China Distributor Relationships Make Sense, Especially Now
My law firm’s China lawyers have written more product distribution agreements in the last three years than in the ten years prior. This is happening because foreign companies want to profit from China’s consumer and industrial markets, but they are wary of going into the country in a way that might subject them to the sort of problems foreign companies have incurred in Russia.
This post will explore the geopolitical context that’s driving the popularity of China distribution agreements and then lay out some of the practical steps businesses should take to establish and succeed with China distribution relationships.
China Product Distribution Success
The key to succeeding with China distribution relationships is finding the right distribution partner and properly formalizing the relationship with that partner. This is typically achieved by engaging in the following:
- Conducting thorough due diligence to choose a Chinese distributor with extensive experience and a proven track record.
- Negotiating a China-specific distribution contract that abides by Chinese law, protects your IP, sets clear sales targets, and outlines termination provisions.
- Registering your trademarks in China before entering the market.
- Working closely with your distributor on tailored branding and marketing to connect with Chinese consumers.
- Monitoring progress continuously to ensure performance goals are met.
This post will walk you through the context, strategies, and legal considerations to build the right relationships and avoid pitfalls.
Why China Distribution Agreements Are on the Rise: Geopolitical Risks
China is becoming increasingly risky, yet it still can be immensely profitable for foreign companies. Distribution relationships allow you to profit from selling your products into China without subjecting much if any of your company assets or personnel to China in-country risks.
a. Shifting Trade Dynamics
As global supply chains get redefined due to political tensions and trade wars, companies are recalibrating their strategies. Having a distribution agreement in China, as opposed to setting up full-fledged operations, can give your company the flexibility to adapt to changing risks, trade policies, and regulations.
b. Mitigating Risk
By collaborating with Chinese companies for distribution, foreign entities can maintain a presence in the massive Chinese market without committing to significant capital investments that could be at risk.
c. Localized Expertise
Having a Chinese distribution partner can provide you with valuable insights into the Chinese market, regulatory environment, and consumer preferences, making it easier for you to tailor your products and strategies to better align with Chinese demands.
d. Learning from What Happened in Russia
Most foreign businesses that had operations in Russia faced severe disruptions from Russia’s invasion of Ukraine and most companies are now keen to avoid and mitigate similar risks in China.
Partnering with a local distributor in China can give you a layer of insulation. Your Chinese distributor is your buffer, and your distribution structure ensures that your assets and operations are somewhat shielded, and the immediate brunt would be borne by the local distributor. We have many clients who are widely viewed as being “in” China because their name and their products or services are there, but they really are not.
The Two Keys to Successful China Product Distribution
There are essentially two keys to successful product distribution in China. One, having a good distributor. And two, having a good distribution contract. In other words, the same things it takes to succeed in having your product distributed pretty much anywhere.
1. Choosing the Right Distributor
In How to Find the Right Overseas Distributor, Laurel Delaney sets out 50 specific questions you should pose to a potential distributor. I like the following ten questions best:
1. How long have you been in business?
2. Can you share some success stories about similar products you have sold?
3. Have you represented other foreign companies? Explain what you did.
4. How long has your relationship lasted with the top three companies you represent?
5. How will our line fit in with your existing portfolio of products?
6. What’s your game plan for building our brand in your country?
7. Do you have good market coverage, including a trained and educated sales force?
8. What specific territory are you interested in covering?
9. Can you deliver on pre-agreed sales targets?
10. Where do you see our brand in 3, 5 or 10 years?
If you take only one thing away from Ms. Delaney’s article, take away that you will be establishing a long-term and important relationship with your Chinese distributor and that means you should find out whatever you can about them before you do the deal. In other words, you need to conduct thorough due diligence.
2. Using a China-Specific Distribution Agreement
As for the deal itself and the contract you use to reflect that deal, the issues are similar to what you would face in the United States or in Europe, but with additional legal issues relating to the legality of your product and the duties/tariffs you will incur in bringing your products into China.
Distribution contracts with Chinese companies are both similar to and different from US and EU distribution agreements. China law gives no special allowances to distributors, so my law firm’s China lawyers draft our China distribution agreements to take advantage of this by providing for Chinese law in a Chinese court. We also do not bother with provisions that try to work around distributor protections because there are essentially no such protections.
Protecting Your Intellectual Property
One big issue in China with nearly all distribution agreements is intellectual property protection. To “further” protect the IP of our clients, our China distribution agreements usually have what we call a “no registration” provision. In this provision, the distributor agrees that our client exclusively owns all trademarks or other IP that might be at risk, the distributor gains no rights to those trademarks, and the distributor will not register any IP in any way related to our client’s IP. We use the words “further protect” because the first line of protection for trademarks and other IP in China is registering them in China.
Here are some additional key steps related to protecting your IP in China when contemplating a distribution relationship.
- Register trademarks and patents in your own company name before entering China. Do not rely on your distributor to handle this.
- Include strong IP provisions in the contract restricting the distributor’s rights. Make it clear all trademarks remain owned by your company.
- Add a “no registration clause” barring the distributor from registering any IP related to your trademarks or products.
- Limit the distributor’s use of your brand identity and trademarks to only what is necessary for the specified contractual purposes.
- If licensing the distributor to use your brand, ensure it is done in a defined, restrictive manner with clear guidelines.
- Require the distributor to notify you of any potential IP infringements so you can take swift action.
- Mandate that all marketing materials using your brand must be approved by you beforehand.
- Specify that upon termination, the distributor must immediately cease use of your brand and IP.
- Conduct periodic IP audits and watch for improper activity or infringements. Chinese distributors sometimes quietly sell knockoffs.
Registering your own trademarks and structuring agreements to limit rights are crucial first steps. But you also need ongoing vigilance, proper brand management, and active enforcement to protect your greatest assets when entering China. Don’t let an eager distributor exploit your IP — take control from the start.
Typical China Distribution Issues
The following are some of the more common issues we see arise in the Chinese distribution contracts we draft:
a. Will your Chinese distributor be your agent?
Do you want to structure your deal so your Chinese distributor essentially becomes your agent in China, and you pay it by commissions, with the actual sales transactions being between you and the end user (as opposed to between the end user and your distributor)? We virtually always suggest the deal be done with you simply selling your product to your Chinese distributor and your Chinese distributor — in turn — selling your product to end users. This distribution method usually makes sense for a whole slew of reasons.
b. How can you integrate franchise and pricing control terms?
When negotiating distribution terms, be aware of two areas of Chinese regulations:
First, ensure you do not inadvertently create a franchise arrangement which would trigger added compliance requirements. If your agreement excessively dictates the distributor’s operations under your branding, it can be deemed a franchise model by Chinese authorities. Maintain the distributor’s independence.
Second, China’s Anti-Monopoly Law prohibits imposing minimum resale pricing. Therefore, your China distribution agreement should not mandate the prices a distributor charges to third parties. Allow market-based pricing.
c. Will you grant your Chinese distributor an exclusive?
Will your Chinese distributor have an exclusive territory, customer type or product range? If so, for how long? Generally, if you grant an exclusive, you should be sure to set sales performance targets that will allow you to terminate the contract if not met.
My law firm has been contacted by far too many companies that granted their Chinese distributors long term exclusive distributorships only to have the Chinese company do absolutely nothing to try to sell the foreign companies’ products in China. Beware the Chinese company that wants exclusive distribution rights to your product not to sell it, but to mothball your products so they do not compete with their own products or with the products of other companies for which it is already a distributor.
Setting adequately high minimum sales quotas will protect you from getting stuck with an under-performing or non-performing distributor. The typical provision mandates a certain minimum dollar value of sales, or a minimum number of units sold. Your Chinese distributor’s failure to meet the minimum for a certain period can result in termination or to it losing exclusivity.
d. Who is responsible for what on sales and marketing?
The key here is clarity. Chinese distributors often expect their foreign product supplier to engage and pay for at least some of the China sales and marketing costs. There is no right way to handle this other than being sure both sides of the distribution deal understand who is responsible for what.
e. What about your trademarks?
If you are going to sell your product into China (whether through a distributor or otherwise), you must register your trademark in China before doing so and you must register that trademark in your company’s name, not that of your distributor. To be sure your trademark remains yours in China, your distribution agreement should license the limited use of your trademark to your China distributor and make clear that use of your trademark is subject to compliance with the contract by your distributor and to compliance with the limitations on the use of your trademark.
f. What Happens if your China distribution relationship terminates?
A good distribution contract makes clear what happens upon termination because doing so greatly improves your chances of smoothly transitioning to a new distributor. Is your distributor allowed to sell down its remaining inventory of your product or must it cease sales immediately? Are you required to buy back the inventory and, if so, at what price? You want to put in your contract that the distributor must inform you of any pending and future sales. Where will your disputes with your distributor be resolved, and by whom?
Conclusion
China distribution agreements can give foreign companies a flexible pathway to get their products into the Chinese market without taking on the risks of fully immersing the company itself into China. By choosing the right distribution partner, formalizing the distribution relationship properly, protecting your IP completely, and collaborating closely on execution, your business can profit from China without taking on full operational risks and exposure.
