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China Business. Nobody Ever Said It Would Be Easy.

By Dan Harris and Steve Dickinson

Tough times make for tough business and China is certainly no exception. For foreign companies doing business in or with China, I am seeing increasing problems or the likelihood of increasing problems in the following four areas: 1. Intellectual Property. Local software company (not one with which you are likely to be familiar). Tells me it wants to sue its employees in China over IP violations. The conversation went sort of like this:

Me: What are the IP violations? Him: They stole all of our software. Me: What do you mean they stole all of your software? Him: We hired them to develop specialized __________industry software for us to market in China and they have taken all of the work for themselves. Me: Explain to me how this happened. Him: [After going off on a wild tangent for about five minutes] We started the company in China about two years ago. I hired Mr. Wang [name is made up] to head up our operations there and he eventually brought on about 20 more people for us. I knew him from my days with _________ and thought I could trust him..... We spent two years on this and more than a quarter of a million dollars and the product is now finally ready and they've just taken the whole thing for themselves. You HAVE to stop it. Me: Okay. Do you have written contracts with these employees that include non-competes, trade secret protections, or non-disclosures? Him: No. We don't have written contracts with them. Me: Hmmm. That could be a problem. Why don't you have written contracts with them. Him: Because we wanted to keep this really under the radar. Me: What do you mean really under the radar? Him: Mr. Wang told me that if we didn't keep everything under the radar that our software IP would get stolen. Me: Mr. Wang told you this? Him: Yes. And I trusted him. Me: Because you knew him from your days at __________. Him: Yes. Me: Okay, so no written employee contracts. Him: Right. Me: Did you pay employer taxes. Him: No. Me: Ummmm. Him: We weren't exactly their employers. Me: What do you mean? Him: Mr. Wang was our only employee. Me: How would you pay Mr. Wang? Him: We would send him $10,000 a month and he would use that for everything he needed, including to pay the other employees. Me: Who is the we that sent the money? Him: Our company. Me: Your US company? Him: Yes. Me: Do you have a Chinese company? Him: No? Me: Do you realize that virtually everything you have described to me was illegal in China? Him: I do now. Me: I don't see how you can sue here. Essentially, we would be asking a Chinese court to rule in favor of an American company that, for all intents and purposes, was never in China. Our claim would be that the people who stole your IP were your employees, even though there is no evidence they were your employees and if we argue that they were your employees, we will be admitting you violated nearly every labor law on the books. I take it you never registered any of your IP in China? Him: No, should I? Me: It might have helped..... Him: Can you help me. Me: I don't want to tell you I cannot help you without first doing all sorts of research to confirm it, but off the top of my head, I just can't see your having a decent case in China and you certainly don't have one here either, unless these China people start trying to bring your software into the US. Him: So you don't see any way at all to help me? Me: Not off the top of my head I don't. Him: It just strikes me as ridiculous that I could have paid these people for so long and China won't protect me at all. Me: Yeah, I think they just feel that if someone does everything illegally they cannot use the Chinese system for protection. Him: But it was one of their own people who tricked me. Me: Yeah, but I think the government would probably say that you should not have relied on him and that you should have been there legally, should have been paying your taxes and should have registered your IP. It's possible you hold the copyright in China anyway and we would be happy to research this for you. Him: I'll get back to you on that.

He never did. This is just a really interesting example, but we are definitely seeing more instances of employees (real employees, oftentimes those whose salaries have been cut) seeking to use their employers IP. If you want to protect your IP in China, do things legally. At minimum, register your business, use written contracts (in Chinese) with your employees that include trade secret protections, and register your IP. When times are good, there is a much greater belief that loyalty will lead to long term reward. When times are bad, there is a much greater tendency for people to try to grab onto any potential short term rewards. For more on protecting your China IP, check out this article on China trademarks. 2. Disappearing Chinese companies. We got one this week and they are definitely becoming more common. Here is how they work. Chinese company on the verge of shutting down takes an order from Western company anyway. Chinese company then ships out the dredges of its product before shutting down for good. We have been called by American companies that essentially received dirty rags instead of shirts, that received bricks instead of fish (this actually was during the Asian crisis), and that had received what looked like sugar instead of candy. In all of these cases, the Chinese company had taken the money and had simply shut down, "leaving no solid clues nor trace, only a space...." Does Chinese law allow for piercing the corporate veil to go after owners for fraud in these circumstances? Yes, the law allows it, but the Chinese lawyers with whom I have discussed this issue tell me most Chinese judges are neither terribly familiar with this concept nor terribly enamored with it. I am not saying that no such case should be pursued, but I am saying that one must think long and hard about whether pursuing such a case makes economic sense. Now more than ever, you must make sure you know as much as possible about those with whom you have business dealings. You also should strive not to pay the entire cost in advance of the products you are buying. A year ago, most Chinese manufacturers were requiring full payment in advance. That has changed and many of our the contracts my firm is writing with Chinese manufacturers are now calling for anywhere from 0 to 50% payment upfront. 3. Joint Ventures Gone Bad. We are working on a number of failing joint ventures right now whose general scenario is that the joint venture has basically ceased providing financial reports and ceased remitting any profits back to the Western joint venture participant. Maybe these joint ventures are no longer even profitable, but our clients are entitled to determine this and if the joint venture should be shut down, our clients are also entitled to a share of the joint venture company's existing assets. For how to prevent/mitigate such problems, check out this article on China joint ventures. 4. Labor Laws Violations. I just received an email from co-blogger Steve Dickinson regarding China's labor laws and the belief among many foreign businesspeople that those laws are being relaxed to prop up the economy. Here's Steve's email:

I just sent you a copy of an article on the labor contract law. This is an important issue. I have been seeing statements on blogs and in the press that foreign companies no longer have to worry about Chinese labor law because the falling economy has led the Chinese government to basically abandon the law. This is untrue and it is a dangerous belief. What the government has been doing is working with large employers in negotiating mass layoffs and wage reductions. However, this process is part of the labor contract law, not a rejection of it. Moreover, all the other provisions of Chinese labor law, such as minimum wage, working hours and safety are being even more strongly enforced now than ever, particularly against foreign companies. I am in the process of reading the numerous policy documents coming out the the current National People's Congress. One thing that is being constantly stressed at the NPC is that China has no intention of responding to the world economic situation by turning back from the last 5 years of reform. Its intention is the opposite. China's leaders see the non-Chinese economies as even more unreliable and risky and they are pushing even harder to make China self reliant and thoroughly modern. They do not intend to allow the financial crisis to push back the recent trends of Chinese development. Two of those trends are to shift away from export led growth and to shift away from reliance on foreign direct investment. For exports, they want to move from being a foreign outsourcing center to a country that exports products of its own design. For FDI, they want to shift from quantity of FDI to quality of FDI. Many foreign observers thought (and still think) that China would turn away from these goals in the face of the financial crisis. Exactly the opposite is happening. China is reconfirming these goals in its search for economic stability.

When the Chinese government puts out a notice in English that it is going to strictly enforce a particular law, the only wise thing to do is to believe it. What are you seeing out there?

Full post as published by China Law Blog on March 10, 2009 (boomark / email).