BizChina

A couple weeks ago, I got what for my law firm is a fairly typical phone call. This was from someone in a second tier city who had been operating a business there for seven years, all done on a business visa without having registered the business and without having secured a long term Z (employee) visa. Seems the local authorities had sent him packing and he essentially had to turn over his fairly profitable business to his five employees. He was calling us to see if there was anything we could do. My response was something along the lines of the following:

Let me get this straight. You have been operating this business in China for seven years, yet you never registered it and you never paid any taxes on it. You built it up to five employees, none of whom are legal. Do you think one of these employees might have been the one to turn you in? In any event, what is it you think we can help you with?

He very wisely chose not to hire us. We get calls like this just about every month and I have written about many of them. This post is a little different, based on something this guy told me at the end of the call. He said something along the lines of the following, though I have to admit by that point I was thinking more about getting off to my lunch appointment so I didn't question him any further:

The local official told me that they are going after everyone who has been in China for more than five years without a Z visa (employment visas) and making sure they are here completely legally and, if they are not, they are making them leave the country immediately.

I thought absolutely nothing of this until today when I read a James Fallows post that talked of something very similar happening to veteran English teachers in China. Fallows' post contained the following quote from a "young Westerner who has taught in China but is now in Europe as a graduate student:"

I am just hearing from two of my expat friends who have been teaching in Chengdu for 3 and 4 years each, that a new visa regulation is being enforced, which will force all but a very select group of people to leave the country for at least one year after having been there for 5 years more or less continuously. Whats that all about? Great teachers who like their jobs and would be happy to stay are forced to leave the country for a year? I don't want to know how many of them will find a job some place else in that year off and never come back.

Only a few days ago, we did a post on how China's attitude towards foreign investment was becoming more rigid and less welcoming as the government becomes more convinced that China's economy will be fine. So certainly this possible new call to crackdown on China expat veterans without proper visas would fit in perfectly with that.

I know people who have been living in China for more than ten years on business or tourist visas. Are their days numbered? What are you hearing/seeing out there?

I dunno.

We recently did a couple of posts on what is required to form a Wholly Foreign Owned Entity (WFOE) in China. In the first of these posts, "How To Start A Business In China -- WFOE," we we set out the four main steps in forming a WFOE. In our second post, "How To Start A Business In China -- The Minimum Capital Requirements For A WFOE," we discussed the minimum capital requirements for such entities. I tagged both of these posts with our newly created "Basics of China Business Law" category.

Micah Schwalb, an attorney and blogger at Boulder2Beijing then wrote me with the following:

One item it might be interesting for you to touch upon is when you DON’T need to do any sort of formation, as in the case of a foreign business contracting with a Chinese business for certain services, or when companies pay (foreign) employees on the basis of service contracts. I’m not saying that these are particularly, well, legal, but it might make for an interesting post, as it happens quite often.

Unfortunately, Micah is right. I say unfortunately, because there is no right or wrong answer on when it is necessary to form a company, which means writing a blog post on it is not an easy task and which means this post will NOT be going into the "Basics of China Business Law" category.

It is necessary to form a business in China is that it is legally necessary if you will be doing business in China on anything other than a temporary basis. But what exactly does that mean?

This post is not intended to give a definitive answer as to when it is necessary to form a Chinese company. Rather, it is meant to raise some of the issues and expose some of the analysis that goes on about those issues.

We face this issue all the time with companies that want to hire independent contractors in China. There is no legal way to do this under Chinese law, yet it goes on all the time. Some companies that do this run very little risk, while some run huge risks. What fascinates me about the companies with which I discuss this is how many of them have not even considered the risks, which include the following:

1. The independent contractors take physical or IP assets and the foreign company cannot sue because it is not even supposed to be in the country at all. We had a software company contact us about its independent contractors in China who had taken their software codes and were now selling their product both inside and outside China. Not a good situation.

2. The independent contractors sue the foreign company on an employment claim. These happen all the time and the foreign company essentially has two options. One, pay the entire claim in an effort to minimize (but not eliminate the risk of being thrown out of China) or just simply pack up (really quickly) and leave.

3. Getting shut down.

The other thing I find people fail to consider is their ability to secure investors or to sell the company later. We have a very savvy client who has started and sold dozens of companies around the world and one of the things he is always telling us is that his expertise in forming companies is one of the things he makes money from on the sale. He has formed and sold around a half dozen China WFOES (he sells them from one American company to another) and he says much of what he makes is relieving the buying company from having to take the time and money to form its own company.

My firm will not write investment contracts for companies that do not exist. Those are never worth it.

Let me give you some real life examples and the advice we gave and why.

1. US services company that sends five highly skilled people to a remote region in China once or twice a year for one or two months at a time to provide services to US companies with WFOEs in China. Because it would not be that big a deal if these people were blocked from entering China or forced to leave on short notice, we jointly determined that the risks involved with not forming a WFOE were not all that high and the client has chose not to do so.

2. US company that had five people whom it called "employees" doing R&D work for it in China. This sort of arrangements are disasters waiting to happen as these are the exact sort of arrangement the Chinese government is stepping up its efforts to shut down. See our post "China: First Let's Clear Out The Long Time Foreigners," for more on that. See also "Fake China Joint Ventures. Why You Calling Me, I'm Not The Guy!" In that post, I laid out what has become an all too typical phone call:

Caller: I've got this great website and it is exactly what China wants/needs. And I've been working on developing it with some Chinese tech friends of mine and we want to take it legal so we can start getting VC (venture capital) funding for it. Here's our plan. Now I know that the old/truly legal/expected/usual way to do this is for me to form my own company and then form a joint venture with my Chinese partners, but I also know that will cost a lot of money. So our plan is for the Chinese company to own the website and then we will have an oral agreement (or a written agreement) that I really own half of it.

Me: Listen, my firm has been contacted at least twenty times after these situations have gone bad and I am aware of at least another twenty times where the same thing has happened, and let me tell you, these arrangements (it is NOT proper to call these joint ventures) virtually always end the same way. They end with the Chinese company booting you out completely and leaving you with no recourse. Protecting foreign companies in legitimate joint ventures is difficult enough, but it is pretty much impossible under the scenario you are describing. We had a guy who paid us a lot of money once for us to do everything we could to try to get "his" multi-million dollar business back. Guess what, we could not even come close to getting it back. Every Chinese lawyer we talked to about suing to get it back told us we had no chance of winning at all. I mean, just listen to the argument we would need to make to the judge:

Your honor, my client knew that China's laws are very clear on what foreign companies must do to operate legally in China, but he thought these very clear laws should not apply to him because, well because he is an American tech company and he was just too smart/too poor to bother to comply with the very clear laws. So instead, he had this great method for completely circumventing China's very clear laws. His idea was to not form a company, but rather, have his Chinese friends form the company and he would have a little side deal with that company. Well, that side deal has now gone bad and my client wants you to go against China's very clear public policy on how foreign business is to be done in China and enforce this unwritten side deal.

What do you think of that argument? Oh, and I should also tell you that since these contracts you have will almost certainly be found to violate Chinese law, the judge will almost certainly find them void them ab initio, which means they will be deemed to have never existed.

Caller: (long pause) I understand things could go wrong with that kind of arrangement, but would you be willing to draft the contract between me and the Chinese company?

Me: No. I can't do that. I can't draft a contract that I know will never work. I just can't. Give me a call if you ever want to do this legally, in a way where you actually have a chance of profiting from your work down the road.

To be crystal clear here, these arrangements are not legal and they do not work.Yes, they might work for a year or so, or even a few years, but our experience and the experience of every single person I know who really knows China is that eventually these arrangements will fall apart and when they do, it will be you as the foreigner who will pay the price. And the interesting thing about these arrangements is that they not so coincidentally fall apart right when the great foundation has been laid and they are really starting to bring in money. No surprise there.

There are really only two ways to handle the situation where you want to have people in China working for your company. One, you form a Chinese entity, either a WFOE a Joint Venture (JV), or a Representative Office (RO) and you hire them as employees (of your company or of a staffing company if you are going in as a Rep Office). Or two, you enter into a business to business (B2B) contract with a Chinese company that itself employs the people in China you would like to see working for your company. It really comes down to a question of costs and control. It will almost certainly cost you more up front (though you may actually save money in the long term) to form your own company and hire your own employees, but you will have more control over them that way. So form your own company and hire people or contract with a legitimate Chinese company with its own employee, but just don't "hire them" yourself without a company in place.

But there are always exceptions. We are "aware" of a company that is operating illegally in China because there is absolutely no way for it to operate legally because its type of business cannot be owned by foreigners. This company knows exactly what it is doing and it has considered the risks and rewards and chosen to go forward. It assumes it will eventually get shut down and it operates accordingly in that it seeks to make as much money in the short term as possible, while spending as little as possible. Its goal is to hang on in China until its type of business becomes legal, and then it plans to do so itself. It has been there for nearly two years now.

3. US service company that every once in a while gets highly lucrative contracts from one particular US company that has it send about twenty people to China for three to six months. It would be a complete disaster (maybe to the point of losing this one giant client) if more than a couple of these employees were not allowed into China right away or if any of them were to be kicked out. So even though the risk of having a problem were actually fairly low, the cost to the company if that were to happen were high enough that we decided it should form a Chinese company and secure employment visas (Z visas) for a sufficient number of key employees. It did that and it has operated without a hitch ever since.

4. US manufacturing company with two salespeople in China. These two salespeople had been with the company for around five years and their relationship with the company had been uniformly excellent. These two wanted to become legal employees themselves and they asked our client to form a China WFOE so that would be possible. Our client was rightfully reluctant to do so because of the formation costs. We talked with them about how they could form a Rep Office and "re-hire" these two people through a Chinese agency. But the whole issue of using commission salespeople in China is a mess and since salespeople are subject to the same employment contract rules as everyone else. So most foreign companies would prefer to treat these Chinese salesmen as 'independent contractors", raising all the issues discussed above. There is no great solution here.

The same is true for the foreign company that wants to hire one or two people to repair their sold product in China. The foreign company has essentially only two legal choices. Form a WFOE and hire these people as employees, or convince them to form their own Chinese domestic company and enter into a contract with that company.

What do you think?

That's Hot.

If two years ago, someone had asked me to describe my law firm's typical China manufacturing client, I would talked about a company that was either doing contracting out its manufacturing to China or doing its manufacturing in China itself, all of this strictly for export from China.

It just struck me today that our typical China manufacturing client has changed. It is now an American company that is manufacturing in China to sell its products in China. And they are all going about this in very different ways. The following are good (and very recent) examples (with a bit of merging of companies and fudging of facts so there will be no identifiers) of what we are seeing out there:

1. US company that had been making about 50% of its products in China for shipment back to the US for sale primarily to one very large American company. It now has a WFOE (wholly foreign owned entity) in China where it makes about 90% of its product for sale to that same very large American company, which now takes delivery of the product in China.

2. US company that was making its product in the US and was using a Chinese company in China to assemble it in China and sell it there. US company and Chinese company had been working together for years and when it came time for the owner of the Chinese company to retire, the US company purchased it and stepped up its manufacturing in China.

3. Chinese company is told by its two largest Chinese buyers that it must bring its product standards up to Western standards or the two Chinese buyers will switch to Western suppliers. Chinese company contacts my client who, in turn, licenses the right to the Chinese company to manufacture the US product. My client very closely monitors for quality and even has the right to reject product for sale. The interesting thing here is that all parties related to this product want it to be that way.

The two Chinese buyers who had demanded US quality product appreciate that nothing will get shipped to them unless my client deems it worthy of its name. The Chinese manufacturer/licensee likes this arrangement because without it, it would not have this business any more. My client likes it because it is making money on China sales that it otherwise would never have made and it is able to do so without having to build its own manufacturing facility and without compromising the quality of its products and its name.

Western companies licensing the manufacturing of their products to Chinese companies is the next big thing. What I find interesting is that the American companies usually start out very wary about these licensing arrangements. They oftentimes want to set something up where the Chinese company manufactures the product for the American company and then the American company buys the product from the Chinese company and then re-sells it on the Chinese market. They want this arrangement because they believe it gives them more control. This sort of arrangement is possible, but it seldom makes sense because it requires additional taxable transactions and it requires the US company to form a Wholly Foreign Owned Entity (WFOE) and it requires the US company to figure out how to market and sell its product in China. In the end, licensing is going to be easier and, if handled properly, can provide virtually the same safeguards.

Our clients are concerned about the Chinese manufacturer selling its US branded product out the side door or using the knowledge it has gained of the US company's product technology and manufacturing processes to start making its own competitive product. These concerns are completely valid but they can be addressed virtually the same way in the licensing agreement
as they would be under an arrangement where the Chinese company sells the product to our client for eventual resale.

We have a client that makes a component part that is so critical for the final product that we have been able to draft licensing agreements for the final product that are not much more detailed than "licensee shall pay $10 for each final product it manufactures and the amount of final product for which licensee shall be required to pay this $10 shall be determined by (and equal to) the number of critical component parts it purchases from the American company." On the flip side, we represented an Asian manufacturer in a licensing deal with one of America's largest and best known consumer product companies that involved a 160 page licensing agreement (not counting the hundreds of pages of technical attachments) that essentially made clear that the American company would monitor, control and determine pretty much everything our client did in relation to the American product, including the content of its advertising and to whom the product could be sold.

In addition to the licensing agreement, the US or other foreign manufacturer must not forget to register its intellectual property (IP), such as trademarks, copyrights and patents, in China under its own name. The licensing agreement can protect the foreign company's intellectual property (IP) from its Chinese manufacturers, but it will not do anything to protect the foreign company from third party's in China using its IP. For that, registration is required.

What are you seeing out there?

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Rich Kuslan over at Aziabizblog has an excellent post up on emails (usually allegedly from China) that seek to scam attorneys. The post is entitled, "How Not to Get Scammed by a Scam Email," and much of the post serves as an equally good lesson on how not to get scammed by a Chinese seller of product whom you are dealing with only over the internet.

Let me back track a bit and talk the attorney scam. These are getting incredibly common and they do sometimes work. The scammer seeks to hire a lawyer to collect money owed to the scammer or the scammer's company. Typically, the attorney quickly succeeds in recovering some or all of the money owed. The fake creditor pays its debt to the attorney by check, the attorney deposits the check into the law firm trust account, and then the trust account cuts a smaller check to the scammer, with the attorney keeping its contingency fee. The only problem is that a few weeks later, the bank comes back to the law firm to announce that the check sent to the law firm by the alleged debtor is a fake and the law firm now has to compensate the bank for the loss. I have read of this happening to at least two law firms and I myself have been contacted at least ten times by lawyers asking me if a particular email is a scam. Every single time it has been.

I have also been contacted at least twenty times by US companies asking me if my firm would be willing to go after what I have quickly determined to be a "Chinese" scam company to whom the US company has communicated with over the internet, sent money to, and then never received product. I put Chinese in quotes because many times there is no evidence even that the scammers are based in China. We even had a client who came close to sending around $8000 to an alleged investment bank in London, but ended up not doing so after we discovered it was a Blimpie's restaurant. We also represented a European client that sent nearly a million dollars to a "law firm" in Seattle that was actually just a warehouse. When we told the client this, based on our having determined there was no such law firm in Seattle, no such lawyer in Washington, and that our Googling of the address had revealed it was a warehouse and the photos of the building online confirmed this, our client still insisted we send someone to this address to make sure. We did and, of course, it was a warehouse.

So how can you tell? First off, let me say it is usually not that difficult, so long as you are willing to spend five minutes doing so.

Kuslan calls for applying the following three part test to the attorney email, but I would add that it is equally applicable to anyone you are dealing with strictly over the internet:

1) Review the content of the e-mail for suspect indicia; 2) Check the e-mail properties for clues as to origin; and, 3) Honestly look at your own motivation for wishing to believe in the purported validity of the e-mail received.

Kuslan's content review consists of the following:

The writer is purported to be an executive of a foreign company owed a substantial debt or, in a twist, and ex-spouse with outstanding custody payments. Generally, some kind of deal is offered that is profitable to the lawyer. Is this already sounding strange to you?

Does the e-mail spend paragraphs describing the company, its business and the legal issue involved? If so, your delete finger should begin to itch. In fact, this is the setup, designed to create a sense of trust in the reader. Warning bells should ring when a stranger tells another confidential information over an unsecure method of communication.

Is the legal issue proposed the collection of a debt? Virtually all scam e-mails I have read propose collection matters. In one common scam, the purported debtor -- in existence only for the scam and quite likely the “client” himself -- pays up with a forged bank check. After attorney wires client the proceeds, the bank check comes back, unpaid, to haunt the attorney, who is now on the hook for the sum he wired plus bank fees for bounced check. Client and Debtor vanish into the night. Instead of agreeing to take a percentage, try proposing to this client an hourly basis with a hefty upfront retainer wired in cash. Better yet, don’t. You won't hear back.

Does the writer compliment you? Here is an actual example: “After a careful research, we have been able to establish that delinquents or past due accounts are settled when reputable and aggressive firm or professional(s) represents an organization in collection of debts or possible litigation that may arise thereof.” …which is why we’ve chosen you! Your vanity meter should read off the scale. A compliment from a stranger may be genuine, but may also lay the groundwork for very subtle scheming. Redouble your suspicions!

Is there extensive use of four and five syllable words, such as actualization, implementation, delinquency, and sentences that run on for 50 words or more? This is an attempt to appeal to those who inhabit the jungle of legal jargon. Business executives hardly write at all and when they do, they do so in bullet points of no more than 10 words of two syllables each. Your delete finger should now be hovering over the delete button.

If the writer offers a substantial retainer, one can virtually disregard the rest of the e-mail immediately. Generally, clients do not wish to pay all. The delete finger should feel heavy now…
Are you addressed by name? If you are addressed only by "Counsel," or not at all, the e-mail is intended for a mass audience. Hit the delete button.

Does the e-mail purport to come from China? China is hot and ripe for scam-ploitation. Chinese rarely, if ever, reach out to people personally unknown, untouched and unseen for representation. Delete.

Is the claim made that the writer came across the attorney's name in a directory in which the attorney isn't listed or doesn’t exist? Delete.

Does the writer claim to have contacted the attorney once before, when there hasn't been prior contact? Delete.

In a lengthy e-mail, are there significant errors of grammar and/or spelling? Delete

 

To which I would add the following questions I ask myself. Does the writer's English sound like someone from China, or does it sound like someone trying to sound like they are from China? Does the email address match the domain name? Oftentimes, the scammer will claim to work for a completely legitimate Chinese company and direct you to the website of that company. Well and good, but then why is the scammer's email address a yahoo account? Legitimate Chinese company or not, now is the time to run a Google search on the email address and the company name. I estimate that at least half the time when I have run such a search after we are contacted by someone who has been scammed, there are people on the internet who have already written about the scam.

Kuslan next calls for reviewing the email properties. Why if the company is in Shanghai, does the email come from Singapore?

Kuslan then calls for putting the address you are given into Google maps to see what comes up. He talks about once having discovered the London address of a fake company to have been a falafel restaurant. See my Blimpies and warehouse example above. I also once had a case involving many investors who invested millions in "Chinese" real estate by sending money to a company whose address was a vacant lot in a Chicago suburb (the funds were wired or sent to a PO Box). Kuslan then calls for you to look at the website's whois information. Absolutely. I did this once for a client and saw that the website of the company with whom he was thinking of investing was run by someone who was still operating under a Federal Consent Decree that required him to pay back $20 million he had stolen in an investment scam

Kuslan then discusses "your own motivations." This is actually the most difficult area. My law firm has a Russian lawyer and a Russian paralegal and we do a lot of Russian work. You would be surprised how often we are called by wealthy sixty year old farmers from the Midwest who are asking us to check out the legitimacy of their incredibly beautiful 22 year old girlfriends who will soon be coming to remote Illinois to marry them. We then point out the following regarding their betrothed:

1. As far as we know, the airport authorities in Moscow have never required someone to deposit $8543 with them as a guarantee that they will return to Russia. Heck, the airport authorities do not even care if someone returns to Russia.

2. The address of their girlfriend is the same address as that used in 6 other girlfriend scams (as determined by an internet search, usually in English).

3. The life described by the girlfriend just does not make any sense at all.

4. What we do not ask is why they would think an incredibly beautiful 22 year old woman in Moscow would want to move to remote Illinois to marry a 60 year old man she has never met.

But here's the strange part. Way too often, the client gets mad at us for what we have found and disputes our findings and says that Olga is different or, if she used to be that way, she clearly is not any more. At which point, we suggest that the client have us retain someone in Russia to confirm our findings, which offer the client nearly always declines. We have done maybe ten of these and I would say that in four of them the client has told us that he will be moving forward anyway. I have emailed some of those people later to see how things went and never heard back from a one of them. So I do not know if they were telling us they were going to go forward just to save face with us, or whether they really did go forward, but it is amazing how cognitive dissonance will cause people to believe what they want to believe and that is exactly what these scammers are counting on.

I am glad Kuslan did his post now because December definitely seems like a prime month for scams and the last time I wrote on this, in a post, entitled, "China: Ipods For $50. PS3 For $75. Wii For $100. PS3s and Xboxes For $150. Who You Kidding?" it was December also.