Foreign Investment in China

China cybersecurity lawsThe PRC government promulgated its Cybersecurity Law on November 7, 2016, with an effective date of June 1, 2017. To say that foreign tech firms are concerned about the impact of this new law on their business in China would be an understatement. In addition to tech firms, our China lawyers have received a steady stream of questions from clients with China WFOEs who are concerned about an entirely different set of issues. Article 35 of the law states that “personal information and other important data gathered or produced by critical information infrastructure network operators during operations within the mainland territory of the People’s Republic of China, shall store it within mainland China.” Our clients keep asking what this will mean for them.

The surprising answer is not much.

Any company that operates a WFOE in China collects personal information about its employees. China’s new cybersecurity law defines personal information as “all kinds of information, recorded electronically or through other means, that taken alone or together with other information, is sufficient to identify a natural person’s identity, including, but not limited to, natural persons’ full names, birth dates, identification numbers, personal biometric information, addresses, telephone numbers, and so forth.” Certainly, the standard information any company maintains on its employees will qualify as personal information under China’s new cybersecurity law.

In the EU and various other jurisdictions, such personal information must be maintained within the jurisdiction and there should be no transfer of such information across borders. This causes many problems for companies that seek to manage an international workforce through a central location.

So what clients keep asking our China attorneys is whether China’s new cybersecurity laws will establish the same sort of protective system within China? The simple answer is that it will not. China does not have a comprehensive law or regulations relating to the collection, processing or transfer of employee data gathered by a WFOE or other business entity in the normal course of its China business operations and China’s new cybersecurity law does not change that situation.

The cybersecurity law specifically provides that its personal data maintenance and collection rules apply only to critical infrastructure network operators. Network operator is defined as “network owners, managers and network service providers.” In more general terms, this means telecom operators and Internet ISPs. The requirements do not apply to the China business operations of normal private businesses with respect to their normal record keeping requirements for their employees.

Even though nothing has legally changed in China, it is still best practice for foreign companies employers in China to follow the basic rules the PRC government imposes more generally in the consumer context on the collection and maintenance of personal information, including the following:

1. Be sure the disclosing party (your employee) is aware that the company maintains personal information. The company should have a written policy (in Chinese and in English) on how long that information is maintained and that policy should be revealed to the employee.

2. You should not collect more personal information than necessary.

3. You should maintain the confidentiality of the personal information you collect and maintain. That means you should limit internal access to that information and you should take proper security measures to prevent a data breach of the company’s online systems.

4. You should not sell or otherwise transfer the personal information to any third party. Stated more bluntly, do not sell employee personal information to marketers or spammers.

Doing business in China.
Doing business in China: relax, you have choices

CNBC recently quoted me in a fascinating article entitled, More and more American companies have decided their big China opportunity is over. The article is by Evelyn Cheng, who consistently writes excellent pieces on China.

The article starts out by noting how China may no longer be “the world’s biggest business opportunity” for American companies. It then cites McDonald’s being in talks to “sell its China unit and license its name to a Chinese company instead, following Yum Brands’ decision to do something similar.” It then (100% accurately) quotes me saying the following:

“The trend is that opening retail business on the ground in China as a foreigner is difficult and expensive,” said Dan Harris, lawyer at Harris Bricken and author of the China Law Blog.

We have for years tried to push a lot of our clients not to do that, but instead do what McDonald’s and Yum Brands are doing, which is … monetize your name and your knowledge without actually being the one who does all the work to make it work in China,” Harris said. “China is a tough, tough market.”

All true.

Except, and just to be clear, the China lawyers at my law firm do not believe there is a one-size-fits all solution for going into China in the retail industry, or in any industry for that matter. And — again, just to be clear — I would not in a million years claim to know better what is right for McDonalds or for Yum Brands in China, as I am quite certain both of those companies know 1000 times better than I do what is right for them.

So, yeah, not going into China with 5-200 retail outlets makes a lot of sense a lot of the time, but a lot of the time it does not. Yeah, our China attorneys oftentimes try to steer (or “push”) some of our retail clients to get away from the idea that the only way for them to make money from China is to set up their stores in Shanghai, Shenzhen and Suzhou, just as they have done in Palmdale, Portland or Peoria. Our goal (indeed our job) as China attorneys is to explain the various options to our clients and to give them the pros and cons of each. The key thing we want them to know is that they have choices and that they should analyze their choices and not just do what some similar company down the street from them did two years ago in China, nor even necessarily what their China consultant is telling them to do.

So let’s talk about some of the options for a Western retail company that is looking to profit from China by doing business in China, and the pros and cons of each.

  1. Go into China Full-On as a WFOE. Under this scenario, the Western company forms a WFOE in China (for all that entails, check out How to Form a WFOE in China). The benefits of doing this are that you are in full control of your China operations because you 100% own your China operations and you can operate them as a subsidiary of your US or your European operations. This way of going into China makes sense if 1) you cannot — for whatever reason — relinquish control of your stores or your product to another company or 2) you eventually want to franchise your stores in China as China requires that you first own your own stores there before you can franchise them out. The negatives are that setting up a WFOE is time consuming and expensive. See Forming a China WFOE: The Method and the Madness. And going all into China as a WFOE in the retail sector can be particularly difficult because your WFOE in Shanghai does not entitle you to just start doing business in Shenzhen. No, to get into Shenzhen, you typically will need to set up a new WFOE or a branch office there, and then figure out all of the issues that come with that, including even whether. Is your company truly ready to navigate China? I cannot urge you enough to read this post from 2012: Are You China Ready, which details a speech on this topic given by Ben Shobert.
  2. Go into China as Part of a Joint Venture. The big plusses of China joint ventures are that you typically share in the costs with another company and you have a Chinese company as your partner in China. For the big negatives, of which there are many, check out China Joint Ventures: The Tide is Out.
  3. Go into China Via a Distributor Relationship. A great thing about distribution relationships in China is that you have a lot of flexibility in how you structure that relationship. See China Distribution Agreements in Real Life. You can give your China distributer exclusive rights for all of China, or for just one city, or no exclusivity at all. You can set all sorts of sales requirements for your China distributor, ranging from sales amounts to exactly how your product will be placed on store shelves. But better than this is that you can usually get your retail products into China cheaply and quickly via a distributor. The downside of this is that by sharing the risks with your distributor, you will also need to share in the profits.
  4. Go into China Via a Licensing Agreement. Under a licensing agreement, you can license your product name and other attributes to a Chinese company, and you can even add in many of the same requirements you might put into your distribution contract. The upsides and the downsides of a licensing agreement are very similar to those of a distribution contract. For more on China licensing agreements, check out China Licensing Agreements: The Extreme Basics and Fear The China Joint Venture And Front-Load Your China Licensing Agreements.

Bottom Line: The one right way to start doing business in China is to work on figuring out the best way for you and your company.

China attorneysIn China to Charge Three Australian Crown Resorts Executives The Wall Street Journal (Wayne Ma) reports that Chinese authorities will be pursuing criminal charges against at least three employees of Crown Resorts Ltd., an Australian gambling company. The article states that three Australians — among 18 people initially detained last month — remained in custody in Shanghai and …. [that one] of the Australians detained was Jason O’Connor, vice president of Crown Resorts’ international VIP operations. The status of the other 15 taken into custody is not clear.

As noted in the article by Peter Humphrey, who himself served time in a Chinese prison for alleged violations involving corporate investigations, “after someone has been charged, ‘the chances of getting them out have diminished by several times,’ said Mr. Humphrey, who maintains his innocence. ‘Whoever laid these charges now has a political stake in making them stick,’ he added.”

The kicker in all this actually comes from a quote by co-blogger Steve Dickinson in this Bloomberg article:

“In the old days, people would insist to me that the only risk was deportation. This is no longer the case,” said Steve Dickinson, a lawyer at Seattle-based Harris Bricken, which produces the China Law Blog and has advised companies in the gaming sector. “Foreigners can expect to be treated exactly like Chinese nationals.”

And here’s the thing about the Crown case: the Chinese government had for some time been signaling its intentions:

Under Chinese law, casinos aren’t allowed to promote gambling in China. Organizing a group of more than 10 Chinese nationals to go to casinos overseas also is a crime.

Overseas casino operators sidestep that ban by marketing only their hotels and entertainment in public promotions.

The detainments appeared to be foreshadowed last year in comments made by Hua Jingfeng, deputy chief of China’s Ministry of Public Security.

Mr. Hua told reporters that his department was investigating a “series of cases” involving foreign casinos in China.

“Overseas, a few countries are treating our country as a big marketplace,” Mr. Hua said, adding that he was aware overseas operators were establishing offices in China with the goal of luring citizens abroad to gamble.

Eight months later, Chinese authorities arrested more than a dozen South Korean casino managers and a number of local agents allegedly for the practice.

Why should you not look away from this post if you are doing business in China? Because it is vitally important to you and to your company that you understand that China will arrest and imprison foreigners and that it has only become increasingly willing to do so.

In a post we wrote back in 2014, China’s Anti-Corruption Drive. What Next? we mused about China’s then nascent anti-corruption drive what it all might mean, and we noted the following:

  • China is serious about corruption and it is starting with the pharmaceutical industry because corruption is so entrenched there. China is going after both domestic and foreign companies, but we are just hearing more about the foreign companies. This is just part of China’s desire to reduce corruption because the Chinese people are really sick of it.
  • Nobody really knows where and when the Chinese government will strike next when it comes to corruption. We all just know that it is striking a lot more often than it used to and striking against a much more varied list of companies (the smaller foreign companies that have gotten hit have for the most part managed to stay out of the news).
  • If you are a foreign company doing business in China in an industry the government deems important or politically sensitive, you should be extra worried/cautious.

And here’s the latest rumor we are getting: China is going to start criminally pursuing those who earn income in China with  independent contractors in China and no company in China and who pay no employer or income taxes in China. For what this situation looks like, please check out my Forbes article, China’s Tax Authorities Want You (written before we started hearing of criminal implications).

So whatever you do, please don’t look away. Better yet, have a full-on audit done of your company to ensure there is nothing lurking there.

For more on the Crown Resorts case and the lessons to be learned from it for anyone doing business in China, check out Doing Something China Doesn’t Like? Don’t Go There and How To Avoid Getting “Detained” in China and Why Your Odds are Worse than you Think.

Forming a China WFOEOne of the features of China’s new Foreign Invested Enterprise (FIE) online filing registration for is the requirement that the foreign investor state who will be the “actually controlling person” of the foreign invested entity. Under the new rules, the management of all FIEs must complete an online registration form. This form defines “actually controlling person” is either a) the person or persons who collectively have 50% ownership in the foreign investor that will establish the FIE OR b) the persons who actually control the foreign investor through means other than ownership, such as contractual control over the foreign investor’s decision making body. For background information on China’s new foreign company registration laws, check out China’s New Foreign Investment Law — Less Than Meets the Eye.

For anyone who works with modern corporation ownership and management, it is obvious that this simply posed question of “who is in control” will in many instances actually be quite difficult to answer. Anyone who works in the field can give examples of complex structures for non-public companies that are intentionally structured to ensure that no single individual has actual control.

We represent many private company clients with multiple owners, none of whom as individuals have actual control. In some cases, the ownership structure is complex, involving individuals, family trusts, angel funds and employee ESOPS. For these clients, my first response to the form was to reply “none” when asked who is the actually controlling person, since that is the only sensible answer. However, the new form does not allow for this simple response. The new form only allows two answers: either the controlling person is an individual or group of individuals OR the controlling person is a public corporation. No “in between” answer is allowed. We all know this simple scenario does not reflect the reality of modern corporate finance and governance.  But the new PRC regulations do not allow for any alternative response.

How does all this work? In the section on “actually controlling person”, the new form gives the following options that must be chosen through a checkbox (translation supplied by me):

从以下类型中勾选 Select from the following categories:
□境外上市公司 Foreign Listed Company
□境外自然人 Foreign Natural Person
□外国政府机构(含政府基金)Foreign Government Agency
□国际组织 International Organization
□境内上市公司 Domestic Listed Company
□境内自然人 Domestic Natural Person
□国有/集体企业 SOE/Collective

Note that NO private business entity of any kind is listed here even though that is one of the most common types of business entity my firm sees; the system allows only for a public company or natural person. That means that for every investor that is NOT a public company, we will need to identify the natural person or persons who control the private entity. In many private companies, no individual owns a controlling share. In this situation, it will not work to say that each owner has a 10% share, so no one is in control. It appears instead that the required response will be that the group of individual shareholders are natural persons who are collectively in control, so we will have to list every one of them. And, if one of the owners is an entity, we will need to drill down and report the ownership of that entity until we finally reach the point of reporting the name of a natural person or the name of a public company.

China’s intent with this new system is clear. The PRC government will no longer allow the use of special purpose vehicles and related entity structures to hide the actual ownership of the investors in PRC foreign invested enterprises. And any attempt by a foreign investor to invoke foreign law that allows secrecy with respect to ownership will almost surely be ignored. MOFCOM has plans to carefully audit all FIEs and that audit will include careful reviewing their ownership structures. More important, however, is that a response that does not list out owners will simply not be accepted by the automated system. A response is therefore forced. A false response is a violation of law that can result in penalties and other legal/administrative action by the PRC government and its agencies.

The way the online form is written does not provide any way around this. We often have clients whose situation is such that listing out their ownership structure as required by the new online company registration system would reveal that Chinese individuals are owners of the U.S. investor, and for that reason the whole investment constitutes a round trip investment. This new company registration system is designed to root out just such round trip investments. Note that Chinese individuals are generally not allowed to have ownership in foreign companies without prior Chinese government approval.

For U.S. investors who are not in this category, this requirement will still be a problem because the actual ownership of the investor is often complex and not public. Think private equity, VC funds, angel funds, family trusts, and limited partnerships. It also is not normal in the United States for private entities to publicly reveal their shareholders. In fact, there are private entities that do not even know who their ultimate individual shareholders are.

The new rules go beyond requiring identifying the controlling persons; they require identifying of each source of investment in the FIE. The online form requires the investor state a) the amount of the investment, b) the type of investment (cash, equipment, land, buildings, intellectual property, etc.) and c) the specific source of each of those types of investment. Under this approach, it is not possible to bury round trip investments from China under other investments that come from outside China. Even if a small part of the total investment is sourced from China, this source must be clearly identified.

As I noted in my earlier post, this new online registration system will not reduce the amount of information that must be provided to MOFCOM. It is just the opposite. To properly complete the online form, substantially more information will need to be gathered and provided to MOFCOM. In addition, local governments will still require their own documentation, and that documentation will still require authentication and other similar procedures. So in the end, China’s new foreign company registration system will end up being even more complex and cumbersome than its current system.

To make it worse, since the MOFCOM report is filed online, there will be no government official available in a local office from whom we can obtain clarification on what is required. This means the form will be submitted without a prior “pre-approval” from the local agency. This will have two negative results. First, it could result in numerous submissions to the online system as an attempt is made to do it right while operating in the dark. Second, due to the vagueness of the requirements, there is substantial risk that MOFCOM officials will find a mistake or defect on subsequent audits.

Registering a China WFOE just got tougher.