. We heard this one last week regarding transactions with Indonesia, from a client with a subsidiary there. Never heard this one until this month.

4. Money will not be sent for certain types of transactions, especially services, which are often used to disguise moving money out of China illegally. This is not exactly new, but it appears China is cracking down on this. For what is ordinarily necessary to get money out of China for a services transaction, check out Want to Get Paid by a Chinese Company? Do These Three Things.

5. Get this one: Money will not be sent to any company on a services transaction unless that company can show that it does not have any Chinese owners. The alleged purpose behind this “rule” is again to prevent the sort of transactions ordinarily used to illegally move money out of China. Never heard this one until this month.

Then again exactly a month later, we wrote Getting Money out of China by Losing in Arbitration about a company that wanted to use our law firm to plot out a fake U.S. arbitration that it would lose so it could then get a large sum of money out of China as payment on the arbitration award. The Wall Street Journal then interviewed me on this incident for its own story, China Capital Flight 2.0: Lose A Lawsuit On Purpose, which in turn was picked up by the Chinese media and Internet and pretty much went viral from there.

Not much has changed.

Earlier this week, Canada’s National Post did a story, Crackdown on Chinese capital flight ‘will impact’ local real estate, quoting me on how China’s crackdown on foreign currency outflows would necessarily impact the influx of Chinese real estate buyers in Vancouver:

Much of that money was destined for hot West Coast real estate markets from Vancouver to Los Angeles. In Vancouver it’s debated whether President Xi Jinping’s government can stop the flood.

Seattle lawyer Dan Harris ­— an expert on facilitating trade with Chinese businesses — said that since January, China has aggressively clamped down on capital flight.

Harris said U.S. realtors are calling his firm more and more often for help in getting cash out of China for luxury home sales that were easily completed in the past.

“That will impact real estate in Vancouver and Seattle,” Harris said in an interview.

“If anyone thinks the Chinese government will not stop people from sending $3 million out to buy a house in Vancouver? Wow. I don’t know what they know that I don’t.”

Harris said Chinese companies seeking to invest in North American real estate started having trouble about three months ago as business transfers were examined more closely.

Yesterday, in Chinese Consumers Race to Buy Dollars as Yuan Slides [subscription is required, but the full article is here in the Australian Business Review] the Wall Street Journal wrote again on how China’s crackdown on foreign currency flows is impacting international business transactions. The article starts out by affirming exactly what our China lawyers have been hearing and been saying: that Beijing is telling China’s banks and others to slow down the foreign currency outflow. In other words, China’s laws on the books have not changed, but its on the ground reality has:

Chinese officials are trying anew to slow an unprecedented money exodus from the country, clamping down on individuals seeking to flee the yuan and making life tougher for companies that need to trade the currency for US dollars to do business.

China’s foreign-exchange regulator in recent months has deployed a new system to monitor individual purchases of foreign funds and has asked banks to reduce foreign-currency transactions.

It has summoned bankers to its offices to give guidance and has grilled them when foreign-exchange activity spikes, according to executives at Chinese and foreign lenders.

Banks, in turn, have increased scrutiny of foreign-currency transactions by businesses ranging from Chinese entrepreneurs investing abroad to companies paying overseas bills.

The article then provides the following examples of companies having troubles due to China’s foreign currency clampdown:

  • A European chemicals manufacturer (presumably its China WFOE) was delayed in obtaining US dollars in Shanghai, threatening its deadline for an overseas licensing payment.
  • The Bank of Tianjin is having trouble getting funds from mainland investors for a planned Hong Kong public stock offering.
  • A water-treatment company struggled to withdraw $US2000 ($2690) for an engineer to travel to the US.
  • A Chinese company was having problems wiring $US15 million to a Hong Kong company that for two years has been helping the Chinese company buy equipment for a South American factory.

This foreign currency clampdown is apparently working as “economists say tightened capital controls are one reason China’s foreign reserves fell only $US28.6 billion in February, less than a third the drops of the two previous months.”

The WSJ article ended with this fascinating/scary statistic:

“If 5 per cent of China’s 1.4 billion people used their full quotas [USD$50,000 in funds allowed to leave China each year], the $US3.5 trillion in foreign-currency demand would drain its ­[China’s] reserves.

China’s new restrictions on foreign currency outflows are literally changing the way our China attorneys practice law in the sense that we now account for this on any transaction that will involve money flowing from China to some other country. I do not want to get specific on what we are doing but I can say that we are now always looking at whether the money can come from somewhere other than China and, equally importantly, we are also always looking to write our contracts so as to minimize China currency blocking triggers.

What are you seeing out there?

 

China Factory Verifications: Do Go There

By Dan Harris on Posted in Basics of China Business Law, China Business

China LawyersIn 4 Powerful Tools For Supplier Verification, The Quality Inspection Blog talks about what companies should do to verify they will be buying their products from a legitimate and financially secure Chinese company. The post starts out by noting that “scammers have multiplied and are targeting inexperienced importers.” Our China lawyers are seeing the same thing.

The post then lists the four ways to vet your China factory, of which I highlight the following two:

1. Supplier/factory visit.  It is what it says. Go and visit the factory:

Is it one guy in an apartment? Is it a sizable manufacturing operation? Interestingly, one can make an educated guess by announcing an upcoming visit and reading their reaction. A legitimate supplier will welcome the visit, while a scammer will look for ways to avoid it.

If you can’t make a visit yourself, many quality assurance agencies, including ours, can do this for under 300 USD in most coastal areas of China. They allow you to know:

Where are they? What does the building etc. look like? How many people work there?
Do they usually make the type of products you are buying, or something totally different?
What processes do they do in house?
Can they show official business licenses and other official documents? Do they match with the company name they show in their email signature?

I cannot stress enough how important this is, for multiple reasons. First, it allows you to see for yourself with whom you will be dealing. This is important for the reasons above. Second, and of equal importance, it allows you to see exactly how your product will be made and exactly what your product, once made, will look like. This is a great time (certainly better than after you get a big shipment) to make modifications. Third, this allows you to establish a relationship with your factory. Your factory probably makes widgets for 10-100 companies. If you go and visit, you will stand out. You will be a human being. And you will be someone who cares enough about his or her products to go to China. I cannot conclusively prove it, but I am convinced that every visit you make (not someone on your behalf) to your factory has a substantial positive impact on product quality. I have heard this far too many times from clients I greatly respect to believe otherwise.

2. Covert ways of verifying a supplier. The post suggests you (or someone you trust) review various government documents on your Chinese factory. I vehemently agree. See Basic China Due Diligence. Is This Chinese Company Legitimate? It is fast and easy to determine if your Chinese manufacturer is really even a manufacturer at all. You would be surprised how many times companies come to us wanting to sue their “Chinese manufacturer” and less than an hour of research by one of our China attorneys reveals that the “manufacturer” was in fact a mere broker all along.

With China’s economy faltering, the scams are going to increase. What will you do to prevent being a victim of one?

China Trademark Protection Basics

By Dan Harris on Posted in Basics of China Business Law

China trademark protectionMy good friend and trademark lawyer extraordinaire, Mike Atkins, recently wrote a post on his Seattle Trademark Lawyer Blog entitled Basics of Trademark Protection in Plain English. Though that post deals exclusively with U.S. trademarks, nearly all of its big-picture analysis is apropos to China trademarks as well.

Below I take what Mike said, and explain how it applies to China or not. Mike’s portion is in regular font and my portion is in italics.

A. Trademark Enforcement principles. The main way to protect a trademark is by perfecting and maximizing one’s rights in the mark, which usually occurs by registering it with the U.S. Patent and Trademark Office, and then by enforcing those rights against competitors, imitators, and would-be users in an effort to keep them as far away as possible from the property.

Enforcement, in turn, usually boils down to sending cease-and-desist letters to the wrongdoers in the hopes of obtaining voluntary compliance with your demands, under threat of suit; and if the wrongdoer doesn’t voluntarily comply, to carrying out the threat and commencing suit. In this respect, protection of one’s intellectual property rights is both binary and simple: either the wrongdoer voluntarily stops its bad behavior in response to your pressure, or it doesn’t; and, if needed, you either escalate the dispute to court, or you don’t. There really aren’t any other legal options. (I don’t count hiring the likes of Tony Soprano (R.I.P) to enforce one’s rights as a legal – or advisable – option.)

Generally true for China, with a few minor modifications. First, and most obviously is that you need to register your mark with the China Trademark office, not the USPTO. Second, you need to consider whether to register your mark in just English, just Chinese, or both. Third, though the bit about having to choose between pursuing and not pursuing escalation is true, China has other dispute resolution options in addition to a straight-up lawsuit. 

B. Basic Principles of Trademark Law. Trademarks function the way cattle brands function on a ranch. Cattle brands distinguish one cow from another, so there’s no question which cow belongs to which rancher, even if they get mixed together. Trademarks are the same way. They are unique names, symbols, or tag lines (among many other devices) that tell consumers that a good or service sold in connection with the brand comes from a particular producer. They are affixed to the product itself, or product packaging, or they are displayed on websites or other promotional materials. When consumers see a Nike shoe, for example, the Nike name, Swoosh logo, and “Just Do It” tag line tell consumers that the shoe doesn’t come from Adidas, New Balance, or any other manufacturer – it only comes from Nike. In this way, trademarks symbolize the owner’s reputation and encourage good, consistent, quality by enabling consumers to efficiently identify producers and make repeat purchases. In other words, if you like Nike shoes, you know where to go when you need to buy a pair (or who to avoid if you weren’t satisfied with your previous purchase).

Trademark law is a creature of both state and federal law (and both statutory and common law). At bottom, trademark rights arise through use, which means affixing the mark to a good or product packaging (for goods) or by displaying the mark on websites or signs (for services), and selling the item to consumers. Registration is available through state governments and the U.S.P.T.O. Registration is not required, but it expands the geographically limited rights that automatically arise through use. There is a lot to say about trademark registration, but further discussion is outside the scope of this discussion.

Protecting a brand normally starts with selecting a brand. Protection has two facets, which you can think of in terms of both sides of a coin. You probably want to register your mark (or at least have that option), and you want to be able to enforce it in court. But you also want to choose a brand that won’t get you sued by another trademark owner. In other words, there are “offensive” considerations, and “defensive” considerations. To understand them, you need to know a few basic principles.

First, the maxim of “first in time, first in right” often controls. That means if you start using your mark first, you (usually) can go to court to prevent later adopters from using a brand that is close to yours in connection with similar goods or services. Registrations can change this outcome, but that discussion is outside the scope of this writing. Therefore, we will proceed with the simple notion that when there is a conflict between two trademark owners’ rights, the first user in a given geographic area will have superior rights – called priority – and will win in a trademark infringement lawsuit against a later adopter.

To do so, however, a trademark plaintiff also needs to prove that the later adopter’s trademark use is “likely to cause confusion” with the plaintiff’s prior trademark use. Whether a likelihood (probability) of consumer confusion exists is determined by the multi-factor test that applies in a given jurisdiction. In the Ninth Circuit, it is known as the “Sleekcraft” factors, after the influential trademark infringement case of AMF Inc. v. Sleekcraft Boats, 599 F.2d 341 (9th Cir. 1979). But other jurisdictions have similar tests under different names. Regardless of the jurisdiction, courts apply this test to determine whether an ordinary consumer would likely be confused into believing that the branded goods or services that come from the later adopter (the “junior” user) come from, are approved by, or having something to do with, the earlier adopter (the “senior” user). If the answer is yes, then a court would find the junior user liable for trademark infringement.

The main factors in assessing a likelihood of confusion are the similarity in the parties’ marks (considering sight, sound, and meaning); similarity in the goods or services offered under the parties’ marks; the similarity in how the parties’ goods or services are advertised, marketed, and sold; and whether consumers have actually been confused in the marketplace. There are other factors, but these usually are the most important.

Mike’s first three paragraphs apply with equal force to China (with the exception of the part about federal and state law). But his last three paragraphs do not really apply to China at all. It is this distinction between the two systems (that of the United States and other common law countries like England and Australia and Canada versus China and other civil law countries like Germany, Japan, Korea, and France) that so often trips up American and British companies. China is NOT a first to use country; it is a first to file company. 

What this means is that if you make all sorts of men’s shirts and I register “your” brand as my trademark in China for men’s shirts, I get that trademark and you cannot use that trademark in China, at all, not even for goods to be exported. What that also means is that if you register your trademark for men’s shirts in China, I can go off and register that same trademark for men’s gloves and men’s shoes and I will get it, likelihood of confusion be damned. 

U.S. and China trademark law. Similar but different.

For more on the basics of China trademark law, check out the following: