ChinaSolved is proud to publish the work of China-based experts and thought leaders. This month Nestor Gounaris and David Hartung of China Solutions LLC share their views on how to minimize your risk when entering the China market
Engaging in international trade with commercial counterparts in the People’s Republic of China (“PRC”) has the potential to be extremely rewarding; however, there is also corresponding risk. In order to mitigate this risk, buyers placing cross-border purchasing orders from Chinese manufacturers must consider a number of critical issues to enhance the likelihood of a successful and mutually beneficial commercial relationship.
Contracts are Key
A well-designed and enforceable contract is vital for a number of reasons, despite opinions that contracts in China ‘are not worth the paper they are printed on.’
Thorough contract preparation will discipline the buyer to conceptualize and understand the purchasing process, and thereby make better decisions about how to allocate and mitigate risk – when and how the purchase order should be placed, when inspections should take place, when payments should be made, etc. There are a few dozen key decisions that must be carefully understood and planned.
Second, the contract will set the tone for the relationship by demonstrating to the seller that the buyer is sophisticated and is aware of PRC-specific concerns. With a thorough contract, the buyer alerts bad faith sellers that fraud or manipulation is not possible.
Furthermore, the seller’s reaction to the substance of the contract will be an important data point for the buyer to understand the seller’s intentions and awareness of the transaction. If the seller readily signs the contract, then be extremely wary. A good faith seller should closely review the contract and provide insight and feedback on the issues it deems critical. A mature buyer welcomes this opportunity to better understand the seller and to add depth to the on-going commercial dialogue.
Finally, a well-designed and enforceable contract (and the corresponding evidence that results from such a contract) becomes the critical platform from which the buyer can enforce its rights. It is a condition precedent – without it, the buyer is unable to enforce its rights. And the alternative? Attempting to enforce an agreement based on grossly inadequate emails and faxes.
Due Diligence on Seller
Performing due diligence on the Seller is a prerequisite to entering an agreement.
The initial step should be to confirm key corporate details (registered name of the seller, model signature of the legal representative and nearly one-half dozen key points). If there is a mismatch between what is set out in the agreement and what is on record, then there is significant risk that the agreement may not be binding (or, at the very least, instead of focusing on the breach of contract, you will need to first prove who is or is not a party to the agreement). In addition, alerting the seller of these issues sends the message that the buyer cannot be easily exploited and goes very far towards establishing a successful and mutually beneficial commercial relationship.
Additionally, the buyer should confirm that the seller is properly registered with the relevant authorities to export their products from China. Such right is no longer as difficult to obtain, but still some sellers do not have this right. In such case, payment and the products must go through a trading company. Sound business practice demands that the buyer conduct due diligence on the trading company in addition to entering into a three-party agreement among the buyer, the trading company and the seller.
Trademark Registration and IP Provisions
Two important intellectual property (“IP”) related issues in the context of cross-border trade are trademark registrations and IP provisions in the contract.
When engaging in cross-border trade, the buyer exposes its trademarks to potentially hundreds of contacts – vendors at trade fairs, potential sellers, export agents, etc. Since China follows a “first-to-file” rule for trademark registration, the party that files the trademark application first is normally entitled to the exclusive use rights arising from successful registration. Therefore, it is highly advisable in China to register trademarks as early as possible. Failure to do so leaves the door open to such contacts filing before the buyer does. There are cases in which such contacts register prior to good faith trademark owners, and then threaten infringement actions against the good faith trademark owners or their distributors.
Thorough contract preparation will compel the buyer to rigorously consider what IP will be exposed. What happens to defective products that are rejected by the buyer but bear the buyer’s branding or proprietary designs? What about trade secrets? The buyer must consider how its IP is exposed and then consider what contractual provisions (if any) can provide assurances. If contractual provisions are not sufficient, the buyer can consider either restructuring the transaction or requiring enhanced monitoring and involvement in the production.
Additional Key Terms
Additional key terms that buyers must consider include: product warranties and product liability; quality control and independent inspection provisions; indemnification; liquidated and indirect damages; and dispute resolution, among others. If a buyer can understand and adequately plan through these and other key terms, and it will be much more likely to enjoy a successful and mutually beneficial commercial relationship with the seller.
Commercial relationships, like all relationships, require thought, planning and attention in order to enhance the likelihood of success. Thorough contract preparation and the consideration of the issues discussed in this post go a long way toward enhancing the likelihood of success.
Ultimately, the buyer elects to come to China (a jurisdiction likely to be foreign to the buyer) to develop a commercial relationship with the seller. The buyer cannot expect anyone else to protect it and therefore must take the relevant measures to adequately protect itself.
Nestor Gounaris is managing partner of China Solutions LLC, and advises foreign investors on effective and successful foreign direct investment in China, as well as teaches Chinese business law at University of California Los Angeles Law School, and University of Virginia School of Law. David Hartung is an associate at China Solutions and Georgetown Law School graduate.