China Distribution Contracts: The Questions We Ask

Forming a WFOE in China and then operating that business in China is difficult and expensive. See e.g., Forming a China WFOE: Ten Things To Consider and also Doing Business in China with Deportation or Worse Hanging Over Your Head on why having a WFOE is a must if you will be doing business within China. Because of this, our China lawyers are seeing increasing numbers of foreign companies choosing to sell their products in China via distribution relationships rather than via a WFOE.

Today’s post focuses on some of the questions we often ask our clients looking to do distribution agreements with a Chinese company. It consists mostly of an amalgamation of emails from our China attorneys seeking more client information and providing additional client assistance before drafting a China distribution agreement.

I have the following basic questions and comments regarding your agreement.

1. For payment terms. The standard is as follows:

a. Shipping terms can be CIF or ExWorks. For products like yours, ExWorks is common, since estimating shipping and insurance costs can be quite difficult. If you do not know the port, you should not quote prices CIF and you should instead quote either Free Carrier (most common) or Ex Works. Either way, your distributor would be responsible for the shipping cost to the port of its choosing. It might be Shanghai for one shipment, it might be Qingdao for another shipment. That would be their decision and you want to leave the terms flexible so they can make the decision in a way that will not put you at a financial disadvantage.

I recommend you do not include price in the agreement but instead provide that your products will be sold at your normal distributor export price pursuant to a price list you will periodically provide to your distributor.

b. China’s letter of credit system is not very effective. If you ship your products before receiving payment for them, you are taking the full risk that the Chinese side will not pay. Our clients usually deal with this in two ways:

i. Conservative manufacturers require full payment before they ship.

ii. Less risk averse manufacturers ship on 30 days after the date of shipment (Net30) terms. These manufacturers provide for the right to shift to payment before ship terms if there is a problem.

2. You indicate wanting your proposed distributor to make advance payment for enough product to cover three months of projected sales. You need to specify an exact amount that must be purchased of each product and you also need to specify the sales terms. Your situation is further complicated by your not having Chinese government import approval yet for any of your products. For the first shipment, even where Net 30 terms are standard, most manufacturers require payment in advance of shipment. If you are not able to provide specific details in the agreement, we will provide that the exact terms of the first shipment will be determined after import approval is received. The agreement will terminate if that purchase is not completed by some certain date.

3. You have provided us with the sales milestones you want for your China distributor. This is always a good idea in a exclusive distributor arrangement but more detail is necessary, including the following:

a. You have discussed milestones for only one of your products. Will you have milestones for your other products as well? If yes, when will they be established and in what quantities?

b. Sales milestones for China distributors are usually set on a quarterly basis and not broken down by province. In formulating your sales milestones, you probably will want to account for the fact that there is not yet China government approval to import your products. If you plan to set sales milestones now for your other products we can do that as part of this agreement.

c. You can, of course, set the sales milestones at whatever level of specificity you desire. This is a business matter, not a legal requirement.

The issue of sales milestone is usually a big issue in this kind of agreement, so setting the milestones in a way that is clear and simple to understand is important.

4. When there is an exclusive agreement the term/length of the agreement becomes of critical importance. The normal procedure is to provide for a term long enough to give the Chinese distributor time to earn back its efforts in promoting your products. A three year term is typically the minimum, with five years more common. Most China distributors that plan to put in substantial work to market and sell your products will require the distribution agreement to automatically renew if they achieve their sales milestones. The China side will often want a provision saying that if the parties cannot agree on new milestones after the end of the first term, renewal will be automatic based on some predetermined formula. Chinese distributors that do not require something like this are oftentimes not planning to do the work necessary to succeed.

You mention wanting either party to be able to terminate the agreement with 90 days notice. Though such a provision is legally acceptable under Chinese law (which generally is far more liberal in what it allows in these agreements than either the EU or the United States), this sort of provision will normally be rejected by a serious distributor. Why would they do all the work necessary to get your product into China and to become well-known in China only to have you shut them down for any reason and with only three months notice?

5. When selling products in China, you need Chinese and English trademark protection for each product that will be sold. Serious distributors will insist that such protection is in place. Our China trademark lawyers can handle the appropriate China trademark registrations or you can have your distributor take care of this on your behalf as your agent. In either case, you should take care of the trademark registrations as soon as possible See China Trademarks: Register Yours BEFORE You Do ANYTHING Else. If your distributor takes care of this for you, you will want to ensure that the registrations are done in your name and not in theirs.

6. Your distribution agreement must be enforceable in the PRC. To make it enforceable we will draft it with Chinese law as the governing law, with the Chinese language as its controlling language, and with enforcement is in a Chinese court. For why we draft these contracts this way, check out China Contracts: Make Them Enforceable Or Don’t Bother.

7. The confidentiality agreement you attach is not enforceable in China. See Why Your NDA is WORSE Than Nothing for China. Rather than draft a separate agreement, we will insert standard China NNN (non-use, no disclosure, non-circumvention) language into the main agreement.

8. The concepts of “hold harmless and indemnify” are pretty much foreign to the Chinese system and there is no effective commercial insurance program for this sort of coverage. We therefore normally provide a simple statement of the parties’ basic duties and liabilities. We normally provide that the distributor will be liable for damage caused to you by their actions in violation of the agreement. Since your proposed China distributor is a relatively small company you should assume it lacks the financial wherewithal to deal with a major claim and you should consider securing your own insurance.

9. I note that you are expecting your China distributor to do a fair amount of work before there will be a flow of products that will provide an income stream to your distributor to do that work. It appears you intend for your distributor to do this work at its own expense. In that regard:

a. Have you discussed this with your distributor? Have they agreed?

b. If you are expecting this preliminary work to be independent of the distributor achieving its sales milestones, the agreement should give you the right to terminate the contract if your distributor never does the preliminary work or does an inadequate job at it, solely in your discretion. You can do this by basing termination on your distributor’s failure to meet an early milestone or  by providing for a separate right to terminate. We should discuss.

For more on what is involved in establishing a distribution relationship with a Chinese company, check out the following: