Forming a WFOE in China and then operating that business in China is difficult and expensive. See e.g., Forming a China WFOE: Ten Things To Consider and See also Doing Business in China Without a WFOE: Will the Defendant Please Rise on why having a WFOE is a must if you will be doing business within China. Because of this, our China lawyers are seeing increasing numbers of foreign companies choosing to sell their products in China via distribution relationships rather than via a WFOE.
This post focuses on some the questions we ask our clients looking to do distribution agreements with a Chinese company. It consists mostly of an amalgamation of emails from our China attorneys seeking more client information and providing additional client assistance before drafting a China distribution agreement.
I have the following initial questions and comments regarding your agreement.
1. For payment terms. The standard is as follows:
a. Shipping terms can be CIF or ExWorks. For products like yours, ExWorks is common, since estimating shipping and insurance costs can be difficult. If you do not know the port, you should not quote prices CIF and you should instead quote either Free Carrier (most common) or Ex Works. Either way, your distributor would be responsible for the shipping cost to the port of its choosing. It might be Shanghai for one shipment, it might be Qingdao for another shipment. That would be their decision and you want to leave the terms flexible so they can make the decision in a way that will not put you at a financial disadvantage.
I recommend you do not include price in the agreement but instead provide that your products will be sold at your normal distributor export price pursuant to a price list you will periodically provide to your distributor.
b. China’s letter of credit system is not very effective. If you ship your products before receiving payment for them, you are taking the risk that the Chinese side will not pay. Our clients usually deal with this in one of the followingtwo ways:
i. Conservative manufacturers require full payment before shipping.
ii. Less risk averse manufacturers ship on 30 days after the date of shipment (Net30) terms. These manufacturers provide for the right to shift to payment before ship terms if there is a problem.
2. You indicate wanting your proposed distributor to make advance payment for enough product to cover three months of projected sales. You need to specify an exact amount that must be purchased of each product and you also need to specify the sales terms. Your situation is further complicated by you not yet having Chinese government import approval for any of your products. For the first shipment, even where Net 30 terms are standard, most manufacturers require payment in advance of shipment. If you are not able to provide specific details in the agreement, we will provide that the exact terms of the first shipment will be determined after import approval is received. The agreement will terminate if that purchase is not completed by some certain date.
3. You have provided us with the sales milestones you want for your China distributor. This is always a good idea in a exclusive distributor arrangement but more detail is necessary, including the following:
a. You have discussed milestones for only one of your products. Will you have milestones for your other products as well? If yes, when will they be established and in what quantities?
b. Sales milestones for China distributors are usually set on a quarterly basis and not broken down by province. In formulating your sales milestones, you probably will want to account there not yet being China government approval to import your products. If you plan to set sales milestones now for your other products we can do that as part of this agreement.
c. You can set the sales milestones at whatever level of specificity you desire. This is a business matter, not a legal requirement. Sales milestones are usually a big issue in this kind of agreement, so setting the milestones in clearly is important.
4. When there is an exclusive agreement the term of the agreement becomes critically important. The normal procedure is to provide for a term long enough to give the Chinese distributor time to earn back its efforts in promoting your products. A three year term is typically the minimum, with five years more common. Most China distributors that plan to put in substantial work to market and sell your products will require the distribution agreement to automatically renew if they achieve their sales milestones. The China side will often want a provision saying that if the parties cannot agree on new milestones after the end of the first term, renewal will be automatic based on some predetermined formula. Chinese distributors that do not require something like this are oftentimes not planning to do the work necessary to succeed.
You mention wanting either party to be able to terminate the agreement with 90 days notice. Though such a provision is legally acceptable under Chinese law (which generally is more liberal in what it allows in distribution agreements than either the EU or the United States), this sort of provision will normally be rejected by a serious distributor. Why would they do all the work necessary to get your product into China and to become well-known in China only to have you shut them down for any reason and with only three months notice?
5. When selling products in China, you need Chinese and English [the client company is based in England] trademark protection for each product to be sold. Serious distributors will insist such protection is in place. Our China trademark lawyers can handle the appropriate China trademark registrations. We should take care of the trademark registrations as soon as possible. See China Trademarks: Register Yours BEFORE You Do ANYTHING Else.
6. Your distribution agreement should be drafted to be enforceable in China. We will draft it with Chinese law as the governing law, with Chinese as its controlling language, and with enforcement in a Chinese court. For why we draft these contracts this way, check out China Contracts: Make Them Enforceable Or Don’t Bother.
7. The NDA you attach is not enforceable in China. See Why Your NDA is WORSE Than Nothing for China. Rather than draft a separate agreement, we will insert standard China NNN (non-use, non disclosure, non-circumvention) language into the main agreement.
8. The concepts of “hold harmless and indemnify” do not work well with China. See China Factory Indemnification: Yeah, Whatever. We therefore normally provide a simple statement of the parties’ basic duties and liabilities. We normally provide that the distributor will be liable for damage caused to you by their actions in violation of the agreement. Since your proposed China distributor is a relatively small company you should assume it lacks the financial wherewithal to deal with a major claim and you should probably secure your own insurance.
9. Since you are expecting your China distributor to do a fair amount of work before there will be a flow of products that will provide them with an income stream. It appears you intend for your distributor to do this work at its own expense:
a. Have you discussed this with your distributor? Have they agreed?
b. If you are expecting this preliminary work to be independent of the distributor achieving its sales milestones, the agreement should give you the right to terminate the contract if your distributor never does the preliminary work or does an inadequate job at it, solely in your discretion. We can do this by basing termination on your distributor’s failure to meet an early milestone or by providing for a separate right to terminate. We should discuss.
For more on what is involved in establishing a distribution relationship with a Chinese company, check out the following:
