legal issues related doing business in china

Smallfry Yachts Pty Ltd (“Smallfry”) is a large Australian company which specialises in the design and production of small yachts. It has an excellent reputation in the Asian region, and has a well-respected trademark of “Smallfry Yachts,” which is registered in Australia, China and a number of other jurisdictions. It has registered a number of Australian and United States patents, relating to the design of engines, and other components for sea-going yachts. It has a number of other technological developments under way which it believes will be patentable in Australia, China and the United States.
The design of the yachts is highly specialised and involves the ongoing use and further development of very advanced technology created by Smallfry’s engineers. Production, however, can be carried out by qualified engineers with a certain amount of training, which Smallfry can provide in-house in its facilities in Sydney. Smallfry has extensive sales in Asia, including China, but believes that there would be many more opportunities in China, as well as lower costs, if Smallfry could expand its production. Smallfry is generally a profitable company and has a good credit line from its bank, but was badly hit during the global financial crisis and is still in the process of recovery.
Smallfry has been approached by a large Chinese company called Zhejiang Specialised Shipbuilding Company Limited (“ZSSC”), which has interests in ship-building and design, as well as other operations in unrelated areas. ZSSC is a limited liability company set up under the Company Law, although it was originally a state-owned enterprise under the Zhejiang government. It is owned by its General Manager, Mr Wang, and his family (55%) and its chairman, Ms Liu (45%), although it has been suggested to Smallfry that both Wang and Liu hold most of their capital as nominees for various local officials. Both Wang and Liu have close connections with the provincial government and the local governments in areas in which ZSSC has operations. ZSSC has numerous subsidiaries with operations in a range of areas, many of which are not related to shipbuilding or to engine design. ZSSC’s shipbuilding business has fallen onto hard times, however, due to its adventurous bidding practices, and it is interested in expanding its range of products and its technical capability. It would also like to increase its exports around the Asian region. ZSSC has a number of operating divisions, including a division based in a large factory in Taizhou which currently engages in the manufacture of ocean going ships. The division employs 900 workers, of which 150 are qualified engineers and 50 have significant experience in ship design. ZSSC suggests that this factory and its employees could form the basis of a project with Smallfry.
In the course of due diligence, Smallfry discovers the following facts about ZSSC: when it was a state-owned enterprise, the land use rights for the factory were allocated to ZSSC for its use free of charge. Although ZSSC has converted these rights into construction land use rights, it financed the conversion by mortgaging the land and factory to the Bank of China. ZSSC has over-extended itself by investing in a number of speculative projects, and does not have large amounts of cash available to either pay off the mortgage or to invest in a new project. It has excellent contacts with the local and provincial government, and some valuable contracts for the production and sale of engines and spare parts. The 900 workers in the factory were originally employed on short-term contracts under the 1994 Labour Law, and at least 400 of them have been in the employ of ZSSC in various capacities for a period exceeding 10 years. ZSSC owns a number of trademarks which are quite well-known in China and used on diesel engines and ship components sold in the Chinese market.
The value of the factory and land use rights is approximately US$10million; the mortgage held by the Bank of China is for the RMB equivalent of US$3million. At least US$8 million would have to be invested in the factory and in training in order to bring the facilities and employees up to the requisite standard. Smallfry is anxious to maintain control over management and particularly over production quality. Smallfry estimates that in order to operate the factory to manufacture products using its technology, it would need 80 of the engineers and about 300 production workers and administrative staff. It would need to second at least 3 high level employees to China, together with their families, for several years in order to ensure adequate supervision of production quality.
Smallfry is concerned about the number of employees already on staff and the drain on its resources in managing a substantial new business in China. In addition, it is concerned about the protection of its existing and the ownership and protection of any new intellectual property arising from the project. It is also seriously concerned about the competence of the Chinese management and the financial stability of ZSSC.

Assume that you are advising Smallfry on its options. What would be the best structure to adopt if the parties go ahead with the project? How should it be financed? What are the main legal and practical issues from the point of view of Smallfry? What Chinese legislation is applicable? Provide a list of the contracts you consider would be required in order to implement the transaction, with a short summary of their contents.

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