China Business Review, the magazine of the US-China Business Council, just did a feature story, entitled, “Hollywood’s Script in China: Three experts discuss China’s rapidly evolving film industry and opportunities for US entertainment companies.“ Our own Mathew Alderson was one of the three experts interviewed for this story, which covered China film issues ranging from the benefits of co-productions to the recent FCPA investigations of a few leading studios to how to structure a China film deal.
Rob Cain, who has been involved in the production side of the China film business since 1987 and Brent Reynolds, who through his company, Q Global Entertainment, licenses and distributes films in China to television stations and web portals, also were interviewed.
We secured permission from China Business Review to publish the full portion of the interview with Mathew (normally you would need to be a member of the US-China Business Council to see it) and so we do so here:
Q: Why are so many studios co-producing films in China?
Alderson: China now has the largest foreign box office market in the world but in China there are effectively no sources of ancillary income, such as income from internet downloads and home rental. So, Hollywood studios want a piece of the box office action. There is a quota for foreign films that can share in box office revenue. The reason for the interest in co-productions is that they are regarded by the Chinese as domestic films and are therefore not subject to the quota. The share of box office payable on co-productions is higher: a co-production can command around 38% of box office as opposed to 13% – 25% available for imported films. The Chinese authorities also require that around 55% of total box office is taken by domestic films so a certain return on domestic films is guaranteed.
Q: What are some of the challenges studios face in co-producing films in China?
Alderson: It is generally assumed that the quota is the biggest challenge but the quota has no application to co-productions. The biggest challenges for studios and producers are getting films approved by the Chinese censors and then getting paid their full share of box office. Censorship is an issue because the Chinese authorities view Sino-foreign co-productions as vehicles to promote Chinese soft power and to educate foreign audiences about China and the Chinese. Getting paid is an issue because of under reporting and other practices engaged in by the movie theaters here.
Q: What is the most common legal mistake you see companies make when it comes to producing and distributing films in China?
Alderson: There are several common mistakes. First, companies often fail to undertake proper due diligence on their Chinese co-producers and other Chinese counter-parties. As a result, fundamental matters such as the existence, identity and domicile of a Chinese person or a Chinese company are not established and the permits or licenses these parties require under Chinese law are not verified. Second, there is a tendency to assume that US law and jurisdiction should apply to all contracts in all circumstances. US law and jurisdiction are of little value unless the Chinese party has assets in the US. Anyway, these days good results can often be obtained by foreigners seeking to enforce contracts in the Chinese courts, particularly in the top-tier cities. Finally, there is a tendency to sign brief memoranda of understanding or other short-form documents without taking independent advice. Normally prepared by the Chinese party, such documents tend to lock the foreigners into a particular type of entity or a particular deal structure when these may be inappropriate or even unlawful. Foreigners are often reluctant to subject these types of documents to close scrutiny for fear of insulting their partner and losing some advantage or opportunity which is usually illusory anyway.
Q: What can they do to avoid these mistakes?
Alderson: Take advice early on from someone on the ground in China.
Q: Are there lessons from China’s film industry that can be applied to foreign companies in other industries?
Alderson: The mistakes made by foreigners in the film industry in China are essentially the same as those made in other industries so the lessons are universal. I would add that the perception that China will soon “open up” to the US seems to persist more in the film industry than in other industries. It is important to remember that foreign investment in the film business is restricted and there is little reason to believe that the film business will re-classified as ‘encouraged’ or ‘permitted’ for foreign investment purposes.
Q: We hear a lot about American films that do well in China, like the Avengers, but how much money are these studios making from China?
Alderson: Precisely what the major studios actually make in China is a well-kept secret. Box office takings are not independently audited in China and there are no trusted intermediaries or collection account managers. Accounting and financial arrangements tend to be opaque, to say the least. Only high-end cinemas in top-tier cities account electronically and even then the accounts are unreliable.
Q: Are there still issues that affect a foreign studio’s ability to make a profit in China?
Alderson: The issues vary depending on whether the studio is merely engaged in discrete co-productions or whether it has committed to an ongoing business operation on the ground in China. Profits from co-productions are affected by the accounting and auditing issues mentioned above. Profits from ongoing operations are affected by the regulatory environment, which includes things like the newly-introduced ‘social insurance tax’ that effectively adds 50% to the payroll for foreign employees. Moreover, given that foreign investment in the film industry is restricted, an ongoing business operation will usually be required to take the form of a joint venture. To establish and operate a joint venture properly is very expensive.
Q: The US Securities and Exchange Commission recently announced an investigation into whether Hollywood studios were bribing PRC government officials to film and distribute movies in China. What can you tell us about this case?
Alderson: The investigation was announced during the 2nd Beijing International Film Festival. The timing was instructive. Clearly, the S.E.C. is sending Hollywood a message here. The message is that the entertainment business in China is no longer the Wild West.
Q: What are a few best practices the movie studios – and companies in general – can implement to avoid violating the Foreign Corrupt Practices Act?
Alderson: At least put FCPA compliance provisions in all contracts made in or in connection with China. The US Association of Corporate Counsel recommends that contracts should specifically mention the importance of FCPA compliance and require partners to represent that they know the elements of the law and will comply with it. You should have a clearly worded audit clause that requires the partner to provide documents and assistance in an investigation. You should also ensure that you are able to terminate a contract if your partner is in violation of the FCPA. Other than that, you should be aware that the SEC tends to regard representatives of SOE’s to be representatives of the Chinese government and as such financial dealings with those representatives are in the cross hairs. So, any US corporation that has formed a joint venture with an SOE needs to be very careful about the payments made to representatives of that SOE.
Q: What are the implications of China’s recent decision to increase the quota of films it allows in the country?
Alderson: Have the Chinese really made such a decision? I am not yet convinced. During Xijingping’s recent visit to Hollywood, the U.S. announced the signing of a new film-related agreement with China. The agreement was said to improve the terms on which the US may import films into China for theatrical release. This all took place in the context of the WTO dispute between the two countries over the importation and exhibition of ‘audiovisual entertainment products’ in China. If the film agreement exists at all, it has not been published at the time of this interview. So far, all we have seen is a draft Joint Communication from the US and China delegations to the WTO’s dispute settlement body. The Communication reports that ‘progress’ has been made in resolving the dispute and that a ‘Memorandum of Understanding’ sets out some ‘preliminary arrangements’ made by the two countries. The Memorandum of Understanding has not been published but the Joint Communication says that it includes certain ‘key elements’. Three of these elements in particular are worth mentioning. First, enhanced format films (e.g. IMAX) are not subject to the 20-flim quota. Second, the distributor of a film imported on a revenue-share basis is entitled to 25% of gross box office takings. Third, Chinese entities other than China Film Group will be entitled to import and distribute films. Clearly, it is impossible to form a view on the situation without reading the Memorandum of Understanding. The Memorandum is likely to state the key elements with greater precision and to attach various conditions and limitations to their implementation. Moreover, it must be appreciated that the deal has apparently been put forward in an effort to resolve part of an ongoing WTO dispute. The key elements of the deal are preliminary. They should be regarded as general statements of current Chinese intentions as opposed to terms of ongoing contractual force.
Q: Will this change the market for foreign companies producing and/or distributing films in China?
Alderson: If these elements are implemented continuously they are unlikely to change the market for co-productions but obviously they would tend to improve the position of the studios whose films are selected for inclusion in the quota.
UPDATE: Rob Cain, one of the other interviewees, posted his full interview on his ChinaFilmBiz Blog. Rob’s interview focused on the business side of China co-productions and it (and his blog itself) make for great reading.