1. Commercial Agreements for Doing Business in China - Distribution and Manufacturing - Excerpt
Atlas Legal
Doing Business in China
David A. Laverty
InternationalCounsel
November 8, 2005, New York
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InternationalCounsel

2. Contract Distribution and Manufacturing in China
Enhancing Revenues and Lowering Costs Without Direct Investment
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3. China Benefits Without Direct Investment
Contract Distribution and Manufacturing: Many companies wish to participate in the China market to increase revenues and reduce costs, yet avoid setting-up a local Chinese presence and the resource needs of a direct investment
The route for many is to distribute their product in China through local sales representatives and/or manufacture their product in China through contract manufacturing
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4. China Benefits Without Direct Investment
Our Focus - Regulation and Agreement Terms: Will address the basic regulatory framework, with some mention of direct investment but a focus on contract arrangements
Will limit discussion of the Foreign Invested Commercial Enterprise (FICE) (allowing foreign companies to establish their own PRC distribution companies) and process manufacturing (allowing the import of raw materials and assembly in the PRC for export)
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5. China Benefits Without Direct Investment - Outline
Distribution
A. Regulatory Framework
Trading Rights - Bring products into China
Distribution Rights - Sell products to the China market
Establish own distribution company - FICE
Appoint local sales representative
B. Key Agreement Terms - Distributor
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6. China Benefits Without Direct Investment - Outline
2. Manufacturing
A. Regulatory Framework
1. Process Manufacturing
Generally using imported materials for export
2. Basic Sourcing Agreement
For China market or export
B. Key Agreement Terms - Sourcing Agreement
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7. Contract Distribution and Manufacturing in China
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8. Distribution in China - Regulation
Separate Approvals for “Foreign Trading” vs. “Domestic Distribution” Two separate steps are necessary for a foreign company selling products into the China market:
(1) bring products into and out of China – “trading” rights
(2) distribute to end-users in China – “distribution” rights
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9. China Distribution Regulation - Foreign Trading Rights
Trading rights = the right to import goods into China and export out of China
Obtain Own Trading Rights or Work Through Company with Rights: Foreign companies can now import their products directly into China through their own trading companies, which may be in the form of a WFOE (a 100% foreign-owned enterprise)
China’s WTO obligations had provided that a foreign company would not even require a China presence for trading activities after 12/2004
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10. China Distribution Regulation - Foreign Trading Rights
Third-Party Chinese (or FIE (a PRC company with foreign ownership)) Import/Export Companies May Still be Preferred: Due to familiarity with import issues, including processing duties, VAT etc.
Some Products Restricted: May be reserved to state owned enterprises or otherwise restricted
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11. China Distribution Regulation - Foreign Trading Rights
Trading rights - Pre-WTO:
Foreign companies were basically limited to the right to import requirements for their FIEs and export what they produced
Trading rights - Post-WTO:
End of 2002 (1 year after WTO accession) – minority share foreign invested JV
End of 2003 – majority share FIE JV
End of WFOE
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12. China Distribution Regulation - Domestic Distribution Rights
Distribution rights = right to sell and distribute imported or locally made goods within China
In line with China’s WTO service trade commitments – commitment to give national treatment (equal to local parties) to parties distributing goods internally in China
Import products into China and either (1) create a foreign company’s own distribution company (a “FICE”) to distribute the products, or (2) appoint Chinese (or foreign) distributor to distribute
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13. China Distribution Regulation - Domestic Distribution Rights
Create Own Distribution Company - FICE (Foreign Invested Commercial Enterprise)
In the past, an FIE was generally only permitted to sell its own products into China and import equipment, parts and materials for its own needs
As of mid-2004, a foreign company can now directly distribute in China, but needs a form of FIE called a FICE to do so
Foreign companies gain the ability to import products which the FIE does not manufacture in China and then sell these in China, including product lines of parent company and affiliates, whether foreign or domestic
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14. China Distribution Regulation - Domestic Distribution Rights
(1) Create Own Distribution Company - FICE
Types of FICE Distribution Activities: The FICE can act as a commission agent, wholesaler, retailer or franchisor - but only through its foreign-invested FICE
Can be WFOE but Some Product Exceptions: As of 12/2004, a FICE could take the form of a WFOE and is permitted to trade in all products with some exceptions
[See full PowerPoint presentation]
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15. China Distribution Regulation - Domestic Distribution Rights
(2) Appoint a local sales representative as an agent or distributor
A Longstanding Option - Local Sales Representatives: Local Chinese sales representatives (or foreign companies through a FICE) can handle domestic Chinese distribution and marketing
If such representatives do not have their own foreign trading license, they must buy the foreign company’s imported products from PRC trading companies that have a trading license
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16. China Distribution Regulation - Domestic Distribution Rights
(2) Appoint a local sales representative as an agent or distributor
Advantages of a Representative: A local representative can deliver knowledge of the target-country market, its channels of distribution, means of importing, and a network of contacts and relationships - acts as an extension of a company’s sales and distribution arm
Can be a substitute for costly and resource-intensive alternatives – such as establishing “greenfield” operations through a WFOE, acquiring or joint venturing
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17. China Distribution Regulation - Domestic Distribution Rights
(2) Appoint a local sales representative as an agent or distributor
Representative Agreements - Subject to Approval?
[See full PowerPoint presentation]
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18. China Distribution Regulation - Domestic Distribution Rights
(2) Appoint a local sales representative as an agent or distributor
PRC Dealer Protection Laws? Has China implemented a dealer protection law, such as is found in the EU and elsewhere?
What about PRC court decisions requiring a period of termination notice and post-termination compensation?
[See full PowerPoint presentation]
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19. China Agent or Distributor - Key Agreement Terms
An Example of Commercial Agreement Terms - Distribution Agreement: Our focus is on the distribution agreement, with some mention of agency terms. Many of the comments also apply to other forms of commercial agreements
From a purely contractual perspective, what are the key issues in standard distribution agreement for US businesses in China as compared with markets such as the EU?
[See full PowerPoint presentation]
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20. China Agent or Distributor - Key Agreement Terms
Preliminary Due Diligence
Yes, it may be more challenging in China to determine creditworthiness and conduct other basic due diligence on a representative, but this is important and often inadequately addressed by the business team. Even if intend to conduct business with a distributor strictly by letter of credit or advance payment, this may change
[See full PowerPoint presentation]
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21. China Agent or Distributor - Key Agreement Terms
In China, can be fixed term unless extended by written agreement of the parties, automatic renewal unless one notifies the other, or option for foreign party to renew by written notice
However, there has been some support among courts in China for a 3-month termination notice. Is a contractual notice period is likely to prevail, and what about handling certain product areas that may require a longer notice period?
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22. China Agent or Distributor - Key Agreement Terms
Territory
Under EU competition law, a representative must be allowed to accept “passive” orders from outside of the territory, though it can be restricted from actively soliciting orders. What about China? How broad a territory to grant in China?
Exclusivity
Is the intent clear - for example, does the “exclusivity” allow the supplier to sell directly to end users in China?
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23. China Agent or Distributor - Key Agreement Terms
Intellectual Property
Volumes have been written about IP issues in China, but what can be done?
Payment Terms
What payment terms are recommended for distributors (who buy and resell)?
For agents (who receive a commission), how to adequately define the revenues upon which the commission will be based?
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24. China Agent or Distributor - Key Agreement Terms
Compliance with Local Law
Responsibilities for permissions and licenses, management of import of products into China, and payment of import duties, taxes and other charges
How to handle foreign corrupt practice requirements?
Limitations on Liability
Can foreign governing law be used and is this effective in overriding Chinese limits on the ability to exclude or limit liability? What about maximum liability provisions?
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25. China Agent or Distributor - Key Agreement Terms
Termination Clause
Advisable to include detailed and clear events of termination, not only the standard breach and insolvency/bankruptcy provisions. This can help make the termination stick in the event of a dispute – both in an initial arbitration or court action and possibly in enforcing an award or judgment
Obligations Upon Expiration or Termination
Apart from standard provisions regarding return and reimbursement for products which remain in possession and cessation of representation of foreign party or products, consider additional audit and assignment provisions
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26. China Agent or Distributor - Key Agreement Terms
Obligations Upon Expiration or Termination - continued
There has been some support among Chinese courts for post-termination compensation. Are contractual waivers likely to prevail, and what about certain product areas which may have mandatory requirements?
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27. China Agent or Distributor - Key Agreement Terms
Governing Law and Dispute Resolution
Required to specify Chinese law for this type of agreement?
What about the UN Convention on Contracts for the International Sales of Goods and ability to specify non-Chinese dispute resolution, whether arbitration or litigation?
[See full PowerPoint presentation]
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28. Distribution and Manufacturing Agreements in China
2. Contract Manufacturing
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29. China Manufacturing Regulation
Two main types of contract manufacturing:
1. Process Manufacturing
Generally using imported materials for export of finished products
2. Basic Sourcing
Finished products for China market or export
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30. China Manufacturing Regulation - Process Manufacturing
Process manufacturing - either with inputs supplied by foreign party on consignment and Chinese party paid a processing fee, with finished goods owned by foreign party (Supplied Materials Processing) or inputs purchased by Chinese party (from foreign party or others) and finished products owned by Chinese party and sold to foreign party (Imported Materials Processing)
Works for manufacturing that requires imported inputs (on duty free and VAT-free basis) and then exported – not sold into China
Duty and tax exemptions available only when there is a commitment that all finished products will be exported
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31. China Manufacturing Regulation - Process Manufacturing
Only Limited Options for Sales into China: If enter into process manufacturing and later wish to distribute in China - appoint Chinese party for process manufacturing and then pay duties and VAT if approved - but there is no approval guarantee
[See full PowerPoint presentation]
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32. China Manufacturing Regulation - Process Manufacturing
As Always, Foreign Trade Rights Required: Keep in mind that foreign trade rights are required for the import of materials and export of finished product
A PRC processing company does not necessarily have such rights. If it does not, a separate import-export company must be engaged for the import and export
Both an import/export contract and a processing contract are required and need to be submitted for provincial COFTEC approval – can be part of the same agreement
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33. China Manufacturing Regulation - Process Manufacturing
Approval Process and Rules - Quick Overview:
[See full PowerPoint presentation]
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34. China Manufacturing Regulation - Basic Sourcing
Basic sourcing = Chinese party manufactures according to foreign party’s specifications, generally using inputs that are not imported. Options for selling finished products:
Export and sell to foreign party – exports outside of China. Manufacturer must then have rights to export
Goods remain in China for distribution – needs a party with distribution rights in China (which can now be a foreign company through a FICE)
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35. China Manufacturing Regulation - Basic Sourcing
A basic sourcing contract - approval and registration?
[See full PowerPoint presentation]
License Aspects of Contract Manufacturing: As with process manufacturing, a technology licensing agreement may also be required, and a trademark license is necessary for an OEM agreement (where foreign party receives does not purchase the output but receives a license fee based on the Chinese company’s sales)
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36. China Manufacturing Regulation - Basic Sourcing
Other License Issues: Other statutory requirements may govern the license aspects of an agreement
The licensor may have the duty to warrant the technology to be "complete, error-free, valid and capable of accomplishing the agreed technical target.” In addition, the licensee may have the right to indemnification for any third-party infringement claim relating to the licensed technology
More Complex than Distributing: Some of the concepts from the distribution agreement discussion are applicable - will not separately discuss manufacturing terms, but note that the terms will be more complex than those in a representative agreement in part due to the manufacturer’s multiple duties
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37. China Manufacturing - Key Agreement Terms
Will not address in detail, but note the following examples of the duties of the Chinese manufacturer:
(a) Manufacture the products pursuant to the terms of the manufacturing agreement;
(b) Provide quality assurance capability;
(c) Acquire equipment necessary to assure quality and other requirements for the products;
(d) Inspect products before shipment for quality and validate quantity;
(e) Assure packaging meets or exceeds foreign company’s specifications, and
(f) Ship products to [a third party in China] or [the foreign company in the U.S. and make all arrangements necessary to export products from China].
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38. I N T E R N A T I O N A L C O U N S E L
An “In-House Equivalent”
Cross-Border Legal Capability
A law firm formed by former in-house international legal counsel to provide legal services to companies with business interests in multiple countries
Delivers expertise in structuring, negotiating and documenting international transactions such as joint ventures, strategic alliances and agency/distribution arrangements, as well as foreign direct investment
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39. I N T E R N A T I O N A L C O U N S E L
200 South Wacker Drive
Suite 3000
Chicago, Illinois
David Laverty
Address:
Telephone:
Facsimile:
Web Site:
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InternationalCounsel