In this edition of our series on doing business in China, we discuss some issues to consider before a foreign seller (the "Seller") enters into a distribution agreement with a Chinese party acting as the Seller's distributor (the "Distributor"), to market and sell the Seller's products and/or services on the Chinese market.

1. Distributor due diligence

It is vitally important that the Seller verifies the identity of the proposed Distributor. There are a range of due diligence options available to verify the "creditworthiness" of the Chinese party, depending on the relevant budget for due diligence. This includes hiring a local Chinese attorney at a reasonable cost to seek disclosure of information filed with the local Chinese company registration authorities.

Alternatively, one may verify for free online at the National Enterprise Credit Information Publicity System ("家企业信用信息公示系统" in Chinese), a website maintained by China's company supervisory authorities for official filings of all companies registered in China, including information on the names of company shareholder(s), key personnel, capital contribution status, approved business scope and history of administrative penalties. In addition, Tianyancha.com also provides registered company information. Although information found on these websites may not be updated in real time, they provide a reasonably reliable outlook on the proposed Chinese distributor's regulatory compliance, financial health and other relevant risk indicators.

2. Exclusivity of distribution and minimum sales target

It is also important for the Seller and the Distributor to decide whether the distribution relationship will be exclusive, sole or non-exclusive. The determination serves to delineate the parties' respective rights to market, sell and distribute the products and/or services in the territory or territories involved.

There are generally three types of distributorship practiced globally:

  • Exclusive - the Distributor is the only distributor, and the Seller cannot appoint other Distributors or sell the products/services involved itself in the relevant territory;
  • Sole - the Distributor is the only distributor and the Seller may also sell the products in the relevant territory; and
  • Non-exclusive - there are several Distributors and the Seller may also sell the products in the relevant territory.

Each option has advantages and disadvantages. For example, if the Distributor requests an exclusive distribution arrangement, we would typically advise that Sellers ask for a minimum annual sales guarantee, to ensure that one exclusive Distributor can generate the sales volume which the Seller could otherwise obtain from having multiple distributors (and/or itself) undertaking marketing and sales activities in the territory involved.

Therefore, if a Distributor wishes to enter into an exclusive distribution agreement, it may be necessary to ensure that it is capable of selling a minimum quantity of the Seller's goods or services to negate the need to engage multiple Distributors, so as to avoid the risk of being restricted to one unproductive Distributor.

3. Minimum resale price

Chinese law prohibits the Seller from placing an obligation on the Distributor to sell products or services to third parties (e.g. consumers and retailers) at a specific price, or for the parties to maintain a minimum resale price, unless one of the statutory exceptions stipulated in China's Anti-Monopoly Law is met, e.g. "where the objective is to raise product quality, lower costs or improve efficiency".

4. Protecting intellectual property rights (IPRs)

Any Seller entering the Chinese market would no doubt be concerned about protecting its business secrets and IPRs. One of the most effective methods of protection is not to disclose highly sensitive information, know-how or unregistered intellectual property rights where possible (or, at least, without a robust non-disclosure agreement in place). It is also imperative that the Seller registers its IPRs before introducing them to the Chinese market.

The Seller should also consider which party owns or has the right to use any modifications, improvements or development made to any of the IPRs relating to the products or services involved. If the distribution agreement involves any joint product or service development, which may yield related product or service modifications and improvements, China has particular rules governing the ownership and usage of such improvements or modifications.

However, if for some reason the Distributor is deemed by Chinese law to have any rights in any of the Seller's IPRs, e.g. through registering the Seller's IPRs in China without the Seller's consent or knowledge, we suggest including a clause obliging the Distributor to unconditionally assign to the Seller all of the Distributor's rights, title and interests in the IPR involved without any payment. In the event that any such right, title or interest in any IPR is not transferrable to the Seller, e.g. in China the transfer of patent rights or patent application rights to foreign parties may be subject to government approval, we suggest the inclusion of a covenant that the Distributor should grant to the Seller a licence to use, exploit and sub-licence any and all such IPRs held by the Distributor, royalty-free.

5. Handling of administrative procedures and regulatory affairs

Due to the Distributor's local presence and knowledge, it is in a much stronger position and more capable than the Seller of carrying out any necessary administrative procedures in the complex Chinese legal and regulatory landscapes. Therefore, we recommend shifting to the Distributor the responsibilities for obtaining any necessary import licences or permits for the entry of the products or services into China, or their delivery to the Distributor. Additionally, the Distributor should be responsible for any customs duties, clearance charges, taxes, brokerage fees and other amounts payable in connection with the importation and delivery of the products or services in China.

In addition, if possible, the Seller should also covenant that the Distributor should inform the Seller in a timely manner about any local laws and regulations (and proposed changes thereto) which may affect the manufacturing, labelling, packaging or sale of products being distributed in China.

6. Document translation costs

The Seller and the Distributor should also consider which party will be responsible for the costs of translating into Chinese all foreign language materials and documents relating to the products or services involved, in compliance with Chinese regulatory requirements and for the benefit of end-users.

7. Indemnification clauses

Chinese law does not recognise the concept of "indemnification" per se. In practice, "indemnification" would be translated as "compensation" which is more akin to compensation by way of contractual damages with the onus on the claimant to show reasonable loss.

Under Chinese law, all losses arising out of commercial contracts shall be framed as claims for compensation due to contractual breach, based on the actual losses suffered by the aggrieved party.

8. Effectiveness of penalty provisions

Liquidated damages clauses and maximum liability clauses are seen frequently in Chinese contracts and certainly provide numerous valuable purposes. However, such clauses can be challenged if the liquidated damages previously agreed are:

  • lower than the actual damages, in which case the innocent party may claim for compensation up to the amount of actual damages suffered; or
  • "substantially higher" than the actual damages amount.

"Substantially higher" has been defined by Chinese courts to be more than 130% of the actual damages suffered. The court's adjustment of liquidated damage provisions is anchored in consideration of actual damage, while weighing up the actual contractual performance, degree of fault and expected interests of the parties. Therefore, any liquidated damages provision may be subject to challenge by the relevant party and adjustment by the court or tribunal.

9. Agreements executed in counterparts

As for agreements executed in counterparts, a standard clause in a commercial contract under English law makes the contract legally binding even if each contracting party does not sign the same copy of the contract. However "counterparts", as understood under the law of some other jurisdictions, is not recognised in China. Instead, to ensure the validity of a written contract, both parties to the contract must sign all copies of the contract governing the parties.

10. Formalising the distribution agreement and other considerations

"Legal representative", a statutory position under China's company law regime, is the company's highest officer and whose acts in the course of executing his/her duties functions shall bind the company. Therefore, wherever possible, be sure to always ask the Chinese Distributor's legal representative to sign the distribution agreement with the Distributor's company name appearing in Chinese (or stipulate the Chinese name of an individual Distributor). It is also important to ensure the Distributor's company seal is affixed on each copy of the contract for maximum legal effect.

Choosing which laws should govern the distribution agreement and the preferred type of dispute resolution mechanism to resolve any dispute arising out of the distribution agreement are also important issues to consider. Readers may refer to our previous issues on these topics, including:

Conclusion

In the preceding article, we have highlighted some issues to consider before signing distribution agreements with Chinese parties. You will also notice that some of the issues in our top 10 list may also apply generally to commercial contracts in general involving Chinese parties, including the need to be mindful of protecting one's IPRs, as well as discussions on indemnification and the effectiveness of liquidated damage provisions.