China: Legal Concerns Of Foreign Companies In China

Last Updated: 2 November 2007
Article by Maarten Roos

In more than four years working for the Chinese law firm Wang Jing & Co., assisting foreign companies in their business activities in China, I have been frequently asked about the major legal concerns that foreign companies in or entering in the Chinese market must deal with. In surveys, foreign businesses operating in China often identify legal issues as among their biggest challenges; while many are idiosyncratic, what concerns are most frequently encountered? Below, I will attempt to identify and share my perspective on the key legal issues in the fields of commercial transactions, corporate activities and intellectual property rights protection that many companies face.

Commercial Transactions – the Need for Due Diligence

The first step in China for many foreign companies is commercial in nature. China has become the workshop of the world for numerous products, and is at the same time an attractive – albeit daunting – market. However, legal issues frequently arise from such transactions.

Many of the problems that foreign companies encounter when dealing with Chinese counterparts directly result from a failure to conduct due diligence. China’s business environment is often thought of as one where the usual rules of business do not apply. Differences in language and culture are taken as an excuse to do away with the checks and balances that are usually applied in business dealings. And Chinese counterparts take maximum advantage of this, by reinforcing the conception that "China is different", and "things are done the Chinese Way". But while differences in languages and culture undoubtedly form an obstacle that foreign businessmen must seek to overcome, this is all the more reason to be cautious.

Confirming that the Chinese counterpart and his representative are legitimate, concluding a proper contract, ensuring the Chinese contents and identifying the parties of such a contract, clarifying products, payment and delivery clauses and deciding on inspection processes, and agreeing on dispute resolution mechanisms in the event that something goes wrong, are the most basic steps that are too frequently ignored. Chinese business partners may try to avoid these issues, emphasizing the friendly nature of your relationship and becoming seemingly offended when you insist. Following blindly may be done in good faith, but in the end, it is the foreign company which will bear the risk of unforeseen conflicts.

One counterargument to due diligence often heard, is that even with a contract and proper due diligence, that if something goes wrong it is impossible to have your rights enforced. "A contract is not worth the paper it is written on", goes the saying. However this sentiment is simply not true. While China’s legal system is still developing, and the enforcement of rights can in some cases be complex, difficult and expensive, this is in fact the most fundamental reason to perform proper due diligence. Dealing with a legitimate counterpart with an interest in completing the transaction as anticipated, becomes all the more important. Contract negotiations are an opportunity to understand your opponent and his priorities, and to educate him on what yours are. And with a proper arbitration clause, for example, the long and difficult road that is Chinese litigation can be avoided.

Many disputes in China arise because the parties to a transaction never fully understood their priorities. Therefore, one of the best ways to avoid future problems is to come to a comprehensive understanding of the transaction and its mutual benefits. The contract is an ideal forum for this, serving as a way to educate as well as potentially enforce.

In the end, whether the costs of a proper due diligence weigh against the risks of the deal going wrong is a decision that every company must make for itself. For many small businesses, such costs can be proportionally high in regards to potential profits. But the fact remains that without proper due diligence, the chances of enforcement, should future conflicts arise, are minimal.

Corporate Structures – Realistic Expectations

In recent years more and more companies, including many of small and medium size, are establishing offices or subsidiaries in China to take full advantage of lower manufacturing costs, to avoid unnecessary taxes or agent fees, or to provide products and services to China’s large and growing markets. Especially for smaller companies, to invest in China represents a pivotal decision, one that may be crucial to the company’s future.

Undoubtedly, the success of such a venture depends to a great extent on commercial factors, at home and in China. However, the legal perspective can add considerable leverage. The basis of any investment should be an understanding of China’s controlled regime for foreign investments, so that potential delays or bottlenecks can be tackled early on. Another major problem relates to the concept of the Joint Venture.

China has promulgated numerous laws to guide foreign investment into China, whether in the form of a representative (liaison) office, a wholly owned subsidiary or joint venture with a domestic enterprise. Up to fifteen administrative departments can be involved in the approval and registrations needed for establishment, with their requirements varying with each separate locale. In the face of so much bureaucracy, too many companies go it alone, or rely heavily on inexperienced consultants, scrupulous or well-intended individuals, or government investment promotion departments. Indeed, sometimes things are done more quickly through the right connections. But a company should always remain cautious. Promises that sound too good to be true are often just that; short cuts in China rarely lead to long-term gain.

Problems that often occur, and will then be time-consuming and costly to resolve; are the signing of a lease agreement and payment of deposit before confirming whether and under what conditions the property in question can be registered as the residence of the office or company, the failure to define properly the business scope in the Chinese subsidiary’s Articles of Association, and financing problems due to inadequate provisions of investment and registered capital. More generally the failure to understand or take advantage of China’s legal framework for investments at an early stage of investment often lead to complications in the establishment process or in the future.

Joint Ventures

A particular problem that some investors face is the choice between joining forces with a domestic partner, or establishing a business on their own. In the past, investment in many industries was only permitted through so-called Sino-foreign joint ventures, whereby a new company is established through investments from at least one Chinese company and at least one foreign company or individual. Statistics show that the popularity of joint ventures has decreased considerably in recent years; on the other hand, there are good reasons to consider such a partnership. Chinese companies for example often have a better understanding of the local market, can bring capital in the form of factories or land, and can contribute management, local connections and general support.

The main misconception of the Joint Venture, however, is that it is like a traditional marriage, whereby two (or more) companies join together to grow old and rich. In fact, the Chinese Joint Venture is much more like a temporary union between parties who retain their own identity, ideas and long-term goals. The joining of forces can be beneficial, but the venture is in most cases temporary in nature. At one point or another, the parties will grow apart, ideas will diverge, a battle for control over the operation and future of the Joint Venture will follow, and the parties will break up.

There can also be good reasons to start a Joint Venture, for parties with little experience in China, or those operating in industries in which connections are vitally important, a Chinese partner can provide valuable support. However, expectations should be adjusted to meet reality. If you start a Joint Venture, know that at some point, you will have disagreements on its direction, the investments needed, or the management practices it is governed by. Chinese partners are often very adept at using the Joint Venture to their own advantage – mainly to gain a better understanding of the foreign party’s business practices. When they feel they have learned enough, they will put all their energy into developing their own, fully-owned companies. The foreign party is entitled to take a similar approach.

IP Protection – Preparing Well

A third area of law that provides foreign companies doing business in China with major challenges is that of intellectual property rights protection. China is well-known as the country where everything and anything can and will be copied, and unfortunately China’s system of legal enforcement of intellectual property rights is still young and lacks sufficient resources to significantly attack the current prevalence of infringement. Nonetheless, foreign companies can take measures to be better prepared.

Above all, trademarks and patents should be registered in China to be protected under Chinese law. Since China maintains a first-to-file system, basically meaning that the first party to successfully register a trademark or patent will "own" such rights irrespective of prior uses by third parties, the early filing of applications for registration of such intellectual property rights is crucial to combat infringements later on.

Many foreign IP owners delay too long in applying for registration. For trademarks in particular, companies often wait till they are actually selling or investing in China. By this time, Chinese competitors, business partners, or independent third parties may have already acquired the rights to the trademark in China. Getting back the trademark is difficult and costly, and will take many years – during which time there is no protection from third parties already using "your" brand. While the holding of IP rights such as trademarks, patents or copyrights is not a guarantee that third parties will not infringe on such rights, it does form the basis for any action against infringers.

Contrary to popular beliefs, China’s legal regime for enforcement of IP rights is actually quite comprehensive. The bad news is that enforcement is often expensive, with a high burden of proof, and the number of infringers ever growing. The good news is that the available measures against infringements are becoming more and more effective. Many foreign companies make the mistake of giving up on the outset. But for all those IP owners that cannot constantly stay ahead of infringers, it is important to acquire full awareness of the various actions that may or may not be effective in specific situations, and to have the protection mechanisms in place so that they can be implemented when they do become (cost-) effective. Part of such protection mechanisms is registering IP rights, keeping your IP portfolio ready to use, recording certain IP rights with customs authorities, including proper clauses in commercial and labor contracts, teaching employees about the value of IP rights and the penalty for infringing them, and collecting evidence of infringement in the market using employees and partners.

To take action against every infringer is a practical impossibility for most companies operating in China, however to do nothing is tantamount to formal acceptance. Taking preliminary steps, understanding the options, conditions and benefits of the various remedies under Chinese law, and a careful balancing of expenses, risks, and results on a case by case basis will allow a company to maximize a limited IP enforcement budget.

Conclusions

Every foreign company in China faces challenges, and must find a way to deal with those challenges effectively. How to manage these daily obstacles depends on the company culture and the specific challenges it is facing. Nonetheless, the general issues discussed above can serve as a guideline for approaching some of the most common problems that foreign companies face when they enter and operate in China.

Foreign companies should take the time to fully understand what their goals are and how they can be achieved. China is not an easy place to do business, and companies face hurdles that may not be as distinct or familiar as in other countries. But these hurdles can be overcome.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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