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Trend: Taking Control of Distribution in China

26 June 2015

In international media, one of the leading economic stories in recent years has been the slowing growth of the Chinese economy. Indeed, China's GDP officially grew by only 7.4% in 2014, slipping from 7.7% in 2013. However, this is not making China less interesting as a target for international business. Heavy industries may be suffering, but the demand for consumer goods and services from China's consumers, for example, is booming. Modern shopping malls are rising across China including in smaller cities, China has taken over as the world's largest car market, and the Chinese have become the biggest buyers of international tourism and education abroad.

For many international businesses, this means a renewed focus on China, and how to reach a middle-class which is growing larger than those of Europe and North America combined. This requires a commercial plan, combined with some crafty legal structuring.

Traditionally, many international brands have outsourced sales in China to distributors in China. A Chinese (incl. Hong Kong) company was deemed more familiar with consumption practices in China, could build and maintain close relationships with customers (incl. state-owned ones), and was even willing to share in some of the cost and risk. In all kinds of sectors from fashion to medical devices, to equipment and to F&B, international businesses relinquished control over distribution in China. Recent trends show that many businesses are eager to take back control over their Chinese distribution channels.

In the remainder of this article, we focus on some of the legal challenges that international companies face when restructuring distributor relationships: how to build self-owned distribution channels, how to terminate distribution contracts, the importance of ensuring IP / trademark ownership, and managing product registrations.

1. Building Self-owned Distribution Channels

Although many international companies have been taking advantage for years, for others it will be news: China allows, and in fact encourages, foreign investors to establish self-owned distribution companies. Over the past two decades, most economic sectors have been opened to foreign investment, with restrictions remaining for only a few sectors that are deemed of national interest. Chinese-registered companies solely invested by foreign businesses (so-called wholly foreign-owned enterprises, WFOE in short) can thus engage directly in the domestic and international trade of all kinds of products. They also have the choice of opening retail outlets to reach individual consumers.

It is no longer difficult to establish a WFOE in trading or retail. Procedures are inevitably more complicated than in "lighter" jurisdictions such as Hong Kong, but there are plenty of good lawyers that can help to navigate China's bureaucracy. Minimum investment requirements have mostly been abolished, while companies have much freedom to determine their own corporate governance structures. The new PRC Foreign Investment Law, which is currently in draft and may be promulgated later this year, is another step to make life easier for international businesses to set-up shop in China.

It is also important to remember that a subsidiary established in one location can do business all over the country. If it makes sense commercially, it can open subsidiaries, branches or liaison offices to have people on the ground in other cities, for example to conduct sales or support local customers.  And local partners can be engaged to provide support in building and maintaining relationships with special customers, such as government departments. But from a legal perspective, all trade can be organized through and financially consolidated in the one Chinese entity. 

2. Terminating Existing Distribution Contracts

One legal challenge that many companies will face, is to terminate relationships with existing distributors. In some cases this is easy: if the distribution agreement was properly drafted, termination clauses should provide clear and unabridged  guidance how to manage termination, and at what cost.

Where the distribution contract is not exclusive, another choice may be to let it run parallel to self-owned channels. Or perhaps it is beneficial  to directly acquire the Chinese distributor or its distribution network - as is permitted under Chinese law. A detailed due diligence will be needed, but if it can be implemented then it will allow for a flying start to further developing the business. The best distribution agreements may already foresee in such an option, though in the end this will usually be a matter of negotiation.

International businesses may face tougher residence if the distribution agreement is exclusive, and does not include any termination clauses, while the Chinese counterpart refuses to deal. A choice will have to be made between breaching the exclusivity term and building a parallel structure, or terminating the distribution agreement without cause and risking claims for damages. A legal analysis will have to be made on a case by case basis, but in practice loopholes can often be found to minimize the risks to potential claims for damages. It is good to remember that filing claims in Chinese courts can be a difficult and cumbersome process for your opponents, acting as a natural barrier to all but the strongest of legal claims.

3. Ownership of trademarks / intellectual property

A key part of any distribution strategy, is to establish the ownership of relevant brands in China. Risking limited contractual claims is one thing, but making large investments without brand security may prove to become an insurmountable hurdle to overcome. Some particular issues in the Chinese setting:

  • China's system for protection of trademarks is modeled on international standards, which means that trademarks must be registered in China (either directly or through the international Madrid system) to be protected in China. By applying the first-to-file rule, China does not offer specific protection to international trademark owners who are late to register their trademarks. As a result, trademark squatting by business partners (incl. distributors) and third parties is very common.
  • In the context of a distributor relationship, international businesses often discover late that their Chinese distributor has taken the initiative to register relevant brand names - if not the international company name and brand names for specific product lines, then at least the Chinese equivalents thereof. This can result in a major dispute. If registered in bad faith, the international owner may have the legal grounds challenge the trademark registration of a distributor, but this will take time and success is not guaranteed. Meanwhile, the distributor continues to hold the trademark rights, and can threaten legal action if the international brand owner tried to enter China directly.

Even international brand owners that are not (yet) contemplating a change to their business model should review whether they own exclusive trademark rights in China; and if they do not, should develop a strategy to either obtain such rights (whether through legal action or friendly acquisition) or build new brand names (e.g. in Chinese) that they control. Even with a less-than-perfect reputation for legal protection of IP rights, it is not advisable to roll out a distribution strategy while being under constant threat of seizures and lawsuits.

4. Managing Product Registrations

Another focus point that deserves attention, is that of product registrations. Many categories of goods are not subject to special licensing, which means that a Chinese trading company (including one with foreign investment) can import such goods and then sell them in China without obtaining specific product registrations or approvals. Other categories of goods, however, are subject to special supervision and/or approvals, and this includes certain food and feed products, medical devices, health products, pharmaceuticals and active pharmaceutical ingredients, cosmetics and ingredients, and even various electronic goods (which are subject to CCC certification).

Product registrations are usually very bureaucratic and therefore take a lot of time to complete, while existing certifications from foreign countries generally do not count for much. As a result, product registrations are very valuable, and so where possible companies should avoid placing distributors in charge of product registrations. Examples abound where distributors take advantage of their powerful position in the distribution chain to extort their international counterparts.  If using distributors in product registrations is unavoidable (for legal or for commercial reasons), then the acquisition or renewed filing of product registrations will become an important part of the strategy to take over distribution through a wholly-owned entity in China.