China Law Blog: What’s the Least Bad Option?
Don't worry about it. Only meant to be understood by gamers.
A recent China Law Blog post on foreign investment in the film sector got me thinking about similar problems in other sectors. As usual, lessons learned in the FDI racket are often generally applicable to a wide variety of situations.
The CLB post was about how to structure revenue sharing on a film deal, the basic option being whether to take a piece of box office receipts or instead get as much as possible upfront. As the dialog shows, neither one of these options comes without risks (FYI: “Alderson” is the attorney giving advice to “Buckham” the client in the following dialog):
Buckham: Quick question. In one of your blog posts, you say that “Insufficient attention is given to the issue of garnering a share of the box office.” We naturally assume we will be “ripped off” for any box office receipts in China . . . .
Alderson: That is a sound assumption.
Buckham: … and therefore would normally structure the deals so that we would get any dollars we actually expect from China (ever) to be cash up front from the Chinese participants.
Alderson: That is the best way to structure your deals. I must add, however, that I see a disturbing trend even among those who structure deals this way. What frequently happens is that the Chinese party promises to pay cash on account of production costs but what they really do is arrange locations, props, equipment or services at substantial mark-ups, through deals with related parties or through deals which are not done at arms length. In such cases the Chinese side is not actually putting in hard cash and it is obtaining a disproportionate share of the production. This is not a good way to structure a deal.
In passing, I might add that this is also why some of the more successful folks in the biz have good people on the ground who keep a close eye on production. Without that kind of experience, you’re asking for trouble.
Two different kinds of situations immediately came to mind after reading that post, one that is quite comparable to the film situation, and another which is very different. Both involve foreign enterprises with a dearth of good options.
The first memory that popped into my mind was a similar conversation I had with a client a number of years ago. The deal was a copyright license, and the parties were a foreign (U.S.) and Chinese publisher.
Client: I’m thinking of X% as a royalty. Is that normal?
Me: I’m not sure “normal” is an operative term. (This was quite a few years ago.) The problem is that you can’t really verify print runs and sales, so your royalty structure invites the publisher here to screw you over. (I’m paraphrasing.)
Client: Oh, right. Well, what about an upfront fee?
Me: Probably the best way to go. That being said, since academic publishing is kind of a monopoly, you won’t have a great deal of leverage to talk up that payment amount.
The second thing that the CLB post reminds me of is a typical (inward) technology transfer deal and the threat of intellectual property infringement. The conversations I have with clients usually go like this:
Client: So I’m wondering about a royalty structure.
Me: Uh huh.
Client: I would like to structure this as a long-term deal, but with a significant upfront payment since I’ve never worked with these guys before. The problem is that they are a relative newcomer and are just expanding the market.
Me: And don’t have a lot of cash.
Client: Correct. So if I go that route, I’m probably not going to get very much. Another option would be a higher percentage on the royalty over the course of the whole deal.
Me: A lot can happen in a few years.
Client: I’m worried about our trade secrets leaking out.
Me: You should be.
Client: So what do you think?
Me: Take what you can get based on what you can reasonably forecast. Once you bring that tech onshore, the clock starts ticking. Either you get enough upfront that you can live with an IP problem later on or, assuming that any IP infringement won’t happen immediately, jack up the royalty towards the front end of the contract period.
Many other examples exist. The problem is that when you’re dealing with restricted industries, or having to deal with a distributor, and you have limited leverage or resources on the ground and no way to verify information, your options are very often limited to “bad” or “worse.”
Have a nice day.
We’re coming at it from a rather different perspective, but our practical experience is that when dealing with Chinese companies (we provide professional legal / tax services to outbound Chinese investment) we structure our fees to obtain as much as possible upfront otherwise we have a significant risk of them reneging on the full contractual obligations when payments due are staged. They know in order to collect on bad debt we have to sue, and it’s a pain to do that in China.
This is despite the fact my firm has a significant China presence and offices stuffed full of lawyers – I don’t want their time spent chasing up receivables or getting involved in litigation when they should be advising clients (most of our clients are foreign investors).
Consequently, we deliberately limit our exposure to Chinese business unless they are prepared to meet our credit terms over fees. I don’t want to develop that business too much because the risk of significantly increasing my receivables is substantial, and I like my receivables the way they currently are (60 days average).
I would imagine the situation is only much worse if the foreign partnership with a Chinese partner has no effective China presence themselves (ie: is based purely in the US).
Accordingly, the question over conducting business with Chinese companies is not just a structural legal matter, but more importantly a question over how far you are prepared to go over extending credit
(a financial decision). It’s only when that has been determined that the subsequent payment terms can be built into a deal to mitigate against that risk, and what claw back procedures – other than litigation – can be put in place to limit exposure to receivables and bad debt.
Our view is that there is significant risk of acquiring large receivables / bad debt without having the proper financial mechanisms in place when dealing with domestic Chinese entities in such a manner.
There is little point in arranging contracts and a deal only to not get paid and have additional legal costs in persuing receivables. It’s a losing game – and the Chinese know this and manipulate it to their advantage on a regular basis. I’d put the risk of acquring financial problems as high as 80% – there are some good Chinese businesses out there that are Westernzed in terms of contractual obligations, but many are still very immature when it comes to international trade and good business practices, tending to hide behind the skirts of fog that cloud the Chinese legal and political systems.
Tread very very carefully when acquiring receiveables in China. It’s probably better not to even try or to place your business in a position where it may do so. – Chris
Considering that both those games have been made into movies it might now be such a long shot for non-gamers to comprehend.
Great post, btw.
You’re assuming people actually go see those movies . . .
I agree with Mr. Devonshire-Ellis in that it’s entirely a finance system decision and assessing the degree of acceptable risk (which may depend from company to company). The legal position is secondary to the business model and collections/monitoring infrastructure. It doesn’t look good though in terms of achieving a result until China’s infrastructure concerning payment systems has improved though does it?. Foreign investors need to have access to that data and the finances that go through the system, not just relying on what amounts to little more than a “commission”, even if contracts are agreed upon by the lawyers. Perhaps they should be held to financial end results, not to hourly rates spent on drafting China legal theories.
Agree agree -
I would like to emphasize the need to always have your own rep on the ground. And when I say “on the ground” not “just somewhere” on the ground. I mean “right there”.
There are too many consultants who have one office, say in BJ, SH, QD, HK or whereever and who pretend they can cover anything anywhere in the whole of China – There are even enough, or let’s call it too many, of them who claim they can advise you without even having an office in China at all.
Having an agent, consultant or whatever rep on the ground in my mind means within an easy day of road travel – yes not railroad and definitely not by air.
We only “do” Jiangsu and that is already too big.
Costly? Yes, but don’t play if you cannot afford to loses.
@Marius – I concur with that view. You need to be on the ground in China and properly invested in the country. Not just subcontracting – either legal advice or indeed manufacturing.
I also like your gambling anecdote. Don’t play in China unless you can afford to lose. And that means adhering to the sentence above. – Chris