Overseas Brands Entering Into The Chinese Market- A Legal Guide To The Distributor Model

With the conclusion of the 8th China International Import Expo, China has once again demonstrated its firm and unwavering commitment to the policy of opening up to the world. Despite withdrawal of certain foreign-invested enterprises from China due to cost and other factors in recent years, the Chinese market, with its huge middle-class consumers group and a resilient economic vitality, coupled with new open policies such as cross-border e-commerce imports, remains a strategic opportunity for many overseas brands. However, for overseas brands that are new to the Chinese market, setting up a company in China means high costs and complex management requirements. Therefore, choosing a Chinese company as a distributor has become an economical and convenient market entry strategy. Behind this seemingly simple cooperation model, there are certain legal risks and problems if the overseas brand owner is not prepared or just proceeds without caution.

Recently, we have handled several cases involving disputes between overseas brand owners from countries, such as France, Italy, Australia and New Zealand, and their distributors, each case revealing different legal issues and risks. Given the complexity and diversity of these issues and risks, we have specially come up with this article to provide overseas brand owners with reasonable and practical guidance, to help them avoid legal disputes, or to provide effective legal remedies and protection in the event of disputes.

Distributor Background Review: The First Line of Defense in Cooperation

Case Study: In the process of expanding into the Chinese market, some overseas brand owners meet potential distributors through trade fairs. However, some brand owners enter into cooperative relationships with these distributors without sufficient review or consultation with professional lawyers. Soon after, problems arise one after another. For example, in one of the cases we handled, just half a year after commencement of the cooperation, the distributor deregistered its company, leaving a series of troublesome subsequent problems. This is certainly not the outcome that any brand owner expects.

Insights and Guidance: Before selecting a distributor, overseas brand owners must conduct a comprehensive and strict background assessment of potential distributors. This step is crucial because it directly affects the stability of the cooperation and the brand's market image. The qualification assessment should include, but not be limited to, the following aspects:

1. Market Experience and Capability: Assess the distributor's market experience and sales capability in the relevant field, including its sales channels, customer resources, and market promotion capability.

2. Financial Status of the Distributor: Understand the distributor's financial strength to ensure that it has sufficient funds to purchase and sell products as well as products promotion, avoiding business disruptions due to cash flow problems.

3. Qualification and Legal Compliance: Review the distributor's qualifications, check for any adverse records or legal disputes, and understand its compliance with Chinese laws and regulations, including but not limited to tax laws, labor laws, and consumer protection regulations.

4. Reputation and Credibility: Investigate the distributor's business reputation and market standing, which helps ruling out of untrustworthy partners.

Distribution agreement: Legal Wisdom for Key Provisions

Case Study: Typically, when distributors and brand owners establish a cooperative relationship, a distribution agreement will generally be entered into. During negotiation of the distribution agreement, both parties tend to aim for instant mutual commercial success to meet certain time target, such as importing or opening up of e-commerce store before major shopping festivals, such as 6.18 (18th June) or Singles'Day (11th November), they may quite often focus on the commercial cooperation terms and overlook the clauses for abnormal cooperation or termination. If these clauses are missing from the distribution agreement or the same is dealt with vagueness and questions unresolved, the brand owner may find itself at a disadvantage in case of disputes, which may even affect the brand's subsequent business arrangements and development in the Chinese market.

For example, when a brand owner needs to replace a distributor, it may find that the original distributor has already occupied the flagship store account, preventing the new distributor from registering and plenty of time and cost will be spent in communication with e-commerce platform and the original distributor. Additionally, after the cooperation terminates, in the absence of certain protective clause in the distribution agreement, the original distributor may sell the brand's products at a low price, distorting the market and confusing the consumers, ultimately causing long-term and significant adverse effects on the brand.

Insights and Guidance: After selecting a suitable distributor, it is necessary to consider carefully and comprehensively on possible scenarios in the cooperative relationship. Drawing on our hands-on experience with past cases, we highlight below the scenarios and considerations that should be built into a more robust distribution agreement. These are the easily overlooked clauses that often matter most.

I. Clearly Define the Scope of Distribution Authorization

In the distribution agreement, it is essential to clearly specify the scope of authorization. This includes the distribution area, sales channels, whether it is exclusive, and the product range. For example, if a brand owner wants to grant the distributor non-exclusive sales rights in a particular area, this must be clearly stated in the agreement. Additionally, online and offline sales channels should be separately defined to prevent unauthorized cross-regional sales or unfair competition by the distributors.

II. Brand Protection Clauses

A brand is one of the core assets of a company, and protecting it from infringement is crucial. The distribution agreement should clearly specify clauses related to brand protection. While overseas brands owners usually retain the right to take legal action for trademark and patent infringements, distributors, as front-line sellers, are often better positioned to detect such infringements in a timely manner. Therefore, it may be beneficial to grant distributors certain authorizations, such as providing them with a brand authorization letter for reporting specific infringements or registering with platforms. This way, distributors can promptly report counterfeits, trademark, or patent infringements on online platforms, by which the platforms can quickly take measures such as interrupting live broadcasts, delisting, or removing the relevant infringing products and links. This cooperative model not only effectively protects the brand but also enhances the distributor's motivation to safeguard brand rights. Besides,the parties may also stipulate in the distribution agreement that the distributor shall promptly report any discovered infringement clues to the brand owner and, upon the brand owner's request, take active legal action.

III. Ownership and Management of "Intangible Assets"

During the distribution cooperation, distributors may collect and accumulate "intangible assets" closely related to the brand or its products, including market information, customer data, customer profiles, and sales data. Moreover, distributors may set up brand flagship stores, which, although named after the brand, are usually registered under the distributor's company on the platform. If not specifically agreed upon, the brand owner may not obtain these assets after the cooperation ends. Therefore, the distribution agreement should clarify the ownership of these assets. For example, if the flagship stores is registered in the name of distributor, it can stipulate that the brand owner is entitled to require the distributor to transfer the flagship store to the brand owner (or require the distributor to unconditionally replace the registered information of the flagship store) upon the cooperation ends, or to transfer or reasonably share market information and customer data subject to compliance with applicable laws. This can prevent disputes over these store assets and protect the brand's long-term interests, both during and after the cooperation.

Furthermore, to establish and maintain the relationship between the brand and e-commerce platforms, based on our practical experience, even if the distributor sets up the brand flagship store, the brand owner should also keep in touch with the platform to avoid communication discrepancies. In practice, we have encountered extreme cases where distributors provided false extended authorization to the platform. Therefore, it is very important for the brand owner to establish and maintain its own communication channel with the e-commerce platform.

IV. Clearance Period and Inventory Disposal

When the distribution relationship ends, how to deal with the inventory is a common issue. The distribution agreement should clearly specify a reasonable clearance period and clearance price and method. This clause may seem to grant rights to the distributor to continue with sale while in fact, it provides the brand owner with re-sale price protection, the right to stop sales immediately after the agreed "clearance period" and the discretion on how to handle the remaining goods.

Regarding the clearance period, there is no uniform rules in law or judicial practice. If a dispute arises, this period is generally determined by the courts considering factors such as the nature of the product, the distributor's purchase volume, the usual sales cycle, and the cooperation practices between the two parties. Therefore, if this is not stipulated in the distribution agreement, before obtaining a judicial decision, the brand owner may face the situation of being unable to stop sales due to the lack of an agreed "reasonable clearance period," which may intensify the conflict with the distributor and negatively impact the brand image and subsequent sales.

Moreover, it should also be clear whether the flagship store or other sales channels can be used for sales during the clearance period, and the disposal method for the remaining goods after the clearance period ends, such as agreeing that the brand owner will be entitled to conduct compulsory repurchase of the remaining goods at a certain price or instruct the destruction of the goods. In practice, if the distribution agreement is silent on this, the brand owner and the distributor would more than often enter into a tug-of-war over the repurchase price, e.g. whether the repurchase price should consider import transportation, insurance, tariffs, storage costs already incurred, etc., which may affect the remaining shelf life of the products and its salability after repurchase.

It has been proved by practical judicial cases that if there are complete and reasonable relevant clauses as mentioned above, the brand owner's subsequent requests for repurchase, termination of sales, or destruction of products will have much more contractual basis and are more likely to gain judicial support. This is because the court will consider that both parties have taken into account the actual situation and needs and have made reasonable arrangements for handling the situation at the end of the cooperation that both parties can accept.

V. Governing Law and Dispute Resolution

When choosing the governing law, overseas brand owners should think twice. In the cases we have handled, overseas brand owners, without consulting a Chinese lawyer when signing the distribution agreement, often assume that their home country's law, courts, or arbitration are more advantageous for protecting their rights. As a result, they opt for their home country's law and dispute resolution mechanisms. Although such choice of law and dispute resolution mechanism may appear more familiar and secure for the overseas brand owners, the reality is generally not the case. Given that the primary location of the distribution activities and the subsequent remedies in case of disputes are mainly in China, opting for Chinese laws and Chinese courts or arbitration could instead avoid the additional processes of ascertaining foreign laws and the recognition and enforcement of foreign judgments or arbitral awards. Chinese laws and dispute resolution mechanisms in practice may be more efficient and cost-effective in safeguarding overseas brand owners' rights and resolving disputes.

In case that the brand has a trusted Chinese law firm, it is advisable to specify in the agreement that Chinese law applies and to designate a mutually recognized arbitration institution or court to resolve potential disputes. In this way, both parties can seek a fair solution within a trusted legal framework in the event of a dispute.

Entering the Chinese market is a journey full of opportunities and challenges for overseas brands. Properly employing legal means and thoroughly considering and planning for various possibilities in advance to minimize risks shall lead to a more long-term and stable development for the brand in the Chinese market.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.