China presents potentially unique opportunities for American businesses of all sizes hoping to expand their production or exports overseas. United States exports to China have increased over 500 percent since China joined the World Trade Organization in 2001, and China’s economy as a whole has grown at a rate above 7% per year. The U.S. Government estimates that by 2020, China’s middle class, which generally views US products as reliable and superior in quality, will contain about 700 million people. Small and medium sized businesses represent approximately 9/10ths of American businesses exporting to China and approximately one third of the exports’ value.
Yet with these gigantic opportunities come challenges, such as a rapidly changing economic landscape, a dramatically different business culture and a very different legal system. China’s GDP growth continues to slow, wages are rising, and the Chinese government increasingly protects Chinese companies. This article seeks to assist businesses doing or hoping to do business with China by pointing out areas of concern and a few tested solutions.
China’s Different Business Culture
Differences in how people in the U.S. and China transact business present a major hurdle. Business in the United States revolves around contracts, negotiated regardless of whether the companies have a pre-existing relationship. Once signed, all parties understand that there is a lasting agreement which, if necessary, courts will enforce. Although parties may modify contracts by subsequent agreement, businesses do not view contracts as organic documents which regularly change if and as a party’s needs or circumstances change. This facilitates transactions between strangers who can confidently rely on each other’s contractual promises.
The relationship based Chinese culture, businesses included, relies heavily on systems of relationships, developed over time and cultivated regularly (“guanxi”), to transact business. These personal relationships develop essential trust between the parties. Without this crucial underpinning, an agreement alone may not suffice to ensure performance or payment.
In western nations, success comes in the form of the completed deal, and a good contract matters more than what it took to get it. In China, the means taken to achieve the end can be just as important, if not more important than the end product. Chinese negotiators may focus more on saving face than on completing the deal and expect extensive haggling- even over items that seemed completed. This can lead to longer, more expensive negotiations but is just part of the process.
It is crucial, then, for businesses wishing to do business in China to take the time and make the effort to form relationships with Chinese partners, agents and contractors and negotiate patiently. The costs are an essential investment. American businesses should actually go to China to scout locations, determine local conditions, and establish personal relationships with key people. Export contracts should make the customer legally and functionally responsible for the products upon arrival in China (before clearing customs) so that the customer’s relationships guide the products through customs, insurance, transportation and related processes and paperwork in China.
Government Involvement and the FCPA
The Chinese government involves itself in the private business sector to a degree rarely seen in the west. China still has a planned economy, and in recent years has become protective of Chinese enterprises. Contracting entities frequently are state owned enterprises, which adds bureaucracy and may slow transactions. Government regulations are omnipresent. Local contacts can facilitate navigation through the bureaucratic maze and provide important continuity (and guanxi), but the clash of cultures in this area can create serious risks under the Foreign Corrupt Practices Act.
The Foreign Corrupt Practices Act of 1977 (“FCPA”), 15 U.S.C. §§ 78dd-1, et seq. prohibits the corrupt payment, promise or gift of anything of value to a foreign official (i) to influence any act or decision of the foreign official in his official capacity or (ii) to secure any improper advantage, or (iii) to use his influence with a foreign government in an effort to assist a U.S. company to obtain or retain business with any person. The FCPA factors particularly heavily into doing business in China because of a deeply ingrained expectation of side gifts accompanying successful deals. Bloomberg even called China’s a “bribery culture” that is centuries old, deeply ingrained, and unlikely to change in the near term.
Despite this culture, American exporters cannot simply avoid working with Chinese officials. In fact, one of the surest ways to delay or frustrate a successful business venture is to fail to work with locals that know how the system works and who they need to work with. To mitigate this risk, agreements with locals should specifically lay out what they can and cannot do in the course of their representation in the contracts and provide the U.S. business with enforcement rights to ensure compliance. For example, the rights to conduct independent audits or to terminate agreements entirely can effectively guarantee compliance.
Intellectual Property Requires Protection
China’s intellectual property protection differs from the United States’ system in a number of ways, particularly in the fields of obtaining and enforcing patents. Despite having undergone dramatic changes in the past several years, intellectual property protection still presents problems for US businesses.
For example, where U.S. patents have a twenty year life, China offers patents for invention with a life of twenty years and patents for utility models and for design with a ten year life. Patents for utility models are only subject to substantive investigation during invalidation proceedings, rather than during the application stage. This expedites patent issuance (commonly issued in one year as opposed to the three to five years it takes to receive a utility patent in the U.S.), which lets the company holding the utility model patent to begin pushing competition out before rivals can get an invention patent. China excludes from patentability things like business methods and animal and plant varieties, which U.S. patents may better protect.
Only counsel licensed to practice in China may file for a Chinese patent. Here again, the quality of the local representatives and length of the relationship are critical. Filing a patent without strong local support, backed by long term business relationships, is frequently the difference between getting a strong patent for the right price and getting an ineffective patent or paying far too much for the same product.
China’s enforcement procedures can pose additional hurdles, even though the enforcement system is improving. Foreign entities now win the vast majority of patent infringement actions, and the number is rising. Unfortunately the judgments remain relatively toothless. If assessed at all, financial remedies are usually only statutory damages of between $1,500 and $150,000, after which infringing companies may reopen under a new name.
Establishing, maintaining and protecting trademarks and copyrights present their own differences and challenges. For example, China has no equivalent to the “fair use” doctrine. Here again it awards low damages and offers no criminal enforcement.
China is still notorious for its pervasive intellectual property infringement. American businesses should consult their intellectual property attorneys before putting themselves and their products at risk of infringement or reverse engineering.
Letters of Credit Can Help Ensure Payment
American companies doing business in China often worry about getting paid. Given the Chinese customers’ approach to contract obligations, prudent American businesses should not rely on open accounts or document based collections. It is best to get as big an upfront payment as possible. To secure the balance, properly drafted letters of credit, even though costly, commonly provide an effective solution.
Letters of credit require careful negotiation and strict adherence to their requirements. Horror stories abound of letters of credit failing because of discrepancies such as spacing or typographic differences, so attention to detail in paperwork and dealing with honorable banks is the best way to ensure payment succeeds. Consult counsel and only use irrevocable letters of credit, under which the bank must pay the exporter even if the buyer defaults.
Not all banks will handle letters of credit with a correspondent Chinese bank, and each involved bank’s reputation is important, since both parties are relying on the banks’ integrity and ability to perform their obligations. A seasoned banker and an experienced attorney are the first steps in ensuring proper payment.
Dispute Resolution Clauses and Applicable Law
Chinese courts are often loath to enforce U.S. law and judgments. Aside from the “home court advantage,” Chinese courts can misunderstand the law selected in choice of law contract provisions, reluctantly or improperly apply foreign laws, or ignore foreign laws altogether. Choice of law and conflict resolution are relatively new to China, effectively dating back to the late 1980s and the 1990s.
During this period, China signed several key international treaties and conventions which make its commercial law more reliable. Among them are the Vienna Convention on the International Sale of Goods and the Madrid Treaty on Trademarks. Since there is global “peer pressure” to adhere to signed treaties, your attorney should make international law superior to national law and insert arbitration clauses which list acceptable neutral countries with established commercial traditions for hosting dispute resolutions.
China’s 2011 Statute of Application of Law to Foreign Civil Relations unified China’s choice of law statutes, established a choice of law framework, and moved China closer to its goal of a comprehensive civil code. This helps Americans doing business in China, but does not solve any problems. Chinese courts must resolve choice of law disputes by interpreting the vague command that foreign law may not control if “application of foreign law would harm the social and public interests of China.” Additionally, certain contract types, such as those dealing with natural resources or creating joint ventures between Chinese and foreign companies on Chinese soil, require that Chinese law apply, regardless of the parties’ agreements.
Unfortunately, there is no simple answer to how best to draft a choice of law provision to protect a contract’s enforcement in Chinese courts. A United States judgment against a Chinese company will only help if the company has resources in countries that will enforce the judgment or if the judgment puts the company under business pressure. Reference to an international arbitral body can help, but may not always be enforced. Chinese businesses readily agree to use Hong Kong law and jurisdiction in contracts, which westerners often find preferable to Chinese law and jurisdiction. Jurisdictions perceived neutral by both parties (such as Sweden) also suffice. Local Chinese counsel can assist greatly in navigating choice of law and dispute resolution issues in the changing Chinese landscapes when drafting contracts in the first place.
With a huge market and substantial profit margins available for the taking, China presents a worthy target for ambitious, yet careful American enterprises. By noting these concerns, working closely with legal counsel in America, and fostering strong local relationships with professionals on the ground in China, Americans doing business in China can succeed while avoiding time and money wasting pitfalls.