V. MARKETING U.S. PRODUCTS A. Distribution and Sales Channels/Use of Agents and Distributors Companies wishing to export to China can either deal through trading companies or other agents, or handle their own sales through a representative office. Searching for an agent in China is complicated by the separation of the two elements that basically characterize international trading firms: import/export authority and aggressive marketing expertise. Foreign companies are not permitted to directly engage in trade in China, other than direct marketing of goods they have manufactured in China. Accordingly, U.S. exporters need to use a domestic Chinese agent for both importation into China and marketing within China. Only those companies that have been authorized by the central government to handle export and import business are permitted to sign import and export trade contracts. As of 1994, over 7,000 Chinese firms have that authority. Fifteen years ago, only 10 or so state trading companies acted as purchasing agents for particular industries nationwide. While this system is rapidly becoming obsolete, many trading firms still retain the buyer's agent mindset. Some have begun to represent foreign manufacturers like a Western-style seller's agent, but these are still in the minority. With careful selection, training and constant contact, a U.S. exporter can obtain good market representation from a Chinese trading company, many of which are authorized to deal in a wide range of commodities. Some of the larger companies have offices in the United States and other countries around the world, as well as branches throughout China. In addition to the trading companies, China is witnessing an explosion in local sales agents to handle internal distribution and marketing. These firms do not necessarily have import/export authority. They may be representative offices of Hong Kong or other foreign trading companies, or domestic Chinese firms with regional or national networks, under supervision of the Ministry of Internal Trade. Given China's size and diversity, U.S. exporters may find it makes sense to hire several agents to cover different areas. China can be roughly divided into at least five major regions: the South (Guangzhou), the East (Shanghai), the Beijing-Tianjin region, Central China and the Northeast. The US&FCS offers a special program called the Agent/Distributor Service (ADS), which is designed to help U.S. exporters find appropriate sales agents in China. This service should be ordered through a district office of the U.S. Department of Commerce. B. Licensing Technology transfer is another initial market entry approach used by many companies. It offers short-term profits but runs the risk of creating long-term competitors. Due to this concern, intellectual property considerations and the lower technical level prevailing in the China market, some firms attempt to license older technology, promising higher-level access at some future date or in the context of a future joint venture arrangement. License contracts must be approved by and registered with the Ministry of Foreign Trade and Economic Cooperation (MOFTEC). A tax of 10 - 20 percent (depending on the technology involved and the existence of an applicable bilateral tax treaty) is withheld on royalty payments. See Section V.K for more on licensing. C. Franchising China has no laws on franchising per se. In practice, however, foreign companies are beginning to establish multiple outlets for distribution under a variety of franchise-type arrangements. China's retail trade, basically still closed to foreign competition, is undergoing rapid change in line with market reforms sweeping the country. Increasingly, foreign retailers are being be permitted to enter the market through joint ventures, or to open specialty stores selling products made at their own factories in China. China is allowing foreign joint venture retail stores to open on an "experimental basis" in six cities (Beijing, Shanghai, Guangzhou, Tianjin, Dalian and Qingdao) and five special economic zones (Shenzhen, Zhuhai, Shantou, Xiamen and Hainan), subject to an overall limit of not more than two retail joint ventures per city. Apart from these retail operations, increasingly foreign fast-food operators and other service providers are beginning to franchise under licensing arrangements involving use of trade or service marks, often in combination with some sort of joint venture arrangement. Despite the legal murkiness at present, franchising looks to be a very promising mode of entering the Chinese retail market. D. Establishing an Office Once a company decides the China market warrants a greater investment, the next logical step is to set up one or more representative offices. These offices are limited by Chinese law to performing "liaison" activities. As such, they cannot actually sign sales contracts, directly bill customers or supply parts and after-sales services for a fee (although some offices have been permitted to perform these after-sales activities for so long as they are covered by warranty as part of the original purchase). Although China's Company Law, effective July 1, 1994, permits the opening of branches by foreign companies, as a policy matter China still restricts this entry approach to selected banks, insurance companies and accounting and law firms. While representative offices are given a registration certificate, branch offices obtain an actual operating or business license and can engage in profit-making activities. Establishing a representative office gives a company increased control over a dedicated sales force and permits greater utilization of its specialized technical expertise. The costs of supporting a modest representative office can range from $250,000 to $500,00 per year, depending on its size and how it is staffed. The largest expenses are rent for office space and housing, and expatriate salaries and benefits. Accordingly, many companies choose to set up offices with a local Chinese manager, and bring in foreign personnel as required. E. Establishing a Chinese Subsidiary A locally incorporated equity or cooperative joint venture with one or more Chinese partners, or a wholly foreign-owned enterprise, may be the final step in developing markets for a company's products. Domestic production avoids import restrictions -- including relatively high tariffs -- and provides U.S. firms with greater control over both intellectual property and marketing. However, the inconvertibility of China's currency means that firms need to devise ways to earn or purchase foreign exchange for purposes of paying expatriate management salaries and benefits, remitting profits and royalties, and covering other hard currency costs. The role of the Chinese partner in the success or failure of a joint venture cannot be overemphasized. A good Chinese partner will have the connections to help unravel or smooth over red tape and obstructive bureaucrats. However, U.S. companies should try to ensure that their prospective partners' objectives are the same, for example, to run an efficient, profit- making enterprise and to access the domestic market rather than simply earn foreign exchange through export. Moreover, the American side should be careful about leaving too much control in the hands of the Chinese side. Common investor complaints deal with conflicts of interest (e.g., the partner setting up competing businesses), hidden agendas and violations of confidentiality. Some companies prefer to establish a wholly foreign- owned enterprise rather than a joint venture, with a view to retaining greater management control, due to concerns over intellectual property right protection or for other reasons of corporate policy. The law on WFOEs requires that they basically either provide advanced technology or be primarily export-oriented, and restricts or prohibits them in a number of service and public utility sectors. However, an increasing number of U.S. companies find WFOEs, which now account for roughly 20 percent of all foreign-invested enterprises, to be a viable entry vehicle to the China market. See Chapter VII for further information on investment. F. Selling Factors/Techniques Relationships: Personal relationships in business are critical. The Chinese like to deal with "old friends," and it is important for exporters, importers and investors to establish and maintain close relationships with their Chinese counterparts and relevant government agencies. It is equally important that American exporters encourage strong personal relationships between their Chinese agents or distributors and the buyers and end-users. A web of strong personal relationships will help ensure smooth development of business in China. Foreign Currency: As of January 1994, Chinese companies are not permitted to retain any foreign exchange. However, they should normally be able to obtain the foreign currency necessary for imports and for servicing approved foreign obligations such as licensing fees, royalties and loans, by taking the relevant documentation to a Chinese commercial bank. In contrast, foreign-invested enterprises (FIEs) are permitted to retain foreign exchange contributed to or earned by the enterprise. In return, these FIEs are excluded from the new interbank forex market and must purchase any required additional foreign exchange through several swap centers that the Chinese government is maintaining for FIE use. G. Advertising/Trade Promotion Advertising: Whether targeted for a specific industry or aimed at a mass audience, advertising can be an effective way to create product awareness among potential consumers and end-users in China. Channels for mass advertising in China include publications, radio, television and billboard displays, as well as sports sponsorship and other innovative means. There are many advertising companies in China, including Chinese, foreign and Chinese-foreign joint ventures. Prices for advertising are regulated by the State, and are higher for foreign than for local companies. The Chinese government has promised to eliminate price discrimination in advertising by the end of 1994. Trade Shows and Missions: Hundreds of international exhibitions per year are now held in China. Most are sponsored or cosponsored by government ministries or bureaus, professional societies or the China Council for the Promotion of International Trade (CCPIT). Other shows are organized by U.S., Hong Kong or other professional show organizers. Though costs for participating in shows are high, trade shows can be an efficient way to make contact with agents, trading companies and end-users. Occasional catalog shows may also be useful. For firms already in China, trade shows of all varieties can be used to conduct surveys and introduce new products. The Department of Commerce's China Desk can provide updated information on upcoming trade shows and missions, organized by the department, various trade associations, and some states. (See, also, Appendix E hereto). H. Pricing Product While China's growing middle class is increasingly willing and able to buy high-priced status symbols, most Chinese buyers are sensitive to price and will usually choose the less expensive product unless they can be swayed by after-sales service or clear technical superiority. Attractive financing packages offered by Japanese, European and other foreign government agencies, which lower the effective price, also may make some U.S. goods look less competitive. Current exchange rates among the U.S. dollar, the Japanese yen and European currencies somewhat mitigate this problem for U.S. products. I. Sales Service/Customer Support As a tangent to China's anti-retail laws, foreign companies and Chinese-foreign joint ventures are not normally permitted to provide sales service and customer support other than in respect of products the company itself manufactures in China. Accordingly, these firms must engage the services of authorized Chinese entities, on a contractor basis, to establish service centers that can provide spare parts and after- sales service. American companies complain that such arrangements give them inadequate control over the quality of customer service and result in loss of customer confidence. Some companies thus opt to provide regular servicing from bases outside of China, such as in Hong Kong. American firms, with the support of the U.S. government, are pressing for relaxation of these restrictions. J. Selling to the Government In its annual report for 1994, the United States Trade Representative found that, with few exceptions, China's government procurement practices are not consistent with open and competitive bidding. For the most part, China's procurement practices remain non-transparent and inaccessible to foreign suppliers. Purchases for virtually all projects in China are subject to at least one, and usually several, approvals from governments at various levels. While tenders for projects that use funds supplied by international organizations are usually openly announced, most government procurement is by invitation only. Competition is by direct negotiation rather than by competitive bid. Goods and vendors for large projects that are covered in the annual state plan are frequently designed during the planning process. All information, from solicitation to award, remains secret and is known only to those companies involved or to officials in the planning and industrial ministries. China has committed to improve this situation. In October 1992, the United States and China signed a Memorandum of Understanding (MOU) on Market Access in which China agreed to increase the transparency of its trade system by publishing all of its rules and regulations related to trade and agreed not to enforce any law that is unpublished. As of December 1993, China published a large number of trade-related laws and regulations and issued State Council Circular 63 stating that only published laws and regulations are enforceable. In addition, the Chinese published government procurement guidelines regarding machinery and electronics. These guidelines, however, contain registration requirements and unacceptably vague tendering regulations. The Administration is discussing improvements in the tendering regulations with the Chinese government that would bring the regulations up to the standards of the GATT government procurement code. K. IPR Protection On January 17, 1992 the United States and China signed the Memorandum of Understanding on the Protection of Intellectual Property. This MOU required China to make certain changes to its laws governing intellectual property protection over the following two years and to join the Berne and Geneva Phonograms Conventions, to which it subsequently did accede. The current focus of bilateral IPR discussions is on enforcing China's IPR laws. Copyright: As a result of the MOU, China and the United States established bilateral copyright relations on March 17, 1992. U.S. owners of computer software, books, films, sound recordings, and other subject matter now enjoy protection under China's copyright legislation (which includes a Copyright Law and separate Regulations on the Protection of Computer Software), the Berne Convention, and the Implementing Regulations for International Treaties. Computer software programs will be protected for 50 years without any mandatory registration requirements. Copyrighted works which were "owned and used" in China before establishment of bilateral copyright relations may continue to be used, provided that they are "neither reproduced nor used in any manner that unreasonably prejudices the legitimate interests of the copyright owner." To date, the Chinese government does not contemplate the creation of an administrative system to arbitrate copyright infringement claims. All such claims must be redressed through China's court system, which now includes several specialized IPR courts in several cities such as Beijing, Shanghai and Guangzhou. Patent: Consistent with the requirements of the MOU, China has amended its Patent Law to protect chemical inventions, in particular pharmaceutical products and agricultural chemicals. The prior law only permitted patent registration for the manufacturing process relating to chemical substances. The Patent Law amendments now also define infringement in a broader sense to include unauthorized sale or importation of products manufactured with the use of patented processes. The MOU also requires the duration of a patent to be extended from 15 to 20 years and places conditions on the granting of compulsory licenses and cross-licenses. Pharmaceutical and agricultural chemicals that do not qualify for protection under the amended Patent Law may be eligible for administrative protection. The MOU imposes three criteria for eligibility: 1) the invention must have been patented in the United States between January 1, 1986 and January 1, 1993; 2) the invention may not have been previously marketed in China; and 3) the invention is intended to be manufactured or sold in China as evidenced by contract. Additional regulations apply to the procedures and supporting documentation required for submitting an application for administrative protection. With the exception of the administrative protection provisions, U.S. patents must be registered in China in order to enjoy protection under Chinese law. Under the Patent Law, foreign parties must utilize the services of a registered Chinese agent to submit the patent application. Preparation of the application may be done by foreign attorneys or the Chinese agent. Trademark: The topic of trademark was not specifically addressed by the MOU. At the time it was being negotiated, China appeared to have been making substantial improvements in the trademark law as indicated by certain draft amendments which were being circulated at the tine. The final amendments to the Trademark Law, effective February 22, 1993, did not include many of the provisions contained in the prior drafts. Lack of protection for well-known marks and inadequacies in trademark enforcement continue to be of great concern to American firms. One significant improvement is that supplemental provisions that impose criminal sanctions for trademark infringement were added to China's Criminal Law. The Trademark Law amendments also permit for the first time registration of service marks. Trademark registration in China should be an integral part of any company's initial market entry. One cannot predict whether the product will become so popular in the market that a Chinese entity may seek to trade on consumer goodwill. Moreover, China's is a first-to- register system that requires no evidence of prior use or ownership, so anyone can register popular overseas marks not already registered in China. Under the Trademark Law foreign companies must utilize the services of registered agents to submit the trademark application. Foreign attorneys or the Chinese agent may prepare the application. Trade Secrets: In September 1993, the Chinese Government adopted the Law against Unfair Competition, effective December 1, 1993. This law defines unfair competition to include conduct that infringes the "lawful rights" of another business operator, including acts that violate "commercial secrets" rights. Commercial secrets are defined to include technical information and operational information not known by the public, which can bring economic benefits to the authorized users and which are protected by the taking of appropriate security measures. Sanctions under the law include civil remedies (damages), administrative sanctions like fines, and criminal penalties for "serious violations." The implementing rules and administrative procedures for this law are still in the process of being drafted. China is further obligated to protect trade secrets under the Paris Convention for the Protection of Industrial Property, to which it is a signatory. As this law is very new and untested, most firms continue to rely upon confidentiality and non- competition clauses in contracts to protect business or technical information. Regulation of Technology Licensing: Technology transfer by foreign companies is governed by the Regulations on the Administration of Technology Import Contracts promulgated by the State Council on May 24, 1985, and their Implementing Rules issued by MOFTEC on January 20, 1988. These technology import regulations pertain to licensing patents, trademarks, know-how or trade secrets; contracts for technical services; and other technology import contracts. Contracts transferring intellectual property as part of the foreign equity contribution to foreign-invested enterprises are generally regulated by laws concerning foreign investment. Technology licensing contracts must be approved by MOFTEC or its provincial commissions. Some of the issues of particular concern to U.S. companies include: -- The legislation does not permit the licensor to require confidentiality beyond the duration of the contract, except where the supplier provides improvements to the technology, and most technology contracts are not to extend beyond 10 years. Upon termination of the contract, the licensee is allowed to continue using the technology, unless the licensor receives special approval for restricting the technology's use. -- The rules do not allow the licensor to restrict sales channels or impose "unreasonable" restrictions on the export of products produced with the licensed technology. The licensor is only allowed to restrict exports to locations where it holds an exclusive license or distributorship, and only the approving authority can grant this exception. -- Special approval is required for extended confidentiality, export restrictions, and preferential treatment for payment of royalty tax. The approval authority may reject or modify contracts which contain unreasonable price terms, assign unclear or inequitable obligations to the Chinese party, or other unequal conditions for exchanging technical improvements. The contract may also be rejected if the Chinese licensee does not have authority to import technology, or the contract purports to bind other Chinese government authorities at different levels or in different provinces. -- The licensor is required to certify that it is the legal owner of the technology or has the right to transfer the technology, and to indemnify the licensee against any infringement claims by third parties. Some sophisticated Chinese negotiators have begun to insist that the foreign transferor of technology agree to be liable for injuries directly caused by defects in products correctly manufactured with foreign technology and also oppose the foreign licensor's attempt to limit liability for injuries resulting from misuse of the technology. L. Need for Local Professional Services Straightforward sales transactions involving import or export normally do not require special professional assistance. However, licensing technology, opening a representative office and establishing a subsidiary in China all involve questions of Chinese tax and other laws, as well as complex questions on structuring and business practices that indicate the need to obtain advice from attorneys, accountants and consultants familiar with Chinese requirements. Under Chinese law, representative offices and foreign- invested enterprises must retain the services of accountants registered in China to prepare for official submission annual financial statements and other specified financial documents. To date, only Chinese accountants and joint venture accounting firms may provide these services. However, China will permit foreigners to sit -- for the first time -- for the certified public accountants exam in September 1994. Moreover, all the major international public accounting firms have offices in China and operate a thriving practice providing services to foreign firms, from advice on tax matters to assistance in setting up accounting systems and preparation of feasibility studies. Only attorneys licensed in China may appear in court and advise on questions of Chinese law. At present, no foreign lawyers are permitted to qualify to practice Chinese law, nor are foreign law firms permitted to form joint ventures with Chinese lawyers. Registered foreign law firms in China are restricted to advising on the law of their own jurisdictions. Nonetheless, many U.S. and international law firms with years of experience in doing business in China are an invaluable source of advice and guidance in setting up ventures, drafting agreements and resolving disputes. They can also help retain the services of local attorneys when warranted. US&FCS posts in China maintain lists of U.S. law, accounting and consulting firms with offices in China, as well as of Chinese firms with which the office or its customers have had favorable dealings.