Legal News: Eye on China Quarterly Newsletter is part of our ongoing commitment to providing legal insight to our clients as they successfully navigate the complex and ever-changing legal and regulatory environment, whether they are U.S. companies doing business in China or Chinese companies looking to expand into the United States. In this issue, we focus on the following topics:
iPad Drama: Apple’s Fight for the Rights to the iPad Trademark in China Continues
By Toni Y. Hickey (firstname.lastname@example.org)
In its ongoing battle to secure trademark rights to the iPad trademark in China, Apple has appealed a decision of Shenzhen’s Municipal Intermediate People's Court, which ruled that Proview Technology Shenzhen is the owner of the iPad trademark, to the Higher People’s Court of Guangdong Province. Arguments were heard on February 29, 2012, and the court must decide whether Apple is the rightful owner of two iPad trademark registrations issued in China in 2001.
Proview International Holdings Limited (Proview Hong Kong) is an investment holding company that was listed on the Hong Kong Stock Exchange in 1997. It has a global network of affiliates that manufacture and sell consumer electronics. Two of its affiliates are Proview Technology, located in China (Proview Shenzhen), and Proview Electronics Co. Ltd., located in Taiwan (Proview Taiwan). In early 2000, Proview Taiwan manufactured and launched an all-in-one Internet terminal named iPad. The product was ultimately discontinued years later. It is reported that between 2000 and 2003, while the product was viable, Proview Taiwan secured 10 trademark registrations for the marks I-PAD, IPAD, and iPAD in the European Union, Indonesia, Mexico, Singapore, South Korea, Thailand, and Vietnam. In 2001, Proview Shenzhen applied to the Chinese Trademark Office (CTMO) for the registration of the mark IPAD. By most accounts there is no indication that Proview Taiwan’s or Proview Shenzhen’s acquisitions of trademark registrations represent a case of “trademark squatting,” as all of this filing activity occurred nearly a decade before Apple’s iPad tablet was launched.
In 2009, Proview Taiwan negotiated and signed a Trademark Transfer Agreement with a United Kingdom company, known as IP Application Development Co. Ltd. (UK IPAD), agreeing to assign its global iPad trademark rights for a reported approximate value of $55,000. The schedule of the assigned trademark rights included two trademark registrations for the mark iPad that were registered in China. UK IPAD then reportedly entered into an agreement conveying the iPad trademark portfolio to Apple in February 2010. Apple’s iPad went on sale in the United States in April 2010.
When Apple attempted to record the trademark assignment agreement with the CTMO, the CTMO rejected the assignments, finding that the iPad trademark registrations were owned by Proview Shenzhen and not Proview Taiwan, the party that had signed the initial assignment agreement with UK IPAD. As is common practice in China, the China-based affiliate, Proview Shenzhen, and not the foreign-based parent, holding, or affiliate company, had secured registration for the iPad marks in China.
Apple and UK IPAD filed suit against Proview Shenzhen in the Shenzhen Intermediate People’s Court for breach of contract, alleging that the agreement signed by Proview Taiwan, assigning its global trademarks for the iPad, included the iPad trademark rights in China. Documents reportedly reviewed by the Chinese court included a copy of the agreement with a listing of 10 iPad marks registered in nine different countries around the world. The Chinese trademark registrations are included in the schedule.
The Shenzhen Intermediate People’s Court ruled that the Chinese affiliate, Proview Shenzhen, owned two valid Chinese trademark registrations, and that Proview Taiwan could not assign what it did not own. In an official press release by the Shenzhen Municipal Intermediate People’s Court, the court found:
The Court noted that Proview Shenzhen did not participate in negotiations nor authorize others to dispose of their trademarks, and ultimately that the agreement is not binding on Proview Shenzhen. This trademark infringement case was arguably decided under principles of contract law, with the Shenzhen Court agreeing with the decision of the CTMO, holding that Proview affiliates Proview Shenzhen and Proview Taiwan are two different legal entities, and that an affiliate does not have the authority to assign a trademark that it does not own.
Apple filed an appeal with the Higher People’s Court of Guangdong Province and, while arguments have been heard, a decision has not been rendered. Should either party not find the decision favorable, an appeal to the Supreme People’s Court, the highest court in China, is possible. The SPC has recently accepted a large number of particularly complicated intellectual property cases and in December 2011 issued trial practice guidelines for trademark infringement cases (Opinions on Exerting the Function of Intellectual Property Rights Judgment to Facilitate Socialist Cultural Development and Prosperity and Promote Independent and Coordinated Developments).
Proview Shenzhen meanwhile has reportedly lodged complaints with more than 40 branches of the State Administration for Industry and Commerce in China, an agency with power to seize infringing products. Proview Shenzhen also has filed civil actions in multiple provinces accusing Apple of trademark infringement and demanding injunctive relief to stop Apple from selling the iPad in China and exporting iPads manufactured in China. A court in Shanghai has refused to grant the injunction, but a court in Huizhou has granted such an injunction.
Proview Shenzhen also has brought its battle to the United States. Proview Shenzhen, with its U.S. affiliate, Proview USA, has filed a complaint in the Superior Court of the State of California in Santa Clara County Court accusing Apple of committing fraud during the negotiation process by creating UK IPAD, a special-purpose entity with the sole purpose of carrying out the purchase of the trademarks, and not disclosing that it was acting as an agent of Apple.
At least in the near term, it appears that this matter is far from resolved.
Tracking ownership of assets in China often presents challenges, and it is common for assets to be owned by parties other than the party claiming ownership. As a result, due diligence to determine the owner in fact of the assets subject to an agreement is critical. A comprehensive trademark search of the CTMO database would have revealed the actual owner of record.
Moreover, unlike in the United States, in China trademark assignments should be recorded. According to the current Regulations for the Implementations of Trademark Law Article 24. Notice of an Assignment, the signatures of the trademark registrant of record and the assignee should be filed immediately with the CTMO. The filing of the trademark assignment likely would have uncovered the correct owner, as the assignment likely would have been rejected by the CTMO. At that time, the problem could have been corrected, or at least Apple would have been on notice of the problem with the ownership of the trademark. Apple, in assuming that the assignment agreement with Proview Taiwan was valid, launched the iPad in mainland China before its assignment with the CTMO was examined and recorded.
Joint Ventures in China: What Every CEO Should Know
By James C. Chapman
In China, as in any foreign market, it is difficult to succeed alone. Business practices, language, culture, legal environment, and other obstacles make success in China elusive. In addition, Chinese law requires a foreign company to have minority ownership of enterprises operating in certain industries such as banks and insurance companies. For these reasons, joint ventures in China are common. It also is widely known that the failure rate of joint ventures in China is high, and joint ventures in China have achieved a reputation for being difficult to manage. Parties will come together, usually after lengthy negotiations, and celebrate the formation of the joint venture — and only a short while later, after millions of dollars of losses, wonder what went wrong. There are a number of reasons that few joint ventures in China succeed while most fail, including differing expectations, overestimation of the Chinese partner’s market position, and conflicting management styles. This article sets forth a number of best practices that, if followed, may help increase the likelihood of success and avoid millions of dollars of losses.
Carefully Select the Joint Venture Partner
Like other ventures, one should take great care in selecting the Chinese joint venture partner. The foreign company must establish a list of criteria for selecting the partner, including experience, integrity, guanxi (a network of relationships designed to provide support and cooperation), expertise, quality, and other factors. In addition, a foreign company must make the investment in building a relationship with the potential joint venture candidates. This usually requires the foreign company to locate an executive or team of people on the ground in China, which demonstrates a commitment to China. As well, there are just some things that cannot be learned from afar; there is no substitute for being on the ground in China.
In addition, the foreign company must conduct thorough due diligence of the short list of potential partners, their management, and major shareholders. The due diligence should include, among other things, (i) criminal background checks; (ii) civil lawsuit checks; (iii) interviews with customers, suppliers, and others that have done business with the potential partner; (iv) interviews with parties active in the target industry; and (v) interviews with employees. There are a number of qualified companies that excel in assisting with the due diligence process. However, notwithstanding the above, the most reliable method of selecting a joint venture partner is to start with a party known to be honest with a proven track record of dealing with parties known by the foreign partner.
Always Allow the Chinese Partner to Maintain Face
Business relationships in China are complex, and disagreements between partners are common. Generally, the Chinese believe that the parties can take different positions on an issue and both be right. Although this concept may seem strange to foreign executives, it is fundamental in China. At the root of this belief is the concept of mianzi, or “face.” Generally, China is a hierarchical society, and one’s position in that hierarchy is very important. Any actions that undermine that position can result in disastrous consequences. In addition, the ability to build the “face” of your partner is an important part of building and maintaining relationships in China. Accordingly, although it is important for a foreign joint venture partner to be firm and protect its interests (being too accommodating creates its own cultural problems), the foreign partner must avoid words and actions that could embarrass, diminish, or undermine the authority and standing of its Chinese partner. Accordingly, solutions to problems and interaction with the Chinese partner must be calculated to allow the Chinese partner to save face and avoid embarrassment. These solutions and actions must avoid a sense of condescension or lack of respect. Many foreign managers believe that the Chinese are not sophisticated and lack modern management skills and experience. Taking the approach that the foreign partner is arriving to show the locals how international business is conducted — which is more common than one would believe — is a recipe for failure.
Develop Relationships With the Personnel Working in the Joint Venture
A Chinese joint venture cannot be managed through periodic board meetings. Although such meetings are important and the relationships with the Chinese representatives on the board of directors must be developed and maintained, the foreign-partner executives with responsibility for the joint venture must have frequent contact and develop relationships with the managers and executives who are actually managing the day-to-day operations of the joint venture in China. The relationship must be based upon respect. This cannot be circumvented, and there are no short-cuts in this process. This relationship-building requires frequent business and social meetings. As mentioned above, this is one of the reasons why a presence on the ground in China is so important. The foreign joint venture partner must invest time and energy in these relationships. Foreign managers must not ignore or fail to listen to local managers. They must avoid being perceived as arrogant.
This relationship-oriented approach is instrumental in identifying problems early and being in a position to solve them. As mentioned above, in order to avoid losing face, managers of the joint venture are likely to downplay, avoid, or even hide problems with the business operation. The best way to overcome this tendency is for those responsible for the foreign partner to have very frequent social and business contacts with those running the day-to-day operations of the joint venture, ask many questions, listen, and understand the Chinese indirect communication style.
Understand and Maintain an Alignment of the Parties’ Interests
Identifying the Chinese partner’s interests in pursuing the joint venture is not an easy task. Unlike Americans, who, for example, tend to be straightforward in discussing their interests in a transaction or relationship, the Chinese tend to take a different approach. The Chinese tend not to reveal their actual interests prior to the establishment of some level of trust between the parties. For example, the Chinese partner may be interested in a quick, short-term profit or obtaining technical know-how through the joint venture so it can independently pursue the business on its own at a later date. It may desire to launch the product line under its own brand or just have the prestige of being partnered with a well-known foreign company. Too often from the initiation of the joint venture, the parties are pursuing different agendas at the expense of the other. Part of the challenge is to overcome the different communication and working styles of the parties. However, an emphasis on relationship-building, training, and management can help build workable communication channels.
In addition, one must be mindful of the “crouching tiger, hidden dragon” phenomenon. The “hidden dragon” concept represents myriad invisible vested interests. In some instances, the Chinese partner is just an instrument of those interests. These hidden interests can change the Chinese partner’s priorities, affect the initial agreements, and change the dynamics of the joint venture. For example, one type of hidden dragon is local government officials, who often can be the real authority behind the Chinese partner. These local officials may control the appointment of key people, impose unreasonable requirements of local tax collection and job creation, and intervene from time to time to impose their will on the joint venture. However, the Chinese partner often has strong guanxi with the local authorities and may indirectly control the joint venture by using this power in the event of a disagreement, hence the reference to “crouching tiger, hidden dragon.” The foreign partner must make an effort to understand the Chinese partner’s relationships with local government officials and other hidden dragons and identify and understand the real decision-makers.
Balancing these interests and keeping them aligned is tough. As mentioned above, an on-the-ground presence is essential for keeping one’s hand on the pulse of and developing relationships with the Chinese partner and local government officials. Constant contact is necessary to understand the others’ interests and adjust as necessary to keep such interests aligned. Once these interests are identified, they must be translated into clear objectives. At this point, the joint venture has a quantifiable standard for measuring progress and satisfaction. For example, investment objectives should be agreed upon and continually re-evaluated jointly as the venture progresses. The partners should set clear corporate values, communicate them to the employees on a continuous basis, and monitor progress in implementing such values. The parties should make adjustments as necessary to keep the interests aligned as circumstances change. These corporate values would include such items as product design, product quality, and customer service. The foreign partner should often communicate the shared interests and mutual benefits. In this way, the parties can relentlessly pursue the achievement of the common objectives.
Always Have a Strong Legal Foundation for Business Relationships
The Chinese commonly use the phrase, “We know the law, but that is not how things are done in China.” Cutting corners or circumventing the law based upon the belief of common practice is a “no lose” situation for the Chinese partner and a ticking time bomb for the foreign partner. It is common for a Chinese party to use the failure to comply with the law as leverage to get more concessions from the foreign partner later or even force the foreign partner out of the lucrative business arrangement. In this regard, the foreign partner must establish a means of self-protection from the beginning. All material business relationships should be documented. A strong legal foundation would include a majority position in the joint venture, both ownership and management; a detailed joint venture agreement; the ability to control key hires such as the chief financial officer, controller, and human resources managers; independent relationships and guanxi with local government officials; strong anti-bribery policies and legal compliance programs; and a strong internal and external trade secret protection program.
In addition, the foreign partner should negotiate control of the “seals” or “chops,” as they are often called. The “chop” is a stamp indicating identity and is often required for authorizing actions by a company in China. In addition, the joint venture must ensure that it has all of the necessary permits to operate. In China, permits authorizing the conduct of a certain business are very narrowly drawn. In addition, the permitting regime is complex. It is not unusual for Chinese companies to operate illegally because of the lack of proper permits. The problem can increase as the company evolves and expands its business. Similarly, it is common for Chinese companies to maintain multiple sets of books, one of which is kept to justify the payment of low taxes. As mentioned above, the foreign partner’s control of the finance function should prevent this type of business practice.
Although China is a very lucrative and attractive market, business success in China is difficult. Foreign companies can save themselves millions of dollars and reap great rewards by learning from those who have previously succeeded and failed in China. Being mindful of the best practices set forth in this article will be helpful as one expands in China.
In the Eye of a Hurricane: Is Reverse Merger Still a Viable Alternative to IPO for Private Chinese Companies?
By Linda Ji and Hunter Qiu (email@example.com)
What Is a Chinese Reverse Merger, and Why Does It Matter?
In a reverse merger transaction, an existing “shell company” — which is a public reporting company with few or no operations — acquires a private operating company with a viable business — usually one that is seeking access to funding in the U.S. capital markets (Chinese reverse merger or CRM). Typically, the shareholders of the private operating company exchange their shares for a large majority of the shares of the public company. Although the public shell company survives the merger, the private operating company’s shareholders gain a controlling interest in the voting power and outstanding shares of stock of the public shell company. The assets and business operations of the post-merger surviving public company are primarily, if not solely, those of the former private operating company.
A reverse merger often is perceived to be a quicker and cheaper method of “going public” than an IPO. For most private Chinese companies, bank lending is out of reach since most large banks are state-owned and favor large, state-owned enterprises. IPOs involve a three-year application process with an uncertain outcome since regulators carefully control the supply of new shares to ensure a buoyant market. A company’s ability to obtain approval for an IPO often depends on whether the company is in a favored industry and the relationships the company’s management has with the Chinese government. The uncertain IPO process also deters some investors who would prefer greater clarity about their exit strategy. In addition, once a company launches its IPO, there is a three-month or longer holding period for shares held by the pre-IPO investors. Private equity is gaining in popularity but is still relatively new. In this climate, it is not surprising that some impatient Chinese entrepreneurs view the reverse merger, for all its pitfalls, as a viable shortcut to a public listing.
In the past several years, reverse mergers were once very popular among Chinese companies seeking U.S. listing. Around three-quarters of the 215 Chinese companies listing in the United States from 2007 to early 2010 are listed in the U.S. capital markets through reverse mergers. In the period from January 1, 2007 through March 31, 2010, out of the 603 reported reverse merger transactions, 159 of those involved Chinese companies, representing 26 percent of all reverse merger transactions reported during that time period.
What Happened to CRMs? Securities Class Actions, Enforcement Actions, and Going Private
As a result of prevalent accounting irregularities, blatant fraud, or inaccurate filings with the Securities and Exchange Commission (SEC), CRMs have been subject to dozens of securities class actions as well as focused enforcement actions by the SEC, Public Company Accounting Oversight Board (PCAOB), and the exchanges. These actions have resulted in a storm of negative publicity in the United States and China, and almost all Chinese companies listed in the United States have been tainted. Like other reverse merger stocks, CRMs also have attracted attention from a large number of short-sellers who tend to make money as these activities cause a decline in the CRMs’ stock prices.
Since the beginning of 2010, more than 33 securities class actions have been filed against CRMs. Nine of the 12 Chinese companies named in U.S. securities class actions in 2010 were listed in the United States through reverse mergers.
In August 2010, the SEC set up an internal task force to investigate fraud in overseas companies listed in the United States through reverse merger. The SEC recently revoked the securities registration of several reverse merger companies for failure to make required periodic filings. In addition, by October 8, 2011, at least six CRMs had been suspended from trading. NASDAQ and NYSE Amex also have suspended trading in several CRMs.
The PCAOB and SEC have been trying to address the systemic problems with the quality of the auditing and financial reporting for CRMs. CRMs are required to be audited by PCAOB-registered accounting firms. The problem is that the PCAOB cannot inspect those qualified Chinese accounting firms due to jurisdictional limitations, while U.S. accounting firms typically outsource part or all of the auditing work to Chinese accounting firms or assistants without proper supervision. The SEC has suspended several accounting firms and CPAs for issuing inaccurate or fraudulent auditing reports. On July 12, 2010, the PCAOB published Staff Audit Practice Alert No. 6, Auditor Considerations Regarding Using the Work of Other Auditors and Engaging Assistants from Outside the Firm. The PCAOB and SEC also are negotiating with their Chinese counterparts for authority to inspect PCAOB-registered Chinese auditors. As a result of the disciplinary actions and securities class actions, accounting firms will exercise more diligence when carrying out auditing work for Chinese companies.
Noticeably, CRMs have been targeted by short-sellers who might be credited for first discovering the accounting irregularities. In recent years, short-sellers have been scrutinizing CRMs’ disclosure documents or even carrying out onsite investigations to discover potential targets for shorting. Some of them shorted stocks of CRMs around the peak of the stock prices and have gained huge profit out of short-selling. Interestingly, because of the low valuation, high maintenance costs, and bad publicity, in recent months, an increasing number of CRMs are in talks with PE funds and investment banks to be taken private. Some of them plan to relist in two or three years in Hong Kong or mainland China, where compliance costs are lower and valuations for such companies now are higher than in the United States.
What Are the New Listing Requirements?
In response to prevalent accounting irregularities and fraud, on November 8, 2011, the SEC approved new rules proposed by NASDAQ, NYSE, and NYSE Amex that toughen the initial listing requirements for reverse merger companies. With limited exemptions, the SEC imposed higher thresholds for reverse merger companies to migrate to the main board:
In addition, NASDAQ, NYSE, and NYSE Amex have the discretion to impose more stringent standards on the reverse merger company based upon certain factors, including, among others, an inactive trading market, a low number of publicly traded shares, or disclosure by the company of a material weakness in its internal controls.
The new rules aim to protect investors by requiring a pre-listing seasoning period, during which the reverse merger company would have produced and filed required financial and other information. The seasoning period could make it more likely that analysts have followed the company for a sufficient period of time to provide an additional check on the validity of the financial and other information made available to the public. By requiring that minimum price to be maintained for a meaningful period of time, the proposal should make it more difficult for a manipulative scheme to be successfully used to meet the exchange’s minimum share price requirements.
Are Reverse Mergers Still a Viable Financing Tool for Chinese Companies?
The heightened listing standards for CRMs make the reverse merger’s advantage over an IPO less obvious. In addition to the time required to complete the restructuring of the Chinese operating companies and the reverse merger, it would take at least one year to satisfy seasoning period requirement and the SEC filing requirement. The additional time results in higher transaction costs, and the minimum stock price requirement would make the timing for listing less predictable.
Chinese companies need to rebuild their credibility among investors in terms of financial controls, corporate governance, and disclosure. They also need to carefully consider the costs and benefits of reverse merger transactions. In the short term, the higher costs of listing, stringent regulatory environment, and negative publicity probably make reverse merger transactions less desirable. In the long term, however, the heightened listing standards and more rigorous auditing standards might revive investors’ confidence and reshape reverse mergers as a viable alternative to IPOs.
Legal News: Eye on China Quarterly Newsletter is part of our ongoing commitment to providing legal insight to our clients and our colleagues preparing to do or doing business in China, or expanding into the United States. If you have any questions about this publication or would like to discuss the topics presented here, please contact your Foley attorney or the following:
James C. Chapman
Partner, Private Equity & Venture Capital and Transactional & Securities Practices
Palo Alto, California
James F. Ewing
Partner, IP Department
Vice Chair, Chemical, Biotechnology & Pharmaceutical Practice
Xueqing Linda Ji
Vice Chair, China Practice
Senior Counsel, Private Equity & Venture Capital and Transactional & Securities Practices
Richard S. Florsheim
Partner, IP Department
Chair, Industry Teams Department
Chair, China Practice
Partner, Transactional & Securities and Private Equity & Venture Capital Practices
Co-Chair, U.S./Greater China Corporate Practice
New York, New York
Special Counsel, IP Department
Stephen A. Bent
Partner, IP Department
Zhu Julie Lee
Partner, International Business Transactions Practice
Steven J. Rizzi
Partner, IP Department
New York, New York
Special thanks to outside author Hunter Wenxiong Qiu for his contributions to "In the Eye of a Hurricane: Is Reverse Merger Still a Viable Alternative to IPO for Private Chinese Companies?" Mr. Qiu practice is an experienced Chinese corporate attorney who recently earned a J.D. from Washington University School of Law. He can be reached at firstname.lastname@example.org.