Distribution country questions: China

China-specific information concerning the key legal and commercial issues that arise when appointing a distributor.

John Huang, Kevin Qian, Winston Zhao, Frank Schoneveld and Leon Liu, MWE China Law Offices
Contents

Regulation and legal formalities

1. Is distribution specifically regulated by national law? Are there any special rules or definitions applicable to:
  • Exclusive distribution?

  • Sole distribution?

  • Non-exclusive distribution?

  • Selective distribution?

  • Is any legislation pending, which is likely to affect distributions?

  • Are there any formalities that a supplier must comply with when setting up a distribution network, for example, any registration or disclosure requirements

Compared to many other countries, there are significant differences in the legal restrictions on distribution contracts in China. For example, restrictions on pricing, resale price maintenance, exclusive supply arrangements, exclusive purchase arrangements, retailer fees, attempts to limit the supplier's or distributor's liability, and the use of standard form contracts are controlled, to a greater or lesser extent, by different aspects of Chinese law.

Discussed below are some of the most significant issues that are likely to be raised in negotiation or to be of particular concern when drafting or implementing a distribution contract in China. These issues will also be relevant to the ongoing business of a supplier or distributor in China.

Addressing these issues early and in the proper fashion will help reduce violations of the law (and the ensuing fines and claims for damages) and will reduce the inclusion of unenforceable terms in an agreement.

Contract Law

The Contract Law, which came into effect on 1 October 1999 (Zhonghua Renmin Gonghe Guohe Guo Hetong Fa (中华人民共和国合同法), Contract Law of the People's Republic of China promulgated by the National People's Congress), provides legally enforceable rules on agreements between Chinese and foreign parties. China's Supreme People's Court has also released "interpretations" on several key issues concerning the application of the Contract Law. These interpretations are not a part of the "law," as may be the case in a common law jurisdiction. Nonetheless, they play an important role in dispute resolution because Chinese courts tend to follow them when adjudicating disputes.

In addition to setting out the various technical requirements for contracts, China's contract law delineates a number of instances where a document that appears to be an enforceable contract can be void, voidable by one or both parties, invalid or unenforceable within China. Significantly, in China a lack of fairness and violation of social norms—which may not be significant factors in other countries—can render a contract void or unenforceable.

Fairness and good faith

The Contract Law requires that parties to the contract adhere to the principle of "fairness" or "equity." A Chinese judge or arbitrator would generally have discretion to decide what is "fair," the standard of which need not be the same as that customarily used by the parties. The fairness principle appears to go beyond the concept of contracting in good faith that is present in many of the continental European jurisdictions. By way of comparison, China's Contract Law requires that parties observe the principle of "good faith" in exercising their rights and fulfilling their obligations, in addition to abiding by the principle of "fairness" (Articles 5 and 6, Contract Law)." If a contract lacks such "fairness" or "equity," a court or arbitration panel may rescind or alter the contract (Article 54, Contract Law). Standard contracts, also known as "adhesion contracts" or "form contracts," are required to be fair to the party that cannot negotiate the terms of the contract (Article 39, Contract Law).

For standard contracts, it is considered unfair to exempt oneself from liability or to increase the liability of the other party in circumstances where the other party is not given the opportunity to negotiate the terms of a standard form contract.

Price Law

China's Price Law was enacted in 1998 (Price Law of the People's Republic of China, promulgated by the National People's Congress on 29 December 1997, effective 1 May 1998). The Price Law's stated goals are to (Article1):

  • Standardise price behaviour in order to encourage the rational disposition of resources.

  • Stabilise the general market price level.

  • Protect the rights and interests of consumers and business operators.

  • Promote the healthy development of the socialist market economy.

The Price Law restricts, for example, a supplier, distributor or both from the following (Price Law, Article 14):

  • Any collaboration to control prices "to the great detriment of the lawful rights and interests of other business operators or consumers".

  • The dissemination of information relating to proposed price increases in order to raise the price of goods or services to excessive levels.

  • Discriminatory pricing to different customers for the same merchandise or service under the same conditions.

The Price Law is also important because it is the principal means through which the government imposes and adjusts price controls such as price ceilings, fixed prices or price guides. Failure to comply with the Price Law can result in fines, confiscation of illegal gains, orders to cease operations and revocation of the offender's business license (Price Law, Article 40).

Anti-corruption Law

Generally, foreign companies in China must pay attention to three sets of anti-corruption laws. Under China's legal system, the laws governing commercial and governmental corruption fall under two categories:

  • Administrative regulations, such as China's Anti-Unfair-Competition Law (AUCL) and the Interim Provisions on Banning Commercial Bribery.

  • Criminal laws, mainly forbidding bribes to government officials.

Foreign companies frequently must also follow the anti-corruption laws of their home countries.

Finally, where applicable, foreign companies should take steps to comply with the far-reaching US and UK anti-bribery laws, which, if breached, have the potential to create extensive liability for most multinational corporations.

Exclusive supply/Exclusive distribution

Exclusive supply or exclusive distribution normally involves an agreement that the supplier will sell products to one distributor only. An agreement is also one of exclusive supply when there are agreed-upon incentives that cause the supplier to concentrate its sales predominantly with one distributor.

As a result, a competing distributor cannot purchase the product from the supplier, and the supplier supplies to one distributor exclusively.

In China, the Anti-Monopoly Law (AML) provides that if a supplier is dominant in the market, it cannot refuse to trade with a distributor without justification. To do so may result in fines of up to 10% of annual revenues and claims in the courts by those suffering damage, as well as confiscation of illegal gains (Articles 47 and 70, AML).

If a clause in a distribution agreement requires a dominant supplier to supply exclusively to one distributor only, the supplier in such a case would have to refuse to trade with any other competing distributors. However, any refusal to trade by a dominant supplier, without justification, could be regarded as a prohibited abuse of dominance, contrary to the AML.

If a distributor is dominant, it cannot require a supplier, without justification, to trade exclusively with that distributor or with an undertaking designated by the distributor (Article 17, AML). To do so would be an abuse of the distributor's dominance and, unless justified, is prohibited by the AML.

In addition, AUCL imposes strict regulations on suppliers possessing "monopoly status." A "monopoly" supplier cannot restrict the distributor in purchasing a product only from the monopoly supplier or undertakings designated by such a monopoly supplier (Article 7, AUCL) . The AUCL does not define "monopoly status," although it appears to refer to those entities that enjoy "exclusive production and sales" in China for particular products.

"Non-compete" and exclusive purchase clauses

A non-compete clause is one that prevents the distributor from selling, reselling, manufacturing or purchasing products that compete with products of the supplier. A non-compete clause can have the same effect as an exclusive purchase clause (see above, Exclusive supply). In effect, a non-compete clause means that the distributor can purchase and resell products only from the supplier. If the distributor buys or manufactures and then sells products that compete (in other words, are substitutable) with those supplied by the supplier, the distributor will be in breach of the non-compete obligation. If the supplier is dominant it cannot require, without justification, that the distributor deal only with the dominant supplier or with others designated by the dominant supplier (Article 17(4), AML).

Specifically, State Administration for Industry and Commerce (SAIC) regulations prohibit a dominant supplier, without justification, from requiring its distributors (the trading counterparty) to trade exclusively with the dominant supplier or those designated by the dominant supplier, and from restricting its distributors from trading with the dominant supplier's competitors (Article 5, SAIC Reg. 54/2010).

When assessing whether there is sufficient justification for a dominant supplier's refusal to deal with distributors, the SAIC must take into account whether the conduct is on the basis of ordinary operating activities and "ordinary interests," and how the conduct will affect economic efficiency, public interest and economic development (Article 8, SAIC Reg. 54/2010). Unfortunately, no guidance or examples are available on the practical application of this provision.

A non-compete or exclusive purchase clause would also require the distributor to refuse to deal with any competitor of the supplier. If the distributor is dominant, under the AML a refusal to purchase from competitors of the supplier without justification is equally prohibited (Article 17(3), AML; Articles 4(3) and 5 SAIC Reg. 54/2010).

With regard to the unjustified prohibitions against non-compete or exclusive purchase clauses when a supplier or distributor is dominant, it is important to note that in China, a market share as low as 10% can amount to dominance in some circumstances.

It should also be noted that there are special rules for sales to large retailers whose aggregate annual sales (including those of all chain stores) are RMB10 million or more (as at 2 October 2013, US$1 was about RMB6.12) (Article 4, Administrative Measures for Fair Transactions By and Between Retailers and Suppliers). If a large retailer is restricted to purchasing a certain type or range of products from a single supplier, that retailer cannot purchase, and therefore cannot resell, products that could have been supplied by others. If a supplier (whether dominant or otherwise) restricts the large retailer's ability to sell goods purchased from other suppliers, this restriction is likely to be contrary to the Fair Retail Transactions Measures (Article 18(2), Administrative Measures for Fair Transactions By and Between Retailers and Suppliers).

Selective distribution

Currently, there are no rules under Chinese law that specifically address selective distribution system.

Formalities a supplier must comply with when setting up a distribution network

There are no general formalities requirements a supplier must comply with when setting up a distribution network under Chinese law. However, if the distribution of goods in China is carried out in the form of franchising or direct selling, certain formalities must be complied with:

Setting up a distribution network in the form of franchising. The main formalities relate to filing and pre-contractual disclosure obligations. Under existing administrative measures, the supplier (franchisor) must file a franchise agreement and various documentation with the Ministry of Commerce. It must also disclose detailed information to the franchisee at least 30 days before the date the franchisee is due to sign the franchise agreement. Disclosures must also be made at least 30 days before the renewal of such an agreement, unless the renewed franchise agreement is on the same terms as the original. Failure to disclose, or providing false information to the franchisee, even unintentionally, entitles the franchisee to rescind the franchise contract.

Setting up a distribution network in the form of direct selling. A foreign invested company involved in direct selling must be approved by MOFCOM. In addition, the foreign invested company must set up a branch in all provinces in which it wishes to directly sell, unless the foreign invested company itself is already registered in that province. A service outlet must also be set up in each such province. The purpose of the service outlet is to provide information to customers regarding pricing, return policies and after-sale services.

 
2. Are there any laws, regulations or case law which apply to agency relationships that might be interpreted in such a way as to apply to a distributorship relationship as well?

No.

 

Competition law

3. Are there any national laws or regulations that would affect the following business practices:
  • Grant of exclusive territory?

  • Tied selling?

  • Territorial restrictions?

  • Customer restrictions?

  • Resale price maintenance?

  • Minimum purchase targets?

  • Imposition by the supplier of restrictions on the sources of supply to distributors?

  • Refusal to deal?

Anti-Monopoly Law

China's Anti-Monopoly Law (AML) came into effect in August 2008 and performs substantially the same role as the EU's competition law and US antitrust laws. The AML immediately made headlines around the world when it was used in early 2009 to block Coca-Cola's US$2.4 billion bid for Huiyuan, a Chinese bottled drinks producer. The AML's stated goals are to prevent and restrain "monopolistic" conduct, protect fair market competition, enhance economic efficiency, safeguard the interest of consumers and the interests of society as a whole, and promote the healthy development of China's economy (Article 1, AML).

A breach of the AML can result in fines of up to 10% of a company's annual revenues, confiscation of illegal gains and private damage actions in the courts. There is also the possibility that an agreement contrary to the AML may be declared invalid and unenforceable.

Since coming into force, numerous cases have been brought by both the AML enforcement authorities and private parties. The AML is a key consideration for businesses that operate in China or that have a component of their business in China.

Anti-Unfair-Competition Law

China's Anti-Unfair-Competition Law (AUCL) was enacted in 1993. The stated goals of the law are to encourage and protect fair competition, discourage unfair competitive acts, and protect the lawful rights and interests of business operators and consumers (Zhonghua Renmin Gonghe Guo Fanbuzhengdangjingzhen Fa (中华人民共和国反不正当竞争法) Law of the People's Republic of China Against Unfair Competition] (promulgated by the Standing Committee of the National People's Congress, 2 September 1993, effective 1 December 1993, Article 1). The AUCL operates together with the AML, the Price Law (see above) and other laws to regulate the ways that businesses are allowed to compete with each other.

The AUCL regulates matters such as the protection of business secrets, commercial bribery, predatory (below cost) pricing, bid rigging, false advertising and other similar commercial matters. The AUCL can have an important impact on distribution because it places limits on what a distributor can do with respect to, for example, prices, advertising, promotions and prizes, and the bundling or tying together of goods and services. Breach of the AUCL can result in confiscation of illegal gains and fines by the enforcement authorities, as well as private civil actions for damages in the courts (Articles 20 and 24–28, AUCL).

Territorial restrictions

A territorial restriction is one where the distributor agrees to only resell the supplier's product in a specified geographic area. Under such a clause, a distributor cannot resell product in territories exclusively allocated to another distributor.

In China, a dominant supplier is prohibited from imposing "unreasonable restrictions on the territory of sales" without justification (Article 6(3), SAIC Reg. 54/2010). If the supplier is dominant, it is unclear under Chinese law what would be regarded as an "unreasonable" territorial restriction and what is sufficient to justify such an unreasonable territorial restriction. In determining whether there is sufficient justification under the AML for an unreasonable territorial restriction imposed by a dominant supplier, the applicable SAIC regulations require the SAIC to consider whether the practice (territorial restriction) is conducted on the basis of ordinary operating activities and ordinary interests, and how the territorial restriction will affect economic efficiency, public interests and development of the economy (Article 8, SAIC Reg. 54/2010).

The SAIC has issued no decision or guidelines that may be of assistance to further clarify these aspects of the regulations.

Customer restrictions

Rather than allocate distributors to an exclusive territory, a supplier may agree to sell its products to a distributor for resale only to a particular group of customers. For example, the supplier of a high-technology product may agree to supply only one distributor for sales to corporate customers, and reserve sales to small businesses and individual customers for itself. The distributor would then be restricted to making sales only to its allocated customer group, which in this example would be corporate customers.

Under Chinese law, these customer restrictions are problematic if either the distributor or the supplier is dominant in its respective market. This is of particular concern given that in some circumstances "dominance" is presumed to exist when an undertaking's market share is as low as 10%.

SAIC Regulation 54 provides that a dominant supplier (or dominant distributor) must not impose "additional unreasonable restrictions on . . . customers targeted" or impose "other trading conditions irrelevant to the items traded" without justification (Article 6). Entities that impose these restrictions without justification are abusing their dominance and violating the law.

In addition, if the dominant supplier refuses to sell to a distributor because the distributor is reselling or proposes reselling outside of its allocated customer group, such refusal to trade, without justification, could equally be regarded as an abuse of dominance. If the distributor is dominant and must refuse to trade with a customer outside of its allocated customer group because of the distribution agreement, such a refusal to trade could, without justification, be an abuse of dominance and be prohibited by the AML (see Question 1).

Minimum stocking and shelf space allocation

A clause requiring a distributor to use all or almost all of its stock capacity or available shelf space exclusively for the supplier's product can amount to a requirement to deal exclusively or almost exclusively with the supplier. Such a clause can therefore have an effect similar to a non-compete clause and could, if the supplier is dominant in the market, be a breach of the AML.

A violation of the law could occur if a minimum stocking or shelf allocation obligation was so onerous as to restrict a retailer's sales of other suppliers' products, particularly if the supplier is dominant (Article 5(3), SAIC Order 54). In such a case there would be limited or no space left for competing suppliers.

A minimum stocking or shelf space obligation could, if very high, also amount to a breach of the Fair Retail Transaction Measures. The Fair Retail Transaction Measures apply to retailers with aggregate sales of RMB10 million or more, whether the level of sales is reached in a single store or aggregated across all sales in the same chain of stores. The Large Retailer Measures provide that no supplier to a large retailer may "restrict the retailer's sale of products of other suppliers" (Article 18(2)). It remains to be seen at what level a high stocking or shelf space obligation will be deemed as a restriction of the retailer's sale of the products of other suppliers.

Tying/bundling

In China, a supplier cannot require a distributor to unwillingly buy another product along with the product that the distributor seeks to purchase (Article 12, AUCL). Under the AUCL, this prohibition on tying, also commonly referred to as "bundling," applies regardless of the market share or market power of the supplier or the distributor.

There is also a provision in China's AML to the effect that a dominant company is prohibited from engaging in the tying of sales unless some justification exists. Unlike in the EU, in China, even if the supplier is not dominant or has a good justification for engaging in tying, a company could still be in breach of the AUCL if it has tied sales of different products.

 
4. Is there specific competition or anti-trust law regulation of exclusive and selective distribution? Describe briefly.
 
5. Are there any national provisions relating to the imposition of minimum or maximum prices?

A supplier may want to control the resale price at which a distributor sells products to consumers or downstream users. In China, unless an exemption under the AML applies, such resale price maintenance (RPM) is generally prohibited. The AML specifically prohibits undertakings from fixing the resale price or restricting the minimum price of resale (Article 10).

Despite these prohibitions, restrictions on resale prices have not been unusual in China, but that will undoubtedly change, because the National Development and Reform Commission (NDRC) imposed a fine of RMB449 million early in 2013 on two producers of liquor for restricting minimum resale prices ("Maotai and Wuliangye Fined CNY 449 Million for Vertical Price Fixing," China Competition Bulletin (Jan/Feb 2013) China Competition Research Centre, pp. 4–5, available at

http://finance.sina.com.cn/chanjing/b/20130222/164314620476.shtml).

There is no prohibition against issuing recommended resale prices or agreeing with a distributor on the maximum resale price. However, care should be taken that a "maximum" price or "recommended" resale price is not, in effect, a fixing of the resale price.

There is an argument that RPM is permissible in China if it can be shown that the RPM does not restrict competition. A 2012 judgment of the Shanghai Intermediate People's Court suggests that if there is not sufficient evidence to show that the RPM clause restricts competition, a clause restricting the minimum price of resale is not necessarily prohibited (see Johnson & Johnson case in China Competition Bulletin, edition 17, Jan/Feb 2012, page 3). It remains to be seen whether such an argument will be successful on appeal.

The Chinese enforcement authorities, notably the NDRC, seem to have taken the view that RPM is prima facie contrary to China's AML. In addition, Article 14(1) of China's Price Law requires that undertakings must not "work collaboratively to control market prices to the great detriment of the lawful rights and interests of other undertakings or consumers." There is an argument that the NDRC could also rely on this article 14(1) to find that a supplier has collaborated with a distributor to control the downstream consumer market price through the fixing of the resale price. If such "collaboration" between a distributor and supplier is determined to be detrimental to the rights and interests of consumers, there could also be a violation of the Price Law (see Question 1).

"Unfair" pricing

In China, sales at unfairly high prices and purchases at unfairly low prices are prohibited if either the seller or the buyer is dominant in the market. Such unfair pricing is considered to be an abuse of a dominant market position (Article 17(1), AML).

If the supplier is dominant in the market, it is prohibited from selling at unfairly high prices. If the distributor is dominant in the market, it is prohibited from buying at unfairly low prices and from selling at unfairly high prices. Unlike other forms of abuse of dominance, such unfair pricing is prohibited even if there might be justification for it. The key test on this issue is determining when a price is so excessive that it is "unfair" (Article 11, NDRC Reg. 7/2010).

Some of the factors the NDRC uses to determine unfair pricing are as follows:

  • Is the price markedly higher or lower than similar products?

  • Does a change in price exceed the normal range?

  • (Dominant seller) Does a price increase markedly exceed an increase in cost?

  • (Dominant buyer) Does a decrease in purchasing price markedly exceed the reduction in costs of the seller?

The fixing of an excessive sale price or an overly low purchase price by a dominant undertaking, if it amounts to a "disguised" refusal to trade, is also prohibited unless justified.

Under the Price Law, a business operator (whether dominant or not) must not "seek exorbitant profits in violation of laws and regulations," or in a "disguised way, raise or lower prices at irrational ranges by artificially raising or lowering grades of merchandise or services." There have been no recent cases to clarify what these two provisions may mean in practice, but it seems likely that the NDRC will enforce the more modern AML rather than rely on the Price Law.

At the same time, it should be noted that the NDRC has applied both the AML and the Price Law concurrently in the same case since the introduction of the AML. Therefore, companies must take care that the terms of a distribution agreement do not breach the Price Law's provisions.

In respect to predatory pricing, under the AUCL, subject to certain exceptions, sales by a supplier or distributor (whether dominant or not) below cost are a breach of the law (see above). The Price Law and implementing regulations also provide that it is illegal for a supplier or distributor (whether dominant or not), intending to exclude competitors or to monopolise the market, to sell below cost, with certain exceptions, notably that the goods are at the end of season, are near the end of their shelf life or are sold because of financial distress, such as bankruptcy

 
6. Can a supplier impose minimum purchase obligations or targets on a distributor?

There are no provisions under Chinese law that explicitly prohibit such practice.

 
7. Can a supplier impose exclusive purchase obligations on a distributor?
 
8. Are there any laws or regulations relating to restrictive covenants or covenants not to compete during the distribution agreement? To what extent is it possible to continue the restrictions after the agreement has expired? In particular, to what extent does the geographical extent and or the length of time of the restriction affect its enforceability?

A non-compete clause is one that prevents the distributor from selling, reselling, manufacturing or purchasing products that compete with products of the supplier. In practice, a non-compete clause means that the distributor can purchase and resell products only from the supplier. If the distributor buys or manufactures and then sells products that compete (in other words, are substitutable) with those supplied by the supplier, the distributor will be in breach of the non-compete obligation.

Under Chinese law, if the supplier is dominant, it cannot require, without justification, that the distributor only deals with the dominant supplier or with others designated by the dominant supplier.

Specifically, SAIC regulations prohibit a dominant supplier, without justification, from:

  • Requiring its distributors (the trading counterparty) to trade exclusively with the dominant supplier or those designated by the dominant supplier.

  • Restricting its distributors from trading with the dominant supplier's competitors.

Under SAIC regulations, when assessing whether there is sufficient justification for a dominant supplier to impose a non-compete restriction on its distributors, the SAIC must take into account whether the conduct is on the basis of ordinary operating activities and "ordinary interests," and how the conduct will affect economic efficiency, public interest and economic development. Unfortunately, no guidance or examples are available on the practical application of this provision.

With regard to the unjustified prohibitions against non-compete or exclusive purchase clauses when a supplier is dominant, it is important to note that in China a market share as low as 10% can amount to dominance in some circumstances.

Territorial restriction

Under a territorial restriction, the distributor agrees to only resell the supplier's product in a specified geographic area. Therefore, a distributor will not be able to resell products in territories exclusively allocated to another distributor.

In China, a dominant supplier is prohibited from imposing "unreasonable restrictions on the territory of sales" without justification. If the supplier is dominant, it is unclear under Chinese law what would be regarded as an "unreasonable" territorial restriction and what would be sufficient to justify such an unreasonable territorial restriction. In determining whether there is sufficient justification under the AML for an unreasonable territorial restriction imposed by a dominant supplier, the applicable SAIC regulations require the SAIC to consider whether the practice (territorial restriction) is conducted on the basis of ordinary operating activities and ordinary interests, and how the territorial restriction will affect economic efficiency, public interests and development of the economy. The SAIC has issued no decision or guidelines that may be of assistance to further clarify these aspects of the regulations.

Post-termination non-compete clauses

In China, the legal position in respect to a post-termination non-compete clause is unclear. Such a clause would require the distributor not to compete with the supplier or its other distributors following the termination or expiration of the distribution agreement.

If the supplier is dominant, there is the possibility that an overly restrictive post-termination non-compete clause may be considered an "unreasonable trading condition" unless justification exists. The SAIC regulations prohibit the imposition by a dominant supplier (for example) of "unreasonable restrictions for the contract period" without justification, and the imposition of trading conditions "irrelevant to the trading objectives" (Articles 6(2) and 6(4)). While both of these terms are rather vague and have not been the subject of a judicial or public SAIC decision, if the supplier is dominant, there is a real possibility an overly restrictive post-termination non-compete clause could be prohibited.

At the same time, the AUCL provides that a business operator must not use trade secrets in violation of an agreement not to use or disclose the secrets, including as a competitor of a supplier (Article 10). It would therefore likely not be prohibited for a dominant supplier to prevent use by a terminated distributor of its IP rights or trade secrets post-termination. This would still stand even if it meant that the terminated distributor could not continue trading without the suppliers' IP or trade secrets.

 
9. Is the supplier free to impose upon the distributor an obligation to buy and keep a full stock of each of the products comprised in the range of products which are the subject of the distribution agreement?

There are no laws or regulations in China that explicitly address this issue. However, a clause requiring a distributor to use all or almost all of its stock capacity or available shelf space exclusively for the supplier's products can amount to a requirement to deal exclusively or almost exclusively with the supplier. Such a clause can therefore have an effect similar to a non-compete clause and could, if the supplier is dominant in the market, be a breach of the AML (see Question 8).

 
10. Where a distribution network involves trading online how is this regulated?

A foreign investor wishing to sell its own products using its own online platform must register the online platform. In China, a licence will be required if the company has an online platform that allows third parties to set up online shops selling their respective products.

However, so far no foreign-controlled entity has ever been granted a licence to establish an online platform that enables third parties to have online shops selling their respective products, and in one instance MOFCOM required the acquirer of such an online platform to stop the service or transfer the licence to a Chinese-controlled entity.

 

Intellectual property

11. Does a distributor enjoy an implied licence to use the supplier's intellectual property rights in performance of his obligations under the distribution agreement?

There will be an implied licence for a distributor to use the supplier's intellectual property rights, but such licence will be solely for the purpose of performance of the distributor's obligations under the distribution agreement. In practice, it would be prudent to clarify either through a separate intellectual property rights license agreement or through the inclusion of a provision in the distribution agreement the rights and obligations in relation to the licence of the supplier's intellectual property rights.

 
12. Is registration of intellectual property licences possible? Does this give any added protection?

Trade mark licensing

Trademark licensing is a common means through which foreign companies conduct business in China.

Licensing can help the parent company retain ownership of the mark and control the use of it. Licensing can also help its local partner obtain proper authorisation to use the mark.

Under China's Trade Mark Law, trade mark rights are regional, and only the owner of a trade mark successfully registered in China is entitled to the exclusive right of that trade mark. Therefore, even if a company's trade mark is well known internationally, if the trade mark was not properly registered in China, it would still be difficult for the company to obtain protection for the trade mark.

A prominent example of the problem that can arise is Apple's reported settlement payment of US$60 million to capture the "iPAD" trade mark registration in China (Apple v. Proview Technology (Shenzhen): "Apple 'settles China iPad Trademark Dispute for $60m'" (2 July 2012) available at www.bbc.co.uk/news/business-18669394).

Most companies entering the Chinese market would be well advised to register their own marks in China, especially their core trade marks and home logo. The Chinese agency in charge of trade marks is the Trade Mark Office (TMO), which is affiliated with the SAIC.

A distribution arrangement may grant the distributor a right to use the trademark either through a separate trade mark licence agreement or through the inclusion of a provision in the distribution agreement. In China, if there is an exclusive trademark licence, it is likely that exclusive distribution would be deemed to exist, since an exclusive trade mark licence would have the same effect as giving exclusive distribution rights in China for the licensed products.

There are two models of exclusive trade mark licensing. One is the traditional "exclusive" licence, under which only one licensee has the right to use the trade mark under licence within a certain scope of use and during a certain period. Another model is a "sole" licence, under which both the licensee and the trade mark owner have the right to use the trade mark. The primary difference between an exclusive and a sole licence under China's Trade Mark Law is whether the trade mark owner will or might be deprived of the right to use the trade mark.

A trade mark licence may include the right to sub-license. However, careful consideration should be given to the scope of any allowed sub-licence—for example, whether the right is limited to granting only non-exclusive, non-assignable and non-transferable sub-licences for limited purposes.

Consideration should also be given to whether the trade mark licence should cover use of the trade mark in any internet domain name. In a distribution agreement or separate trade mark licence agreement, it is often prudent to include provisions such as the following:

  • The distributor may use the trade mark only as authorised and only to the extent necessary to perform the terms of the agreement.

  • The distributor does not have and obtains no rights regarding the trade mark by engaging in distribution activities.

  • All goodwill associated with the trade mark belongs exclusively to the foreign trade mark holder.

  • The distributor is not to use the trade mark in conjunction with any other trade mark.

  • The distributor is not to change, distort or improperly use the trade mark, or to register or use any trade mark similar to that of the licensor's trade mark.

  • The distributor is to notify the licensor if it becomes aware of infringement or potential infringement of the trade mark.

The trade mark licence should be recorded with the TMO (Zhonghua Renmin Gonghe Guo Shangbiao Fa Shishi Tiaoli (中华人民共和国商标法实施条例) Detailed Implementing Rules of the Trade Mark Law of the People's Republic of China] (promulgated by the State Council, 29 April 2014, effective 1 May 2014, Article 69).

It is also possible to register a patent licence in China. However, such a registration is not a condition to the validity of the licence.

 
13. If the supplier is based abroad, does the distributor need to be registered as owner or user of the trade mark in order to be able to import goods bearing the trade mark?

No.

 
14. Does the distributor become entitled to any rights in a trade mark (or any other intellectual property right) by virtue of selling the trade-marked products in his territory?

No, but it is good practice to include a clause to this effect into the distribution agreement (see Question 12).

 
15. Are there any competition law or anti-trust implications of licensing intellectual property rights?

General competition law principles apply to licensing agreements.

 
16. Can the supplier impose restrictions on the use of the supplier's confidential information by a distributor either during or after the expiration of the distribution agreement?

Yes. The AUCL provides protections against the infringement of trade secrets. When drafting a distribution or franchise agreement, or other arrangements such as, for example, a trade mark licence, which include the grant of an exclusive right to use trade secrets, consideration should be given as to whether the licensee/distributor should be able to act unilaterally when enforcing infringement of trade secrets in the Chinese courts.

If a distributor is granted a licence to use trade secrets on an exclusive basis—for example, as part of a master franchise or distribution agreement—the owner/licensor of the trade secrets may want to limit the power of the exclusive distributor/master franchisee to unilaterally take legal action for unlawful disclosure of a trade secret.

In 2007, the Supreme People's Court issued an interpretation stating that if a distributor/franchisee has an exclusive license to use a trade secret, such distributor/franchisee may, without the intervention or knowledge of the owner of the trade secret, unilaterally bring an action for infringement of the trade secret. In practice however, a licensor/owner of a trade secret typically will want to be notified of the infringement of its trade secret before any court action is taken, and may also want to restrict the exclusive distributor/franchisee to only bring legal proceedings with the consent of, or jointly with, the owner of the trade secret. This typically happens because the licensor/owner wants to ensure that its rights and interests are taken into account in any legal proceedings (or settlement thereof) for infringement of the trade secret.

 

Employment law

17. Is there a risk that distributors may be treated as employees of the supplier?

In general, there is no such risk, although misunderstandings may arise if the distributor is a natural person. However, even if the distributor is an individual, the risk of being regarded as an employee is still very remote.

 
18. Could employment liabilities of an outgoing distributor be transferred to a new distributor or to the supplier itself?

No.

 

Tax

19. Will a foreign supplier who appoints a distributor directly in the national territory be regarded as carrying on business for tax purposes in that territory?

Generally not, but one should always be aware of the issue of permanent establishment and its implications.

 
20. Are any withholding or other taxes levied in the territory on remittance monies? When and by whom are they payable?

Yes, withholding taxes will apply. Normally they must be paid by the onshore payer, and the withholding will be made before the remittance.

 
21. Will there be any difficulties in a domestic distributor making payment to a foreign supplier, either in local currency or in the currency of the supplier's country? Are there any exchange controls in operation?

In China, there are restrictions on transferring money out of the country and on exchanging foreign currency into and out of China's currency, the renminbi (RMB).

A Chinese distributor typically must exchange and remit foreign currency overseas (in other words, jurisdictions outside of China, which include Hong Kong, Macau and Taiwan) in order to pay a foreign supplier or parent company.

Before the distributor can do so, it must register with the relevant branches of the State Administration of Foreign Exchange (SAFE). The registration requirement applies whether the payment is for goods or services supplied, licence fees, royalties, commissions or other such fees.

Before funds for payments associated with imported goods can be remitted overseas, a Chinese importer (including a distributor if the distributor is also the importer) must present to its bank all the documentation, such as shipping documents and customs declarations, required by SAFE.

For payments on imported goods, all businesses must report to SAFE within 30 days of payment of any overseas payments or receipts that are:

  • Prepaid, or received more than 30 days in advance of the date shown on the import declaration form.

  • Paid or received more than 90 days from the date shown on the import declaration form.

  • Paid or received using a letter of credit with a payment term that exceeds 90 days.

Generally, the prepayment amount cannot exceed 25% of the total payments that the company made for all imports in the previous 12 months. If prepayment exceeds this amount, SAFE may exercise its discretion to conduct an onsite investigation of the company (Detailed Rules for the Implementation of Guidelines on Management of Foreign Exchanges in Goods Trade).

In addition, only certain designated banks can exchange foreign currency for RMB and vice versa. Current account items (such as interest on foreign currency loans, insurance premiums or construction expenses payable in foreign currency) may be converted relatively easily if they do not exceed US$100,000.

These restrictions can result in cash being "trapped" in China when it might be more efficiently used elsewhere. Early planning of a distribution network and structure, such as the use of shareholder loans, can be crucial to reducing the risk of "trapped" cash.

It should be noted that a wholly foreign-owned enterprises (WFOE) (or other foreign-invested enterprises (FIEs)) can only use converted RMB for purposes within the WFOE's defined business scope. For example, RMB might only be used to purchase land for a distribution warehouse for the WFOE's own use. If the WFOE's business scope does not include the purchase of shares in any entity, that same tranche of RMB cannot be used to purchase shares in a wholly owned subsidiary that in turn purchases the land with the warehouse for the WFOE's use.

If a sale of goods or services is between businesses and individuals in China, the sale price must be in RMB and may not be priced in a foreign currency. Foreign businesses selling into China may price their goods or services in foreign currency, as may Chinese businesses selling their goods and services to buyers outside of China.

Appropriate clauses to minimise delays and disruptions for payments overseas for the purchase of products, prepayments, commissions, fees and royalties can be included in a distribution contract. Some suppliers stipulate that failure to obtain and maintain the necessary licences or permits is grounds for automatic termination of a distribution agreement.

 

Product liability

22. To what extent is it possible to exclude liability as between the distributor and supplier for the supply of defective goods or services? To what extent can a distributor be indemnified against product liability claims?

Product liability

China's Product Quality Law imposes strict liability on a manufacturer of a product for damage or injury to persons or property caused by a manufacturing or design defect. 180 Negligence does not need to be shown in such cases. Strict liability applies regardless of whether the manufacturer is a foreign company or domestic Chinese company. However, unlike for the manufacturer, it is unclear whether a distributor will be strictly liable for such defects or must be shown to be negligent.

China's Tort Law provides for compensation to be paid for negligence causing damage or injury. This includes compensation for damage and injury when a company appears to be the manufacturer because, for example, it has allowed its name or logo to be placed on the negligently manufactured product. A number of suppliers have their distributors do final processing or packaging of a product (before supply to a retailer or customer in China), but leave their own trade mark or logo on the product. Doing so attaches strict liability under China's Tort Law. Insurance is typically used to minimise the risk.

Given China's still-developing insurance market, a foreign manufacturer or supplier may prefer taking out its own insurance and reflecting the insurance cost in the price, rather than relying on a contract clause requiring the Chinese distributor to take out insurance coverage for liability in negligence or for strict liability under the Product Quality Law.

Product quality

Under China's Product Quality Law, a manufacturer is responsible for ensuring the goods that it supplies (Article 26):

  • Pose no unreasonable danger to individuals or property.

  • Meet all applicable national and industry standards.

  • Are fit for their intended purpose except when defects clearly indicate otherwise (for example, second-hand or obviously partly damaged goods).

  • Are in conformity with the standards on the packaging and labeling of the goods.181

If the seller is a distributor only (and not also the manufacturer), the seller must, among other things, adopt the following measures (Articles 33-37):

  • Implement measures to maintain the quality of the products that it sells.

  • Establish an examination and acceptance system for the purchase of inventory to ensure that the inventory includes the required product quality certificates.

  • Examine the packaging of products sold to ensure information concerning product specifications, warnings and facility location are included182

Products that fail to meet mandatory standards are prohibited from being manufactured, sold or imported (Zhonghua Renmin Gonghe Guo Biaozhunhua Fa (中华人民共和国标准化法) Standardization Law of the People's Republic of China] (promulgated by the Standing Committee of the National People's Congress, 29 December 1988, effective 1 April1989) Article 14, Product Quality Law). If a supplier or distributor does so, it can be subject to fines, confiscation of goods and, in serious cases, criminal prosecution (Article 20, Standardization Law; Articles 32-36, Standardization Rules).

 

The distribution agreement

23. Are any particular formalities required for a distribution agreement to be legally valid and enforceable under national law?

None. General principles of contract law apply.

If a contract is for the cross-border sale of goods, and the U.N. Convention on International Sale of Goods, which China ratified in 1998, applies, a binding contract is formed at the moment of acceptance of the offer to sell. This acceptance can be made by a statement or other conduct of the offeree that indicates assent to the offer (Article 18, United Nations Convention on Contracts for the International Sale of Goods 1980). Frequently this is done by signing a document that sets out the terms of sale. Chinese law acknowledges that a contract can also be formed by oral agreement.

In addition, the Contract Law provides that where "the parties enter into a contract in the form of a contract instrument, the contract is executed at the time when both parties place their signatures or affix their seals onto the instrument" (Article 32). Affixing to a contract the corporate seal or "chop" is therefore sufficient to legally bind the company to the contract. However, it is normal business practice to also require the signature of a legal representative or other corporate office holder of the contracting Chinese company (Article 50).

When contracting between or among individuals, it is not unknown for individuals to execute the contract by affixing a fingerprint to the contract, rather than a signature. It is now clear that a contract bearing only the individual's fingerprint will be equivalent to one having the individual's signature under seal (Note 5, 2009 Explanation of Supreme People's Court on Questions Arising Under the PRC Contract Law).

In China, the corporate seal or chop is frequently required to lodge documents with various authorities, including customs, tax and corporate regulators. The seal or chop is also often required to enter into contracts in China. Therefore, business can come to a standstill if the chop is controlled by a recalcitrant or obstructive general manager, director or employee.

The corporate chop should be strictly controlled and only accessible to a very limited number of trusted individuals. Under normal circumstances, a distributor should never be given access to a supplier's chop, because the chop can be misused, either deliberately or mistakenly, to create an assumption of agreement to enter into a binding legal relationship. There is at least an assumption that a contract has been validly entered into if the distributor's chop appears on a contract, even if misused or applied mistakenly. In addition, if the distributor fails to return the chop, it can be extremely difficult to conduct business without it, because it can take weeks to have a replacement registered with the authorities in China.

 
24. Is it possible to incorporate the supplier's standard conditions of sale into the distribution agreement? What do such standard conditions normally cover?

Yes. Such standard conditions of sale normally cover all the aspects of the sales and purchases of products.

 
25. Does national law impose any obligations on the supplier?

Generally speaking, no special obligations are imposed on the supplier. However, there will be certain special obligations legally imposed on the franchisor (see Question 1).

 
26. Are any terms implied by law as to the supplier's title to the goods? Is any specific wording necessary and do buyers normally impose a higher standard than is implied by law?

No.

 
27. What term is commonly agreed for a distributorship? Does national law regulate the length of notice periods?

Market practice varies, and there is no commonly agreed term for a distributorship.

 
28. What events will be regarded in law as justifying termination of the distribution agreement? Do any statutory obligations arise on termination? What provision is usually made in the agreement for termination?

There are no special rules on what events will be regarded in law as justifying termination of the distribution agreement. Neither does any statutory obligation arise in the event of termination. General rules under contract law will apply.

In a distribution agreement, the most common termination provisions include:

  • Termination events, which usually include mutual agreement to terminate, one party's material breach of the contract, one party's bankruptcy, force majeure, infringement of the supplier's IP rights and so on.

  • Effects of termination, which usually clarify how the stocks of products in the possession of the distributor will be dealt with and how these documents and materials relating to the products or any other aspect of the business of the distributor concerning the products will be disposed of.

 
29. What rights does the distributor have to compensation on termination of the distribution agreement? How is compensation for termination calculated?

Under Chinese law, there are no particular mandatory requirements on compensation for the distributor on termination of the agreement, as well as how compensation will be calculated. General rules of contract law will apply.

Generally speaking, and subject to the general rules of contract law, the terms and conditions agreed by the parties under the distribution contract will apply to compensation.

 
30. Where the distributor holds stock or money or other property belonging to the supplier, can the supplier assert his rights of ownership against third parties:
  • In the event of insolvency of the distributor?

  • In the event that the distributor has dishonestly disposed of them to third parties?

In the event of insolvency of the distributor, the supplier has the right to assert his rights of ownership against third parties with respect to any property belonging to the supplier. Under China's Enterprise Bankruptcy Law, the supplier can request the administrator of the insolvent distributor to return that property to the supplier.

In the event that the distributor has dishonestly disposed of the property to third parties, the supplier will be unable to assert his rights of ownership if the third party purchaser was a bona fide purchaser.

The authors would like to thank Roy Zhu for his contribution to the Q&A.

 

Contributor details

John Z. L. Huang, Managing partner,

MWE China Law Offices

T +8621 6105 0588
F +8621 6105 0501
E johnhuang@mwechinalaw.com
W www.mwechinalaw.com

Areas of practice: Antitrust, regulatory & government affairs, healthcare, corporate & cross-border transactions, intellectual property and international arbitration & litigation.

Winston J. Zhao, Senior Counsel

MWE China Law Offices

T +8621 6105 0568
F +8621 6105 0501
E wzhao@mwechinlaw.com
W www.mwechinalaw.com; www.mwe.com

Areas of practice: Corporate, mergers & acquisitions, private equity, labor & employment, joint ventures & strategic alliances.

Kevin Y. Qian, Managing Partner

MWE China Law Offices

T +8621 6105 0566
F +8621 6105 0501
E kqian@mwechinalaw.com
W www.mwechinalaw.com

Frank Schoneveld, Senior Counsel

MWE China Law Offices

T +8621 6105 0519
F +8621 6105 0501
E fschoneveld@mwechinlaw.com
W www.mwechinalaw.com www.mwe.com

Areas of practice: Alcohol regulatory & distribution, antitrust and trade regulation, energy and commodities advisory, EU competition, EU regulatory, international arbitration, international trade – Brussels, life sciences – medical devices and technology, renewable power, software & IT services.

Leon C. G. Liu, Partner

MWE China Law Offices

T +8621 6105 0533
F +8621 6105 0501
E lliu@mwechinlaw.com
W www.mwechinalaw.com

Areas of practice: Regulation & government affairs, white collar crime, FCPA/anti-corruption, corporate governance and litigation & arbitration.


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