Outline of Presentation given at Wine Roadshow XIX - 2011 By Richard Kimber ? Negotiating Contracts with the Middle Kingdom Overview When dealing with Chinese corporates as business partners I always advise clients that they should not think of China as a single country but as a group of 23 city states (provinces) which operate in an autonomous fashion. Each province has its own idiosyncrasies for doing business. The same is true of their distribution reach across China. Distribution is very fragmented and it would be correct to say that you can probably count on one hand the Distributors who really operate on a national level. As goods are shipped across provincial borders, road tolls must be paid and sub-distributors will all take a cut so that ultimately, the FOB price of AUD2-5 per bottle translates into RMB 300 (AUD 45) on the retail shelf. Proper Due Diligence on the Chinese Distributor Due Diligence has to be handled in various ways. China does not operate a centralized or computerized equivalent of ASIC so if due diligence is done it is necessary to request an investigator or law firm on the ground to visit the local company registry where the Chinese partner is registered to check its financial statements and filings. Also requesting a copy of the business license of the Chinese company (stamped with the original chop) will show: (a) Amount of Paid Up Registered Capital (b) The year it was established (c) Registered Office Address (d) Name of Legal Representative (eg Chairman of Directors) (e) Official registered Name of Company in Chinese characters (to cross-check against the company seal or chop) Also, one should seek information from the potential Chinese partner of other 3rd parties with whom it deals and cross-check its trading history with these 3rd parties. Certain information can also be gleaned from the name of the Chinese company itself. If it is a trading company, and therefore possesses and import /export license, it will have the word ?trading? in its name in Chinese characters. Most provinces will also not permit a company to use the name of the province in the official registered name of the Chinese company unless it has paid up capital of at least RMB 2,000,000-3,000,000. Eg. Zhejiang Wing Fung Trading Co. Ltd. Therefore, be wary of companies which only contain the name of the local town or village as these are likely of little substance. Also, if you are approached or contacted by Hong Kong registered companies which only provide a Shenzhen or other mainland Chinese phone number then it is likely these are shelf companies established by a sole trader. The Chinese Business Psyche and the Art of Negotiation As a lawyer operating for almost 17 years in China I have been involved in a great number of negotiations for both the foreign party and the Chinese party. These have included negotiations on sole source and supply agreements, exclusive distribution agreements, cooperation and research and development agreements and in many cases, negotiations which take place to establish joint ventures in China. Over this time it has become clear that while the negotiating styles of the Chinese party may differ from province to province, there is one overriding factor which one encounters when dealing with the Chinese. They operate on a different time scale to western businessmen, and they show a singular patience in their negotiations which Western business sometimes finds frustrating or which in Western eyes is not regarded as commercially efficient. What has to be understood is that the decision makers in these Chinese companies are often men, (seldom women) who have only embraced western methods of doing business in the last 15 or so years, and a large number of these decision makers have moved from the State Owned Enterprises where decision making is on a committee basis. Also profit and Return On Investment is not always the focus in their business. Committee Vs Individual Decision Making Coming from the culture of State Owned Enterprises, negotiations and decision making is very much done on a ?committee basis? with large teams of personnel lined up on one side to negotiate on a business deal. However, the Chinese are very good negotiators and also use the ?committee? approach to exert pressure or win concessions from the Western side which has its own commercial pressures to ?strike a deal?. Often, the Chinese side in negotiations will raise issues which to the Western party appear irrelevant or of minor significance. This will often occur when it is the Western party who has travelled to meet with the Chinese side. The purpose of this is two-fold. As a collective decision making process, the involvement of many from the Chinese side in the negotiations is to ensure that all issues are canvassed by having many points of view at the table. Secondly, the involvement of many can mean that the other side can stall by raising peripheral issues in the knowledge that the Western side has a limited time scale in which to finalise discussions before returning to his home country. It is therefore common for the important terms such as pricing, sales targets and branding or IP issues to be raised late in the day when the Western side is under the most pressure due to his or her imminent need to depart to catch a plane or train back to where he is from. Memorandum of Understanding Therefore when discussing the terms of the business relationship with the China based distributor it is preferable to take charge by suggesting the conduct of negotiations take place in a neutral location and by preparing a detailed Memorandum of Understanding or Letter of Intent for discussion with the other side. The advice I give clients is to make the MOU as detailed as possible so that there is no confusion about what are the important contract terms which need to be focused on by both sides. Also, it is good to raise the issue of a MOU early with the Chinese side on the basis that both sides are keen to have a long term business relationship and an MOU will ensure both sides are clear on what each must bring to that relationship. The MOU should bullet point the essential terms which will need to be placed in a well drafted Distribution or Sales / Production Agreement and for a MOU such terms should also be listed with some explanatory detail under each heading of the MOU. A well drafted and detailed MOU will shorten considerably the time needed to later finalise the binding agreement. Also, while it is ?the long term relationship? that is the focus of the Chinese Side than the formal agreement, where a MOU has been signed and agreed, the Chinese will view this as an important record of the deal made. Post Contractual Issues Post Contract issues often arise when dealing with Distribution Agreement. This is because sales targets, performance issues and marketing expenditure and branding profile will continue to be assessed and reviewed during the operation of the agreement. One should be careful of how to raise such issues where these relate to performance issues or where sales targets are not being achieved. This is because the Chinese see the relationship as a long term one and not so much as the ?Seller? on one side and the ?Distributor? on the other side. Therefore, when raising performance issues, or sales targets not having been achieved, the Western side should be careful to not to raise the issue in a critical manner, but instead suggest a meeting or telephone conference to discuss how both sides can work together to improve the performance of the Chinese distributor. Direct criticism or plain language communications to the Chinese side may be misinterpreted or cause a ?loss of face? issue and give rise to a period of non-communication or lack of cooperation. Case Studies In this presentation I have given 3 examples of business deals, 2 of which I have been involved personally and the third which is one of the most famous cases often cited by business schools as class 101 on how international joint ventures in China should not be handled. (a) 1st Case Study The first case study is in respect of an olive oil distribution joint venture in China and illustrates that intellectual property protection must be dealt with ideally before any formal negotiations start with a Chinese distributor or indeed when the Australian Wine Maker is first considering access to the Chinese market. In this case the Australian producer took a small equity stake in the newly incorporated Chinese distributor in order to show a commitment to the development of an agricultural produce trading business which is still in some infancy in China. The distribution agreement took the form of a long term Distribution Agreement together with an exclusive Trademark License of the Brand to the Distributor for the territory of China. After the JVC distribution company was established the Australian producer discovered that their brand had been registered by an associated company of the Chinese shareholder of the JVC which meant they were not able to receive royalties under the Trademark License Agreement. This is because under Chinese foreign exchange regulations, a Chinese trademark licensee cannot pay royalties offshore unless the trademark and the trademark license agreement have been registered with the trademark office in Beijing. In fact, the Chinese side has registered the trademark in China with no ulterior motive other than to protect the trademark for the China business which it was developing and as the JVC had not yet been incorporated, it registered the mark in the name of an associated Chinese entity. In the eyes of the Chinese distributor this was for the protection of the business in which the Australian company would have equity. This case study illustrates two points: (a) Protection of your intellectual property needs to be activated through proper trademark registration. (b) From a Chinese viewpoint, it is the China business that must be protected rather than the interests of a shareholder to that business. 2nd Case Study The second example which I raise in my presentation also involves a joint venture between a UK company and a major Chinese telecommunications company. This example is to show that in negotiations which may involve very complex financial issues such as transfer of IP rights and board and management control issues, the negotiating skills of the Chinese side should not be underestimated. In this example the UK client gave authority to our office to negotiate on its behalf and remove the advantage of the Chinese side in stonewalling on issues until the time when the UK party was scheduled to return to the United Kingdom. Also, it shows that where possible the Australian party needs to focus on setting and controlling the agenda in negotiations and where possible the location where negotiations are to take place. By preparing the first draft of the MOU it can highlight those contractual issues which are of most importance and ensure these are the issues which remain the subject of the negotiations. 3rd Case Study A large beverage joint venture is a well known example of where the famous French partner of a manufacturing company allowed the Chinese side to exert operational control of the business without taking an active interest in the management. As a consequence of the foreign side?s failure to be actively engaged in the business, the Chinese party began to regard the business as its own private enterprise and also started to hive off products and production to related family entities. This breakdown in the operations of the joint venture was due to the complacent attitude of the foreign side who, having obtained majority control (with the false sense of security that this brings) allowed the local JV partner to operate with little oversight. This particular JVC which has irretrievably broken down has resulted in lengthy and expensive arbitration and litigation in both Europe and in China which is still ongoing. The lesson from that joint venture is that for the Chinese side, a 51/49 joint venture was a partnership of equals whereas for the French partner it signified that ultimately they had legal control. However in China legal control does not always translate to operational control which the French side found out significant financial cost. Lessons Learned ? File for IPR protection before you arrive in China. ? License trademarks, patents, IP rather than assignment. ? Include a clause that if there is a change of control of the Chinese distributor this triggers a right to cancel the TM license or distribution agreement. ? Avoid JVCs where equity is split 51/49 or 50/50 ? the Chinese see this as a JV of equals. ? Domestic joint ventures always clearly show who is majority shareholder ie 60/40 or 70/30 ? this reduces the risk of disagreement on business direction and management control. ? Be an active participant in the JVC ? attend Board and Shareholder meetings. All of the above are examples of joint ventures and for wine producers they may consider that these do not hold much relevance. However they demonstrate how Chinese companies view business relationships which they form and the manner in which they conduct business. As discussed above the Chinese business psyche sees a fluid relationship in business and where detailed distribution agreements are entered into, the distributor will commonly wish to re- negotiate pricing terms, marketing obligations etc to deal with the vagaries of the China consumer market. Be ready to be flexible and learn that compromise will be necessary if the distributor relationship is to properly develop. Below I therefore set out a list of important issues for the Australian producer who is looking to engage with a China based distributor for the first time. Lessons for the Wine Producer ? Do pre-contract due diligence on the distributor to determine if it has the distribution network which it claims to have and what is its relationship with the large retailers. ? Check whether it operates offices or branches in more than one province. ? Ask for details of other wine brands it handles and cross check this with these companies. ? Recognize that the Chinese consumer will buy from retailers in China whom it regards as international, eg Tesco, Carrefour, Metro, Walmart so check that the distributor has these retail relationships. ? Wealthier Chinese shop at these international retailers and will accept higher priced wines. ? Consider retailers such as the German wholesaling retailer Metro which can import direct with Australian producers and tolerate a higher import price. Emerging Trends in Cooperation As mentioned, small equity stakes in Chinese distributors can permit the Australian Wine Producer to maintain a more hands on interest in the activities of the distributor by having representation on the board of directors of the distribution company. For smaller producers this may not be commercially possible, however be aware this suggestion may often come from the Chinese side. On the flip side, we are seeing increased offshore interest by Chinese investors in the past 12 months, looking to acquire wine related businesses in Australia and New Zealand. This interest and these enquiries have extended into other agricultural sectors as well such as dairy and sugar operations. This trend will only increase over time as the Chinese food conglomerates look to ensure long term supply of foodstuffs for a Chinese generation whose dietary requirements are increasingly becoming more western. Wine consumption will also be a large part of this and our office has this year alone, seen half a dozen Chinese conglomerates enquire about possible acquisition of Australian wine production enterprises. It is however an early trend and for the Chinese side there are significant hurdles to overcome in successfully achieving an M&A transaction in the wine sector. Firstly, most of the Chinese conglomerates looking to acquire wine businesses in Australia are SOEs (State Owned Enterprises) and they are not known for making quick commercial decisions. Secondly, there is also a language barrier and thirdly, there does not yet exist (on the Chinese side) the business capability to successfully asset manage such acquisitions. Also, for the Chinese they look for large scale production output and apart from companies such as Fosters, etc, the wine industry is still fairly fragmented in size so it is difficult for the Chinese to obtain economy of scale. In our experience, scale of production remains a much more important issue for the Chinese than the particular ?brands? which may be obtained as part of an acquisition. Therefore, Australian wine producers looking to engage with these potential Chinese investors need to consider how to offer a form of business cooperation which will enable the Chinese to satisfy their long term supply needs. Possibly, in the form of offering significant equity in the Australian business to the Chinese investor in exchange for obtaining expansion capital and a guarantee of long term supply to the Chinese buyers. This has been a trend in the Australian mining sector and could possibly be duplicated in the wine sector as well. Another alternative would be the undertaking of contract production in Australia for a well known Chinese wine label to again ensure long term supply for that label?s China consumer market. The above types of cooperation would be more successful as they enable the Chinese investors to gain valuable knowledge in Australian wine production techniques and to ensure continued asset management of the Australian wine company in which they have acquired an equity interest. Finally, wine producers need to be aware that consumption of wine in China is not only a gift giving phenomenon, but is also a means of demonstrating wealth and affluence. It is therefore important that brand profile is given priority in marketing to Chinese and such marketing needs to emphasize the luxury or success connotation that drinking a certain label of wine will bring. Again, this is where the issue of ?face? must be remembered as well. It is a little known fact that the affluent Chinese as consumers are very internet savvy and make 70% of their purchase decisions online and from recommendations made through online discussions and blogs. Therefore, an Australian producer will need to check that the distributor they choose is aware of how to use the internet to promote their Australian brands and has a well thought out marketing strategy which involves the use of the internet. In conclusion, this paper is and can only be an overview of the art of negotiation in China and of the Chinese business psyche in doing business. Hopefully it does provide some useful pointers for Australian wine producers of how to successfully develop the distribution relationship for the China wine market. Richard Kimber Managing Partner RHK Legal (Copyright all rights reserved 2011)