By Mark Schaub and Atticus Zhao  King & Wood Mallesons’ Corporate & Securities group

It was not so many years ago when it was common practice for international brands to sign away exclusivity for the Chinese market with little afterthought.

Back in the 1980s and 1990s it was not unusual for the Western brand to start a relationship in Hong Kong and then add China as an afterthought – it was considered a place far away, with few potential customers. 

What a difference an economic boom can make – in the space of 25 years China has moved from a place far away with few customers to the centre of world consumerism with over 300 million upwardly mobile middle class consumers and another billion wanting to join them.

This boom has led China to go from afterthought to front of mind within 25 years and many international brands need to re-consider how to approach this market. Many of the international brands have found that their incumbent distributor just does not deliver what they believe they need for this very different, very diverse and increasingly sophisticated market.

The reasons are legion but they typically include that the partner is unable to adequately cover all of China; partner does not meet international standards; partner unwilling or unable to invest in building out the stores; or simply after many years everything has changed except for exclusivity and it is just no longer a good fit – the distributor for the China of 1993 may not be the right distributor for the China of 2017.

Although there are exceptions many early distributors are Chinese entrepreneurs who made their own money in a growing but challenging market. As a result, many tend to be somewhat unruly and unorthodox in their business methodology but are equally puzzled by restraints they face in terms of implementing their business and conforming to an international brand’s business manuals (documents they certainly have not read and very likely do not know where they are stored).

For all these reasons (and many others – each case is different) many international companies feel the pressure to take back their distribution channels within China in order to grow the business more in “their” way. This does not mean eschewing Chinese partners but rather will typically involve a combination of brand owned flagship stores; selected franchise partners for certain provinces or markets; and a beefed up online presence.

So What Next?
Typically after the international brand has decided it must take back its Chinese distribution channel the next step is to consider how to actually do this.

A usual starting point will be to look at the contracts – something which will often lead one to consider that contracts signing away exclusivity with little conditions and that were executed 25 years ago may not best reflect today’s situation.

Most such contracts suffer from a combination of formalistic problems as well as not being fit to deal with practical complexities of unwinding a distributor in China.

Common formality problems include invalid or unenforceable choices of law and enforcement as well as issues relating to identity of the counterparty. This can mean the international brand owner may face difficulties in launching an action, difficulty in enforcing and ultimately difficulty in moving forward unilaterally.

Another problem can be that the contract may be too good for the international brand – unfettered ability to terminate franchise rights; ability to take over leases; ability to take over staff. All good ideas … but all are utterly unworkable.

In short, fighting through the courts or attempting to rely on unilateral contractual rights to terminate will likely be either pointless or counter-productive in most cases.

Contracts are important and can be useful to set pointers or a framework for future negotiations. Agreements can set targets; tying failure to meet targets to a loss of exclusivity or set details as to valuations. In our experience it is unlikely that an international brand can easily terminate the agreement of a long term distributor or franchisee and then pick up the business either cheaply/for free. You can try but this will normally backfire in a spectacular and disruptive manner. Accordingly, for most international brands the only practical way to grab back their distribution channel is to buy it.

How to Buy?
One of the first questions the international company will wrestle with when considering to buy back its distribution in China is whether the transaction should proceed by way of a share deal or an assets deal.

Although very much the road less travelled … the share transfer does tend to be far quicker to negotiate and implement. A share deal is simpler as the documentation is basically limited to a share transfer agreement whereas an assets deal requires far more comprehensive documentation which also leads to more protracted negotiations. Also the share deal is far less disruptive and allows the business to remain intact (i.e. operational certificates need not be changed; contracts remain in place). In most cases a share deal will have a lower tax burden than as assets deal. Also in a share deal the closing is clearer – the issuance of the revised business license is normally the main closing event. In an assets deal there is no one-off approval – registrations required for branches and there are complexities in this regard as well as taking over stock; transferring employees; assigning leases; dealing with vendors etc.

Despite these advantages the share transfer option is generally unloved by international companies, their accountants and lawyers (actually almost everyone) due to concerns of liability. However, personal experience has been that authorities do not pursue companies bought by a MNC for previous non-compliance. In practice, there are often more issues post-approval in asset deals as they are more disruptive and tend to bring problems to the surface. There are cases where asset deals are legitimately preferred – i.e. the seller has multiple businesses operating within its company or the due diligence detects major issues. However, each deal should be analyzed on a case by case basis.

There are normally four steps to a successful retail acquisition.

  • LOI – Once the main parameters of the deal are agreed the first step will be to document these in a letter of intent which will allow the due diligence process to start. It is important, but often forgotten, to have a legal review of the letter of intent before signing in order to avoid agreeing terms that are not possible or sensible under Chinese law.
  • Due Diligence – After the letter of intent is signed the next step will generally be due diligence of the Chinese target and/or business. Retail businesses tend to be far simpler from a legal perspective than a manufacturing business and the due diligence is similarly relatively straightforward. The due diligence will normally concentrate on leases; inventory; employees and compliance (largely key money to landlords). The type of leases (i.e. whether a lease agreement or consignment agreement) is important to note during due diligence as it will directly affect the complexity of the implementation process – consignment stores are easy to transfer with almost no licensing issue being involved. Things become far more complicated in respect of leased stores as this will require de-registration of licenses held by the seller and registration of new licenses in the name of the buyer. This process can take several months. Customer data is also a sensitive issue to review in the due diligence process as consumers’ consents may be required for the transfer of their data. It is important to note that China has placed increasing emphasis on protecting personal data in recent years. Another important issue to bear in mind is to consider whether the international company would be able to operate the business successfully if it changes the operational model of the seller (i.e. becomes fully compliant).
  • Negotiation – Very few cases in respect of retail will fall down on issues detected in the due diligence. Problems tend to arise in the next phase – negotiating the deal documentation. As outlined above if the transaction is a share deal the documentation will be simpler to draft and negotiate. An assets deal will be much a more involved and complicated process. Naturally each additional complexity represents more risk.

    The negotiations themselves tend to spend a lot of time (especially assets deals) on process but in most cases the main commercial issue will inevitability be the price.

  • Closing – Once the documents are signed the parties will need to move towards closing. In a share deal this tends to be straightforward and with recent changes only requires filing and registration. The Chinese authorities are unlikely to raise any issues in a retail acquisition. The filing and registration takes approximately 2 months.

An assets deal has a much more complex implementation and will require the buyer and seller to co-operate to ensure the business is properly transferred. Depending on the size of the business the transition from signing to closing will likely take between 6 and 9 months. It is important to ensure that payment (or at least the main payment) will only be made once the closing conditions have been completed. Otherwise it can be difficult to motivate the seller.

China’s evolution into the world’s biggest marketplace has led to many international brands re-thinking their China strategy. For many this means taking back their distribution channel within China.

In most cases this will only be done successfully by acquiring the business of the distributor. A dispute with a Chinese based distributor will unlikely turn out to be anything other than disruptive and damaging to the brand’s business in China. If poorly done the result can be litigation; disruption to business; dumping of the brand’s stock and great cost to distributor – very much a lose/lose outcome.

Accordingly for many international brands the only route forward is to buy out its distributor. The good news is that in our experience once the international brand has acquired its distribution channel in China then the business rapidly improves. The difficulty is the actual acquisition – in this regards careful planning, drafting and execution are key to a successful transaction.