Got an email today from a reader who wanted to let us know how much a particular blog post that we did way back in 2006 had helped his company. The post this emailer was extolling was James McGregor’s China Tips and he wanted to know whether I thought all of McGregor’s advice was still relevant.
Boy do I.
The post listed out the following six tips for doing business in China:
  • The Chinese will ask you for anything because you just may be stupid enough to agree to it.  Many are.
  • Avoid joint ventures with government entities unless you have no choice. Then understand that the partnership is about the Chinese obtaining your technology, know-how and capital, while maintaining Chinese control.
  • If you decide to sell your soul and succumb to Chinese corruption, get a good price and focus on charity work in your old age.
  • Government officials can lie to you, but you must never lie to them. Exclude information, but never provide false information.
  • Any tech company doing business in China should assume that its designs and products are being copied.  When forced to share your technology in China, isolate the pieces from each other so that your partner doesn’t have the whole picture.
  • If your boss wants to come to China to do a quick deal, lose his or her passport.

Let’s go through these tips for doing business in China one by one.

  • The Chinese will ask you for anything because you just may be stupid enough to agree to it. This is completely true. I remember a few years ago when one of our clients was seeking to buy its product supplier. The product supplier started out asking for some absolutely absurd amount and when pressed, admitted to one of our China lawyers that the only basis he had for that amount was that he had heard that American companies “get so excited about doing business in China they will agree to anything.”
  • Avoid joint ventures with government entities unless you have no choice. Absolutely true, but it generally makes sense to avoid all joint ventures with anyone. For more on the problems inherent in China joint ventures, check out the following:
  • If you decide to sell your soul and succumb to Chinese corruption, get a good price and focus on charity work in your old age. Completely agree, and you need to know only two things on this. First, GSK. Second, it is no accident that my firm’s China attorneys are seeing more growth in anti-corruption compliance requests than in any other practice area.
  • Any tech company doing business in China should assume that its designs and products are being copied.  When forced to share your technology in China, isolate the pieces from each other so that your partner doesn’t have the whole picture. Absolutely the case, but this holds true for just about all foreign companies doing business in China, not just tech companies. For more on the dangers of IP theft in China and on how to protect your IP from China, check out How To Protect Your IP From China. Part 1.
  • If your boss wants to come to China, hide his passport. There are actually two schools of thought on this. One school says you do not want your boss to come to China because he will make big mistakes, but the other school says that you do want your boss to come to China because he will make big mistakes and then realize that he’s better off leaving China to his company’s China experts.

What do you think?

I am going to be speaking at USC this weekend and in poring over old PowerPoints (to create a new PowerPoint for my talk), I came across one with a fairly extensive China law bibliography of some of our most helpful posts.  This bibliography is definitely slanted towards the legal issues that confront foreign companies doing business in China.

Here it is:

CHINA CONTRACTS

CHINA LICENSING AGREEMENTS/CHINA DISTRIBUTOR AGREEMENTS/CUSTOMS

CHINA COMPANY FORMATION/CHINA WFOE FORMATION/CHINA JOINT VENTURES

NEGOTIATING WITH CHINA

CHINA —INTELLECTUAL PROPERTY

During the first 25 years of China’s opening up process, joint ventures were the favored vehicle for FDI in China. In 2005, the favored form of investment shifted away from JVs to direct investment through WOFEs (Wholly Foreign Owned Entities). During the last year, however, foreign SMEs have been shifting away from WFOEs and back to joint ventures. An even more dramatic shift has seen SMEs decide not to have any direct involvement in China at all. For these companies, licensed manufacturing and sales has become an attractive alternative.

The shift away from WFOEs has occurred because of the worsening environment for small private businesses in China.  Consider just the following in terms of the shift that has occurred in the last ten years:

  • Taxes: In 2003, WFOEs operated in China tax-free. WFOEs are now subject to basic income tax, VAT taxes and a host of local taxes and fees.
  • Wages: In 2003, Chinese wages were some of the lowest in the world. Now, the wage for the average worker on the coast is higher than in Mexico. In 2004, a WFOE could hire and fire workers at will and employ them for as many hours a week as the workers would tolerate. Now, employment is subject to a strict employment contract law system that makes firing workers difficult or impossible and that requires overtime for work in excess of 40 hours per week.
  • Benefits: In 2003, foreign employers could safely ignore paying benefits to their workers. Now, foreign employers are required to pay benefits to both foreign and Chinese employees that amount to almost 40% of the employee wage.
  • Rent: In 2003, rent in Chinese cities was low by world standards. Employers who located outside the major cities often negotiated free rent merely by agreeing to locate in a rural or relatively undeveloped area. Now, free rent is unheard of and rents in general are some of the highest in the world.
  • Environmental and safety regulations: In 2003, a foreign manufacturer could operate in China with minimal concern about environmental and safety regulations. Now, in virtually all jurisdictions, the Chinese authorities require compliance with relatively strict standards.

As this list of major changes shows, the business environment for foreign investors in China has changed dramatically in just one decade. However, many foreign companies that are planning operations in China assume the situation is the same as it was in 2003. It is a nasty shock to most when they evaluate their potential China operation under the current conditions.

Stated simply, many small WFOEs simply do not “pencil out.” However, because China remains an absolutely critical market for countless foreign companies, simply abandoning the China market is not feasible for many. Companies that must operate in China are starting to shift their Chinese investment plans. We are seeing two trends along these lines:

First, joint ventures are experiencing a revival. In the most basic situations, what the joint venture means is that the foreign investor is saying to its Chinese partner: we cannot make this project work by ourselves in China. We need your help. We will provide you with funding and expertise. What we want from you is management and guidance to allow the venture to earn a profit in this difficult environment.

In addition, more complex forms of joint venture are being considered. Two variations we have seen lately are:

  • The foreign company has technology but no money and no ability to manufacture or market anywhere in the world. The foreign company seeks to do a Joint Venture with a  Chinese company that will provide both necessary funding and the support needed to commercialize the product based on the technology. The structures for these China Joint Ventures are complex and are made more difficult by the antiquated and inflexible Chinese laws on joint ventures, financing and IP protection.
  • The foreign company has an existing successful product that it wants to manufacture and then market in China. Licensing is one option. The other is a complex joint venture. As above, the Chinese side of the proposed joint venture is seen not just as a source of manufacturing expertise, but also as a source of funding.
Years ago, my law firm developed a reputation for not liking joint ventures and there was some truth to that.  We did not like joint ventures that were mainly based on the Chinese side claiming that was our client’s only option.  We did not like joint ventures for joint ventures’ sake when there were other, better options for our clients.  We fully recognize that Chinese landscape has changed and whereas six or seven years ago eight out of ten joint venture proposals that crossed our desk did not make good sense, that ratio has probably completely flipped today, to the point that in the overwhelming number of instances, we make no effort to talk our clients out of their proposed joint venture.
The second trend we are seeing is companies abandoning the concept of directly investing in China and instead moving to a contractual approach. We are seeing this especially with foreign SMEs that are determining they do not have the resources to do manufacturing WFOEs in China. Basically, they are determining that Chinese owned factories are better/cheaper at manufacturing in China than foreigners. This includes multi-nationals such as Apple and HP.

In response, the current trend is to work towards purely contract manufacturing (product outsourcing), with no JV and no WFOE involved. This often involves complex IP issues and can also involve complex issues of start-up funding for the Chinese manufacturer. In connection with this trend, the foreign parties are finding that they need to work with their manufacturers to bring up their level of product quality to obtain required certifications such as HACCP and GMP.

Non-manufacturing businesses are also following this trend. In the creative industries, foreign companies are licensing their expertise to Chinese companies who then do the work on the ground. The same approach is taken even where a final product will be produced, such as a magazine or website.  I estimate that my law firm is doing at least five times this sort of work as opposed to just a few years ago and I am seeing the same sort of numbers with China joint venture deals.

This approach also requires complex contracting. In 2004, few foreign businesses had any faith in the enforceability of contracts within the Chinese legal system. This (justified) lack of faith meant that these contract-based approaches to doing business in China were not considered feasible. China’s dramatically improving legal system (at least with respect to contract enforcement where it is now ranked 19th in the world) has made it possible to shift to contract-based approaches to doing business in China. As with WFOEs, many foreign SMEs and their lawyers are not aware of this improvement in the legal system and continue to make their decisions about their China investments based on outdated, 2003 conditions.

By: Steve Dickinson

This post is Part Two in our two part series on how Chinese companies typically view investments and how this view impacts Western companies that invest in Chinese companies, and even how this can impact all companies doing business in China.

As I explained in Part One of this series, Chinese companies simply do not value investment to the same extent as Western companies.  Chinese companies value work. I ascribe this, at least in part, to Communism, which values the worker over the investor.

China’s pervasive attitude towards investment explains many of the difficulties foreign investors have in joint ventures in China. The typical failed joint venture works as follows. A failing Chinese state owned company is desperate for working capital. However, the enterprise has been cut off from life support from the state and no bank loan is possible. Or a private enterprise finds itself on hard times and no bank loan is available.

The venture then sets out hat in hand and finds a foreign joint venture partner. The foreign partner contributes cash, technology and markets. The Chinese side contributes land, buildings, staff and management. The foreign side takes the position that the Chinese side ought to know what it is doing and so it becomes only  minimally involved with the Chinese domestic operations. Through the hard work and dedication of the Chinese staff and management, the joint venture business succeeds. Often this success is won only after years of struggle and financial losses.

With financial success finally achieved, the foreign joint venture partner now thinks: finally, we can relax and earn a return on our investment. However, the Chinese side thinks exactly the opposite: finally, we can be rid of our foreign partner. The response to the success of the company is exactly the opposite. Why is that? The foreign side is of the view that without its investment, the company would have failed. The Chinese side is of the view that it has already paid the foreign joint venture back for its investment with a small profit. The foreign investor is doing no work and has done no work. Work is all that counts. The foreign joint venture investor is acting in bad faith by insisting on being paid when it has done little or no work. The Chinese side with then go to extraordinary lengths to get rid of its foreign partner, even if it damages the company in the short term. In doing this, the Chinese side thinks it is doing the right thing and the foreign partner that insists on staying around is the one acting in bad faith.

This attitude has been pervasive in China since I started working here in the 1980s. I have seen little or no change and I therefore expect little change in the immediate future. My discussions with Chinese businesspeople and Chinese lawyers only confirm this. The reason is obvious. China was and still is very much a communist country. Labor counts. Investment does not. This fundamental value assessment must be taken into account in designing your investment program in China.

We have been drafting an increasing number of contracts for foreign companies licensing their concept or technology for use in China. In the old days, this type of licensing was primarily in the industrial sector. These days, most of our work has been on licensing agreements in the services sector in China. Much of this licensing is for operations in China that are prohibited from direct participation by foreign companies, such as in publishing, media, telecom, insurance and finance. Most of these foreign companies are choosing to license, rather than to participate in a China Joint Venture.  This post describes the negotiating tactics I so often see from the Chinese side and sets forth how foreign companies can counter those tactics.

The Chinese government is internally conflicted on how to treat this new form of licensing. In industrial sector licensing, the Chinese government is eager for the technology transfer to occur. The same is not true in the service sector. On the one hand, the Chinese government formally welcomes the transfer of Western expertise in the service sector. On the other hand, the Chinese government fears that U.S. participation in China’s service sector will result in unacceptable control of the Chinese system. As always, the Chinese government is uncomfortable with the introduction of Western intellectual concepts into China.

This ambivalence is mirrored by many of the potential licensees that we deal with in the service sector. Industrial licensees bargain hard, but the bargaining is similar to any commercial negotiation. In the service sector, we are finding that the Chinese side works to strike a much harder deal. This often surprises our clients, since they expect the service side to be softer than the industrial.

As part of this process, in service sector licensing contracts we are starting to see the Chinese side dust off negotiating tactics that were common in the 80’s and 90’s when the Chinese were negotiating their famously dysfunctional joint venture agreements.  In negotiating service sector licensing agreements with Chinese companies, we are seeing the following tactics from the Chinese side:

  • The most common tactic is for the Chinese company to seek to wear the foreign side down with endless issues. This tactic actually has two variants. In the first variant, the Chinese side raises a series of issues. As these issues are resolved, the Chinese side then raises a series of unrelated new issues. The list of issues is endless and the process never stops. The second variant is for the Chinese side to make a several unreasonable demands and then refuse to address the concerns of the foreign company on the other side. As in the first variant, the discussions proceed with no attempt at all by the Chinese side even to pretend to address the concerns of the other side. All of this is designed to simply wear down the foreign side in the hopes that the other side will simply concede. When the other side concedes, the Chinese side then inserts provisions in the agreement that are beneficial to the Chinese side, under the assumption that the foreign side is simply too tired to object. The success of this strategy rests on the negotiators on the foreign side being busy people with a lot to do, while the negotiators on the Chinese side are functionaries who have no other job but to involve themselves in the endless negotiation.
  • My favorite tactic is the artificial deadline. It is my favorite because it is such an obvious manipulation of the foreign side and yet it seems to work extremely well. The tactic works like this. At the very beginning of the negotiating process, the Chinese side sets a fixed date for executing the contract. It then sets up a public signing ceremony on that date, at which high-level officers from both sides will participate amidst much pomp and circumstance. The date is set far enough in advance to ensure that parties negotiating in good faith can reach agreement on the contract. The Chinese side then ensures that no agreement is reached. This results in panic on the foreign side, since failure to get an agreement that the bosses will sign is seen as a loss of face. The Chinese side then uses this concern to extract concessions from the already exhausted foreign side negotiator.  This tactic also has two variants. The first variant is the crude approach. The Chinese side simply refuses to concede on key points under the quite reasonable assumption that the foreign side will crumble when faced with the fixed signing deadline. The second variant is much more subtle. In this variant, the Chinese side initially concedes on key points, while still holding its ground on numerous minor points, consistent with the “wear them down” tactic. Then, just a day or two before the signing ceremony, the Chinese side announces that the contract must be revised on one or more key issues in a way that entirely benefits the Chinese side. The Chinese side usually justifies this by refering to the demand of a “government regulator” or an outside source such as a bank or insurance company. The claim is “we don’t want to go back on our word, but these other folks have forced us to do this.” Again, the plan is that the combination of the pressure of the impending signing ceremony and the general fatigue of the negotiators will result in a crucial concession favoring the Chinese side.
  • The final technique is to come back to the key issues after the lawyers have left the room. Again, though this is an obvious technique, it seems to work very well with service businesses. This tactic involves the Chinese side signing a contract, conceding on the key issues. By virtue of the contract having been signed, the key negotiators, China advisors and most importantly the lawyers, are off working on other projects. The Chinese side then waits a reasonable time and works to get the project started. Once the project is started, the foreign side is then invested in the project. Since service projects involve people, rather than machines or product, this means certain key persons on the foreign side are now fully committed to the project. Once this happens, the Chinese side then comes to the committed parties on the foreign side and announces that certain key provisions of the contract must be changed. The Chinese side usually claims this change is mandated by law, government regulators or banks and insurance companies. The only people left at this point are the “committed parties” with a strong incentive to allow for the change so the project can proceed. Often, these people do not even fully understand the implications of the change the Chinese side is now demanding. The foreign side then presents the change to busy upper level management as a minor technical revision and it gets signed. Everyone remembers how the initial negotiation was so troublesome and nobody wants to bring in “legal” to start the process over again.

Though crude and obvious, the three tactics work wonderfully well and so Chinese companies do not hesitate to employ them regularly (pretty much always).  There is one simple antidote for each tactic:

  1. If the Chinese side uses the “wear ’em down technique,” the foreign side should refuse to participate. The foreign side should firmly state its position and not bend unless and until the Chinese side agrees or at least moves closer to the foreign side’s position.
  2. Never agree to a fixed signing date. Make it clear that the signing ceremony will be scheduled only after the contract has completed final negotiations. If that takes forever, then it takes forever. Never allow the Chinese side to use a deadline as a tool. This seems like obvious advice, but we see the rule constantly violated. Chinese companies love signing ceremonies and foreigners fall into the trap because they do not want to cause offense at the start. The Chinese have contempt for a sucker, so refusing to go along on this obvious technique will not cause offense: it will instead earn the respect of the Chinese side.
  3. Make it clear to that there will be no changes to the contract after signing and any attempt by the Chinese side to change the contract will be treated as a material breach, leading to termination and a lawsuit for damages. Chinese companies are well known for using the signing of a contract as the start of a new negotiating process, not the termination. If the foreign party is willing to accept this approach, then a clear procedure must be instituted on the foreign side that brings back in the legal and China advisory team. The neutral players on the foreign side must make the decisions. The decisions should not be made by the foreign side players who have already become committed to the project.

Negotiating a good licensing agreement with Chinese companies is difficult and time consuming, but not so much if you know how to handle Chinese negotiating tactics.  There is no reason to make the situation worse by falling for the simple negotiation tactics discussed above.

China now has the second biggest box office market in the world and the third biggest film production industry in the world.

As you would expect, here in China we are seeing an upsurge in foreign interest in the domestic business of movie theaters or cinemas. This interest is driven by the sheer rate of growth in screen numbers, combined with the lingering expectation that the market is about to “open up.”  Increasing interest in cinemas complements and encourages the corresponding jump in interest in Sino-foreign film co-productions.

But until such time, if any, as the entertainment industry in China truly does open up, we need a sober assessment of the regulatory environment. This post is part of a series aiming to assist with such an assessment.

Let’s start with how China looks at foreign investment in general.

The industries in which China will accept foreign investment or foreign business operations are limited.  Foreign involvement in Chinese industries is categorized as “encouraged,” “permitted,” “restricted” or “prohibited.”  Industries move between, or appear within, the various categories from time to time, depending on the changing requirements of the Chinese authorities and the economy they oversee.

Before making an investment or commencing operations in China, it is essential that foreigners understand where the relevant industry sits in the categorization scheme. This simple reality is often overlooked in the headlong rush to get into the Chinese market or to reach the Chinese consumer. An awareness of it not only assists foreigners to avoid illegal or unwise investments, but it also allows for an understanding of the level of regulation to be expected in a particular industry, as well as the business entity prescribed for that industry. In restricted industries, for instance, foreign involvement can only occur through a Sino-foreign joint venture.

Foreign involvement in the entertainment business in general, and the business of operating cinemas in particular, is “restricted” in China. It follows that there are substantial barriers to entry into the cinema business, that the business is heavily regulated, and that a joint venture is required in almost all cases. For more on China Joint Ventures, check out “How To Survive A China Joint Venture” and the posts cited within it.

The regulatory framework for foreign investment in cinemas is created by a series of Interim, Provisional and Supplementary Provisions promulgated by SARFT in 2000, 2004 and 2005, respectively. The salient features of the regulatory framework may be summarized as follows:

  • With the exception of investors from Hong Kong and Macau, non-Mainland Chinese are not permitted to wholly own cinemas or cinema chains
  • With the exception of investors from Hong Kong and Macau, non-Mainland Chinese must hold their investments through a Sino-foreign joint venture
  • A cinema joint venture requires registered capital of not less than CNY 6 million ($950,000)
  • The Chinese joint venture partner must generally have at least 51% of the decision-making power
  • In Beijing, Shanghai, Guangzhou, Chengdu, Xi‘an, Wuhan and Nanjing, foreign investment in the joint venture may be as high as 75%. In all other places foreign investment in the joint venture must not be more than 49%
  • No cinema joint venture can run for more than 30 years
  • The joint venture requires a Film Screening Business Permit

In future posts I will look at the application of this regulatory framework in more detail and consider other aspects of the cinema business in China.

 

Yesterday, co-blogger Steve Dickinson wrote a post essentially excoriating VIEs. That post went live early this morning. A few hours before our post went live, Bill Bishop (who knows as much about China’s tech industry as any human being alive) wrote a post essentially saying that those who are trashing VIEs are engaging in scare tactics and that there is little cause for worry.

Bishop makes his very powerful counter-argument on his Digi-Cha blog, in a post entitled, “Bloomberg Keeps VIE Fears Alive: China Companies Evading Rule With U.S. Listings Stump Regulators” [link no longer exists]. Bishop contends that “so many powerful interests have financial stakes in VIEs that it would be career suicide or worse for a Chinese bureaucrat to destroy this structure on a wholesale basis.” We do not disagree with this statement, but we do not think it deals with the two main issues. One, the government has come out with regulations making very clear that such structures are illegal. On top of that, and as we have said all along, these regulations probably should not have even been necessary because VIEs were almost certainly already illegal under a proper reading of the various applicable laws. Having said this, however, we fully recognize that the Chinese government has in the past come out and said something was illegal and then done nothing about it. See, for instance, “China Rules Skype Illegal. Tell Me Something New,” where we predicted that the government’s making Skype “illegal” would have no real impact.

But with VIEs it is different and Bishop does not address our main point (note again that his post came before ours).

Whether or not existing VIEs are shut down (and at this stage we tend to agree with Bishop that they generally very likely will not be), the reality is that they have now been deemed illegal and that cannot help but have a major and game-changing impact on them. As mentioned above, VIEs are a structure that allows foreign companies to control the Chinese entity via various contracts. Now that those various contracts have been declared illegal, it will be difficult/impossible to enforce those contracts in Chinese courts. In this VIE structures, many of the contracts involve foreign countries and foreign country enforcement so their illegality in China may be minimized to that extent. However, even outside China, the party seeking to avoid enforcement of a contract will, in many cases, still be able to argue against enforcement based on China’s having made the structure illegal.

In many ways, what is happening to VIEs is no different from what we have called “fake Joint Ventures” and on which we wrote in the post, “Fake China Joint Ventures: Why You Calling Me, I’m Not The Guy:

In that post, I very loosely transcribed into one conversation a number of conversations I had been having with people wanting to set up contractual arrangements to avoid China’s expensive and difficult joint venture laws:

Caller: I’ve got this great website and it is exactly what China wants/needs. And I’ve been working on developing it with some Chinese tech friends of mine and we want to take it legal so we can start getting VC (venture capital) funding for it. Here’s our plan. Now I know that the old/truly legal/expected/usual way to do this is for me to form my own company and then form a joint venture with my Chinese partners, but I also know that will cost a lot of money. So our plan is for the Chinese company to own the website and then we will have an oral agreement (or a written agreement) that I really own half of it.

Me: Listen, my firm has been contacted at least twenty times after these situations have gone bad and I am aware of at least another twenty times where the same thing has happened, and let me tell you, these arrangements (it is NOT proper to call these joint ventures) virtually always end the same way. They end with the Chinese company booting you out completely and leaving you with no recourse. Protecting foreign companies in legitimate joint ventures is difficult enough, but it is pretty much impossible under the scenario you are describing. We had a guy who paid us a lot of money once for us to do everything we could to try to get “his” multi-million dollar business back. Guess what, we could not even come close to getting it back. Every Chinese lawyer we talked to about suing to get it back told us we had no chance of winning at all. I mean, just listen to the argument we would need to make to the judge:

Your honor, my client knew that China’s laws are very clear on what foreign companies must do to operate legally in China, but he thought these very clear laws should not apply to him because, well because he is an American tech company and he was just too smart/too poor to bother to comply with the very clear laws. So instead, he had this great method for completely circumventing China’s very clear laws. His idea was to not form a company, but rather, have his Chinese friends form the company and he would have a little side deal with that company. Well, that side deal has now gone bad and my client wants you to go against China’s very clear public policy on how foreign business is to be done in China and enforce this unwritten side deal.

What do you think of that argument?

Caller: (long pause) I understand things could go wrong with that kind of arrangement, but would you be willing to draft the contract between me and the Chinese company?

Me: No. I can’t do that. I can’t draft a contract that I know will never work. I just can’t. Give me a call if you ever want to do this legally, in a way where you actually have a chance of profiting from your work down the road.

For more on this, check out “China SMEs, Own If You Want To Own.” To get a feel for how difficult it can be even with a fully legal joint venture, check out this article by Steve Dickinson in China Brief, entitled, “Avoiding Mistakes in Chinese Joint Ventures.” and this Wall Street Journal article I wrote, entitled, “Joint Venture Jeopardy.

Update: In, “Private Equity, Venture Capital and ‘Fake’ China Joint Ventures,” China Hearsay very nicely maps out the way these deals are typically done (using an offshore holding company) and notes that you might have legal recourse in the rare instances where your Chinese partner has “huge assets offshore” in a country in which you can sue and win:

You can tie up the Chinese founders in 100 different contractual knots, but unless those founders have huge assets offshore (real assets, not equity in the holding company) that you can go after in a dispute, they can always tell you to piss off and kick your ass out of the business.

All I can say is that I have never and I will never invest in a company based on so thin a reed.

FULL DISCLOSURE: Our firm long ago made the decision to work with those companies and individuals with claims based on the arrangements set forth above, as opposed to representing those wanting to enter into such arrangments.

THIS JUST IN: Stan Abrams over at China Hearsay is out with a post, entitled, “A Post-Holiday Update on VIE Chatter,” that essentially says what this post says, which is that the dividing line between Bishop and us is that Bishop is analyzing what the government is likely to do with existing VIES while we are analyzing the risks involved in having a corporate structure based on unenforceable contracts. Stan completely nails it when he says he thinks the differences between us and Bishop stem largely from the angle from which we are looking at the VIE issues:

Anyway, I have nothing new to say, but I did want to point out a couple of new things for you VIE groupies to read. First is a lengthy Bloomberg overview of the issue. It’s generic, and therefore a decent place to start if you’re looking for a jumping-off point to the topic. Second and third are two opinion pieces, by Bill Bishop (DigiCha) and Steve Dickinson (China Law Blog), who sort of set themselves up on opposing sides of the issue.

It was interesting reading these two blog posts, since both authors are wicked smart, experts in their respective fields, and very opinionated (not that there’s anything wrong with that).

Stan then describes Bishop’s post as putting forth “The sky is not falling” position and Steve’s post as “VIEs are complete rubbish and should be avoided like the plague.” Stan then notes how the positions appear very different, but maybe not so:

So, at first glance, two very different views, and I bet they would get into a serious argument if the opportunity arose. But I actually think that their fundamental conclusions are both right but are merely coming at the issue from two very different perspectives. Bill is a Internet and finance guy, and is looking at the market, firms’ access to capital, and what the government is likely to do.

Steve, on the other hand, is a corporate lawyer. He is looking at potential risk, at what might go wrong, and what is/is not a technical violation of the law.

When Bill says that we shouldn’t worry about the government going after Chinese listed firms in the U.S. that use the VIE structure, I think he’s right. All the inside chatter on that issue seems to indicate that the government will grandfather in those companies even if it adopts a new enforcement strategy.

And when Steve says that VIEs are rubbish, he’s of course right. These things are illegal in that their purpose is to deliberately skirt foreign investment restrictions. I don’t actually agree with him on what the M&A rules mean (I think it’s too early to tell), but I definitely agree with his overall legal opinion.

Stan then goes on to say essentially what I say above, which is that the story is not the shutting down of VIEs, it is the inherent risks they present by being based on illegal contracts:

All this being said, if I have one bone to pick with recent commentary on this subject it’s that it emphasizes the latest regulatory goings-on without paying attention to the real risk story with respect to VIEs. The most likely source of problems with these companies has nothing to do with the government, but rather with unenforceable contracts and unstable shareholding structures. Perhaps this is one of those things to which Bill was referring when he said that there are other reasons to be cautious about investing in China. (I should also point out that Steve regularly writes about these sorts of legal issues as well.)

I completely agree.

UPDATE: Fredrik Öqvist over at the China Finance Blog did an excellent post today, entitled, Consolidating Recent Opinions on VIEs, in which he seeks to synthesize all the posts that have been written on VIEs in the last few days by me, by Steve Dickinson, by Stan Abrams, and by Bill Bishop. Fredrik concludes his post with his own take on VIEs:

Here’s where I think the real issue lies, but I don’t think it’s entirely confined to future deals and PE/VC investors. This could for all intents and purposes have a deeply negative impact for listed companies as well.

In order to consolidate VIEs one has to show that the listed company not only receives the economic benefits and takes the economic risks of the venture, a second condition is to show that the VIE is in fact controlled by the listed company. If the contracts, which are put in place to establish this control, are indeed deemed illegal and unenforceable, fulfilling the second part of the consolidation requirement becomes decidedly more difficult.

I agree.

I love it when I read something that tells me what I already knew, but simply had not realized. That happened to me today when I read  a post on the Asia Healthcare Blog by my friend and fellow-Seattleite, Benjamin Shobert, entitled, “Life Sciences Companies Go to China to Raise Capital” [link no longer exists].

Ben sets out the three main reasons pharmaceutical companies are going to China:

[F]irst, and most obviously, build market share in China’s high-growth market. Second, access China’s inexpensive R&D capabilities to complete drug discovery faster and less costly than what is possible in North America or the European Union. But, American pharmaceutical start-ups are beginning to take note of another opportunity in China: as a source of potential investors for their start-ups.

Though my firm has worked on/is working on a deals/potential deals involving Chinese investors in American tech (no pharma) companies, until I read Ben’s post, it had just not occurred to me that this is a trend. But it clearly is. Chinese companies are looking to put their money into United States based companies both in the United States and in China.

Of course, Chinese investing in foreign companies in China is nothing new as they have been doing that via joint ventures (JVs) for more than twenty years. What’s different about today, however, is that in the past foreign companies typically merely allowed Chinese investment when they had no choice. Today, foreign companies are actively seeking Chinese investment because they need the money.

Ben sets out the three key issues foreign companies face when taking in Chinese investment:

  • Losing intellectual property to the Chinese investor
  • Having to turn over the Chinese market to the Chinese investor
  • Eventually having to turn control of the company over to the Chinese investor

Absolutely true. It has been over one (or more) of these three sticking points on which most of the deals on which we have worked have foundered.

The tension is obvious. The American (in our cases) company wants to maintain full control over its IP and is concerned about the Chinese investor taking that IP to one of its other companies. Some of the Chinese companies are quite up front in saying that one of their reasons for investing in the U.S. company is to have full access to the American company’s IP. Most American companies cannot abide by that. The turning over the Chinese market to the Chinese investor is usually the easiest of the three issues because compromise is usually possible by agreeing on a timeline and/or a market sharing arrangement. Surprisingly enough, the same is usually true with respect to turning over the company to the Chinese investor because that too can usually be resolved by agreeing on the preconditions for any turnover and the terms for if and when such a turnover situation is triggered.

Chinese investment in your company. Are you ready for that?

Got an email from a client/friend yesterday with a link to an Industry Week Article and a note saying that i needed to give this “CLB’s dumbest article of the month award.” We do not actually have such an award (should we?) so for that reason alone, it is not in contention. Bad articles on China abound, but this one stands out because it is in a very influential magazine and because much of what it is wrong on has been repeated so often I fear it is beginning to pass for truth.

The article is in IndustryWeek Magazine and it is entitled, “Why Is China Cheaper?” It is written by Michele Nash-Hoff, President of ElectroFab Sales. She is also the author of the book, Can American Manufacturing Be Saved?

The main point of her article is that China manufacturing is cheaper than US manufacturing for reasons that go far beyond wage disparities. I do not dispute that point, but I do dispute much of what she says in support of that claim.

Her article starts out well by describing the costing differences between manufacturing a stuffed teddy bear and a Frisbee. Ms. Nash-Hoff points out that about 70% of the cost of manufacturing the teddy bear goes to labor, whereas the labor costs make up only around 20% of the cost of manufacturing the Frisbee. She then notes how because China deals in such massive quantities of the plastic resins that go into the Frisbee, its material costs for the Frisbee will be “as low as it could be.” I am not sure whether Ms Nash-Hoff is saying that the plastic resins will cost less in China than in the United States and I am not sure whether that is true or not.

Ms. Nash-Hof then tells us that labor is cheap in China because China has “one billion people living at the poverty level.” This is by far the highest number I have seen listed for those living at or below the poverty level in China but so be it.

As a result, wages have finally been rising by about 15% per year over the past four years. It took suicides by workers in the summer of 2010 to achieve additional improvement in wages and working conditions at plants that were more like prison camps with dormitories for workers to live on site and fences around the buildings so workers couldn’t leave the premises.

Okay.

This argument contains its own flaw. Wages in China have increased (fairly briskly) every year since the late 1980s and the average wage for workers in urban areas was four times higher in 2006 than in 1995. As Ms. Nash-Hof herself points out, wages have been rising “by about 15% per year” since 2006. With these statistics, is it really fair to claim that it took “suicides by workers in the summer of 2010” to achieve additional improvements in wages? Also, is she implictly saying that it is not fair to the United States that China has so many poor people and that those people should not be employed? Or is she saying something else?

 

Ms. Nash-Hof’s third reason for China being cheaper is that China’s workers receive “nothing” when they are injured on the job:

Third, there are the costs of compliance to health and safety regulation and environmental regulations. These costs are less expensive in China than in the United States because the Chinese government imposes few health and safety or environmental regulations. China doesn’t provide workman’s compensation insurance for their workers so workers hurt on the job don’t receive any compensation when they are injured to the point that they are disabled.

Ms. Nash-Hof is both right and seriously wrong in this argument. Of course the cost to comply with health and safety and environmental regulations is way less in China than in the United States. I say “of course,” because even if China’s regulations were exactly the same as those in the United States and even if the enforcement of those regulations were exactly the same in China as in the United States, compliance would still be considerably cheaper in China. Compliance would be considerably cheaper in China because medical care and wages (and pretty much everything else) are considerably cheaper in China than in the United States.

But beyond that, Ms. Nash-Hof is right to claim that China does not enforce health and safety and environmental regulations nearly as rigorously as the United States, but she is flat out wrong to claim that China does not have workers compensation when it does and she is also flat out wrong to claim that “workers hurt on the job don’t receive any compensation when they are injured to the point that they are disabled” because they almost invariably do. Again though, a worker who loses a finger in China might get $500 while a worker who loses a finger in the United States might get $50,000. I wonder if Ms. Nash-Hof is seeking an increase in workers compensation in China or a decrease of it in the United States?

Ms. Nash-Hof then argues that China’s VAT law works in its favor as against U.S. manufacturing:

Next, there is the cost of taxes and duties. China is one of over 150 countries that utilize a Value Added Tax (VAT) system. It is a tax only on the “value added” to a product, material, or service at every state of its manufacture or distribution. The VAT rate is generally 17%, or 13% for some goods. Chinese companies receive a VAT refund from the government for materials of products produced for export. American imports to China are charged a VAT, but the U. S. doesn’t have a VAT to charge Chinese imports.

Help me out here readers because I am just not seeing it. Maybe I am missing something here, but I do not see how China’s VAT has anything to do with its manufacturers being able to produce for less. I just do not understand how charging the VAT for domestic sales, but refunding it for exports reduces Chinese manufacturing costs. Could I not argue that the VAT actually increases manufacturing costs by reducing domestic sales and thereby making it tougher to achieve economies of scale? Is not this exactly what pretty much every country does with its VAT and exactly what U.S. states do with their sales tax?

Ms. Nash-Hof then makes a completely off-base factual argument that I am seeing and hearing much more frequently of late, which is that foreign companies cannot go into China without a Chinese partner:

In addition, the Chinese government requires foreign firms to have a Chinese “partner” company, who maintains the majority interest, takes most of the profits, and has the real control of the company.

This is just false. Completely 100% false. When I wrote a Wall Street Journal article on China Joint Ventures back in 2007, “only 27% of new foreign-invested businesses used this legal mechanism [Joint Ventures] in 2006, compared to well over 50% in 2001.” I would guess that percentage is less than 20% today. China allows foreign companies to go into China alone in just about all industries other than media, military and mining.

Ms. Nash-Hof also gets it wrong when it comes to China R&D and technology sharing:

More seriously, China now requires U. S. companies to share their technology and relocate their R&D centers to China if they want to have access to Chinese markets.

This statement is just so wrong I hardly even know how to attack it. First off, there are hundreds of thousands of U.S. companies that have “access to Chinese markets” without having any presence in China at all. Every U.S. company that sells a product or a service to China has “access to Chinese markets” and many (most?) of those companies are not even in China, much less sharing their technology and relocating their R&D centers there. Then there are the foreign companies in China that do no R&D there and zealously protect their technology. China does not require U.S. companies set up an R&D facility in China or share their technology with China to have access to China’s markets. Apple Computer, KFC, The Gap, McDonalds, Price Waterhouse, and an endless list of other American companies that are thriving in China give lie to this bizarre claim. There have been instances of what Ms. Nash-Hof describes (see the Chevy Volt), but fortunately, that it is not the norm.

Unsurprisingly, Ms. Nash-Hof also attributes the China Price to China’s undervalued currency:

Above all, there is the ever-present currency manipulation, where China undervalues their currency by an estimated 30%-40%, which simply makes every product that China ships out 30-40% cheaper than those of a potential American competitor.

I am not going to dispute that the Yuan is undervalued, but 30-40% seems high to me. Is it?

Lastly, Ms. Nash-Hof talks about dumping and I am not going to fight her on that.

What do you think? Am I being too harsh on Ms. Nash-Hof? Is she right?

I just think that with election season upon us, it is more important than ever that we get our facts right.

If you are a foreign business, it will not be easy or cheap for you to set up a business to operate legally in China. The following is just the most basic of lists of what you need to do to set up and operate legally in China:

  1. Register your legal entity in China. This will typically be a WFOE, a Rep Office or a Joint Venture.
  2. Lease property that will permit your company registration to go through.
  3. Enter into written employment agreements with all of your employees. You should have an employee manual as well.
  4. Figure out and pay all of your taxes, including all of the taxes and mandatory benefits on your employees.

To put it bluntly, doing/complying with the above is not going to be cheap or easy. But it is necessary. I have lately been seeing an increase in foreign companies setting up “quickly and cheaply” in China through their Chinese “partners.”

Let me explain.

As China is becoming wealthier, its need for service businesses is multiplying rapidly and it is almost exclusively in the service sector that I am seeing this troubling new trend. I usually “see” it when the Western service company calls me to “review” its contract with its Chinese partner and I immediately realize that the Western service company needs a heck of a lot more than that.

Here is what is happening. The Western service company goes over to China and gets wooed by a Chinese service company, usually in the same or an allied industry. The Chinese service company convinces the Western service company that there is a huge demand in China for the services the Western service company can provide — this is easy, because there almost certainly is. The Chinese company then convinces the Western service company that their two companies should work together to market their services in China.

The Chinese company then convinces the Western company that it will handle “everything” and get the Western company up and running in a few weeks. The Chinese company then has the Western company lease some space from the Chinese company and the Chinese company even hires a couple Chinese employees on behalf of this putative joint venture. To top it all off, the Chinese company puts the Western company’s name and logo on the door and, voila, the Western company now has a business in China.

Except it doesn’t.

In “Forming A Chinese Company. Do It Right Or Do It ALL Wrong, But Don’t Do A Rep Office,” we talk about those who choose to form illegal Rep Offices because forming a WFOE is too time consuming and expensive:

I get the sense that the people contacting us on forming a Rep Office (when only a WFOE would be legal) are hoping that they somehow have found THE loophole that nobody else has found and that if only they can get the blessings of an attorney (one of the China lawyers at my law firm) for what they are doing, their operating illegally in China will somehow not be “so” illegal. I wish I had some magic oil I could sell (for a helluva lot of money) to sprinkle on these sort of illegal China businesses to make them legal, but I have no such thing.

Those who think they are going to become “sort of” legal by forming what is clearly an illegal Rep Office in China are very similar to those who think they are “sort of” protecting themselves legally by doing a “sort of” joint venture with their girlfriend.

I went on to write of how going “half-legal” is not only riskier than operating legally, but also riskier than operating completely illegally:

As lawyers we are never going to tell our client to go full illegal, but in my role as a blogger, I have to think going full illegal would probably make better sense than paying a lawyer to draft a void contract. I think people know this, but their rightful discomfort at operating illegally makes them want to clutch on to something that will allow them to justify (however falsely) their actions.

The same holds true with respect to forming a Rep Office when a WFOE is required. Forming the Rep Office in that situation will just serve to let the Chinese government know where you are and what you are doing and will make it easy for them to realize that what you are doing requires a WFOE. On top of that, as I am always saying, you should not form a Rep Office with plans to form a WFOE in a year or so “if everything works out.” You should not do this because you will end up paying THREE times as you will pay for forming the Rep Office, pay for shutting down the Rep Office (and this is not cheap), and then pay for forming the WFOE.

What really drives me crazy about all this though is that on at least three occasions, companies for whom we have refused to form Rep Offices have written me to tell me that “so and so” company formation company is willing to form the Rep Office for them, as though this mere fact means that my firm was wrong in declining to take money to do something we know will eventually not work.

And though I take no happiness from this, I will note that one of the three companies that went ahead and formed a Rep Office against our advice did contact us about a year later to tell us that the Chinese government was now making them form a WFOE. [UPDATE — After I wrote this post, a company contacted me to let me know that their illegal Rep Office had been shut down within three months of its having been formed. All it took was one knock on their door to be discovered as having too many employees for a Rep Office!]

These quasi-partnerships with Chinese companies are the same way and having a relationship with a Chinese entity is likely not going to help you if the government discovers you are operating illegally. It is also not likely going to help you if one of your employees sues you and is able to point out that you do not really exist in China.

In fact, I have very strong suspicions that your relationship with the Chinese entity is only going to hurt you in your dealings with the Chinese government and overall.

Whenever I learn of these “fake” joint ventures, the first thing I suggest is that the Western company immediately register its trademarks in China because it is using them already, but without any protection. More than once, one of these Western companies has assured me that everything was fine because their Chinese partner had registered their trademarks, only for us to learn that the Chinese companies had registered the Western company’s trademarks in their own names and not in the names of the Western company. Fortunately, in both instances, the relationship at that point was good enough that (with a bit of cajoling) we were able to get the Chinese company to assign the trademarks to the Western company.

My biggest fear with these partnerships is that when they have become really successful, the Chinese company will either directly or indirectly through the government, simply boot out the Western partner. And when that happens, the Western partner will very likely not have any legal recourse to stop its Chinese partner from taking over the business. I mean, if the Western partner is going to sue its Chinese partner, what will it even say?  “Your honor, I know my business was here in China completely illegally, but that is because starting up a business legally here is just so difficult and expensive, but now that the business is worth millions, it just is not fair for me to get kicked out of it and for my Chinese partner to get the whole thing.”

Good luck with that.

I will note that every single time we have been retained by the Western partner to clean up this sort of situation in China, their Chinese partner insists the whole time that what we are doing is a complete waste of time and money. But what else would you expect them to say?

What are you seeing out there?