China's new foreign investment law
                                                                                                  Image by Ixocactus

In a series of recent posts, we discussed what the new PRC Foreign Investment Law is not and how the media and many commentators have wrongly ascribed great things to it. See New China Foreign Investment Law: Not Good News, China’s New Foreign Investment Law and Forced Technology Transfer: Same As it Ever Was and China Approves New Foreign Investment Law to Level Playing Field for Foreign Companies. MEH. In this post, I will discuss the ways in which the new FIL might positively impact foreign investment in China.

The core concept of China’s new Foreign Investment Law is that of national treatment. Under this principle, foreign investors will be treated the same as Chinese investors. WFOEs and Sino Foreign Equity Joint Ventures will disappear. If this policy is followed, then at least the following changes that could benefit foreign investors will be the result:

1. The procedure for forming foreign owned companies in China will be radically simplified. It currently takes many months to form a WFOE or a JV.  See Forming A China WFOE. How Long Will That Be Going On? China’s WFOE and Joint Venture policies are constantly changing and yet forever unclear and the processes vary from jurisdiction to jurisdiction. It is nothing like forming a company in the United States, Canada, Hong Kong, the EU, Australia, etc. On the other hand, forming a Chinese owned domestic company is simple, fast and inexpensive and very much like forming a company in the United States, Canada, Hong Kong, the EU, Australia, etc. In many Chinese cities, forming a domestic Chinese company can take as little as one week and the costs of doing so are relatively trivial. Under the new Foreign Investment Law, this simplified system should apply to all forms of foreign invested enterprise: both wholly foreign owned and mixed Chinese foreign owned. Costs and timeframes should radically decrease.

2. Foreign investors will be permitted to acquire stock in private Chinese companies. See China Scam Week, Part 4: The China Stock Option Scam. Our clients often come to our China corporate lawyers with well plans to purchase a non-controlling interest in a Chinese company. Under the current rules, the only way to do this is to restructure the Chinese entity as a joint venture. This seldom makes legal sense and so this kind of purchase is seldom practical. Under the new system, foreign investors should be permitted to acquire ownership interests in existing Chinese companies on the same basis as a Chinese investor. This should open many areas of economic cooperation not possible in the current system. For example, this should allow Chinese companies to pay for technology or high tech services with their own stock rather than in cash.

3. Many high tech Chinese companies want to hire foreigners and expats to work in their companies. The standard employment package in this sector includes stock options. Under China’s current system, Chinese companies cannot offer stock options due to the prohibition on foreign ownership. Because of this prohibition on foreign ownership, complicated and often unenforceable nominee structures are used, causing no end of problems as these structures unravel. Under the new system, Chinese companies should be able to offer stock options to foreign employees the same as they offer the stock options and other stock based incentives to their Chinese employees.

4. In the U.S. and Europe, it is common to structure investor company ownership that departs from a straight one RMB for one share arrangement where all shareholders are treated in exactly the same way. For example, common alternatives are a) sweat equity, where some shareholders make no cash payment but get stock in exchange for employment and b) preferred returns, where certain shareholders are granted a right to profits greater than their ownership percentage. Under China’s current system, where there is a Chinese/foreign joint venture arrangement, this type of innovative ownership/return policy is often prohibited by local governments. But under China’s new Foreign Investment Law, local governments should be removed from this sort of supervision and approval of private financial arrangements and the use of complex shareholder and partnership agreements should become accepted, greatly increasing the flexibility of foreign investment in China.

5. Under China’s current system, it has been mostly impossible for foreign investors to effectively form and operate investment funds. When forming WFOEs and Joint Ventures, local governments almost always insist that a specific project be identified and that the registered capital of the WOFE/JV be focused exclusively on that single venture. This has made it nearly impossible to form a WFOE or Joint Venture that openly states that it will engage in a series of investments in currently unidentified projects. In addition, the PRC allows general and limited partnerships. Though these partnerships are a common (even preferred) structure for investment funds, foreign investors have been effectively prevented form making use of these structures. Under the new Foreign Investment Law’s national treatment system, this all should change and the vast Chinese investment fund market should open to foreign investors, either operating on their own on in partnership with Chinese investors.

I have written all of the above in the indicative. In reality, the subjunctive mood is more appropriate. This is because in a realistic analysis, this set of potentially beneficial changes to China’s foreign investment environment is subject to two significant limitations that may render its surface changes illusory.

First, we will not know how this new system will work until after formal rules are issued and adopted and it becomes clear what local governments will actually do in this area. I have been following China’s national treatment/negative list plan since 2015 and I have not seen a single mention in the Chinese language government/policy analyst discussions the five issues I discuss above. It is almost as though the Chinese authorities are unaware that these five changes are a natural result of a consistently applied national treatment system. Since these five changes will radically break from decades of Chinese government practice, it is an open question as to what will actually happen when China’s new Foreign Investment Law comes into effect. A healthy dose of skepticism is therefore appropriate.

Second, the opening up measures I discuss above will remain constrained by China’s fundamentally closed economy. As I discussed in New China Foreign Investment Law: Not Good News, foreign investors are consigned to a small playing field within the Chinese economy. So the rights that appear to open under the new Foreign Investment Law may be largely illusory. Put simply, for sectors of the Chinese economy prohibited to foreign investment, foreign investors will not have any of the new rights under the new Foreign Investment Law.

For example, consider stock options. If the industry sector is prohibited to foreign investment, the right to issue stock options to foreign individuals will also be restricted and most expats who would be offered stock options will be working in high tech businesses prohibited to foreign investment. Investment in fin-tech, high speed securities trading, insurance company investment analysis, software as a service (SaaS), Internet products of all kinds, Internet gaming, online e-commerce are all prohibited or severely restricted for foreigners. Foreign individuals employed by Chinese banks and other major SOEs will also not be allowed to invest in their employers, via stock options or otherwise.

What then will actually change under China’s new Foreign Investment Law? So long as China’s economy remains largely closed, the answer is that very little will change. The real issue with China’s treatment of foreign investors is that China continues to protect its domestic economy against foreigners. That level of protection was perhaps appropriate for China in the 1980s and 1990s, but it is not appropriate for a China that is now the second largest economy in the world. But as the US-China trade talks have only reinforced, the Chinese government has no plans to reduce its stronghold over China’s economy. If China does not open its economy to foreign investment (which is exceedingly unlikely to occur), all of the above five changes (even if they do occur, which itself is far from certain) will be little more than putting lipstick on a pig.

China’s new Foreign Investment Law is a sleight of hand magic trick of the type so popular on Chinese television. Seeing through this illusion is the first step. The second step would be to force the Chinese government to open its domestic market in all the areas where it is currently. I have seen no discussion at all of the second step. Until China takes the second step its new Foreign Investment Law will change little.

Taiwan contract manufacturingAs countries around the world seek to reduce their exposure to China, Taiwan finds itself in the center of the process. I just spent two months in Kaohsiung, Taiwan (working on a large multi-country project involving China, Taiwan and Indonesia) and during my time there I heard much about Taiwan’s response to the trade crisis. My preliminary thoughts are as follows.

First some history. Taiwan was a true pioneer in contract manufacturing. That is, manufacturing products solely for the export market. This process began in the 1980s. I remember the first Timex watch plant built in Zhongli in 1981. Taiwan created the free trade zone model subsequently copied by China in the 90s. The system developed rapidly. By the end of the 1980s, Kaohsiung was the third busiest port in the world, shipping out the products produced in Taiwan’s free trade zones.

In the 90s, it was Taiwanese businessmen who took that export processing expertise to China. The success of the Taiwanese in China was overwhelming. By the 2000s, virtually all Taiwan’s low end manufacturing had moved to China. As in the United States, what remained in Taiwan was largely limited to high tech manufacturing in the semiconductor business or production of specialty materials in the plastics and metals industries.

As we approach 2020, Taiwan business people are now considering what to do about China. The current response has focused on moving China based export processing factories to other countries in Asia. Virtually any Taiwan business person you meet will share with you their stories of moving to Vietnam, Thailand, the Philippines and Indonesia. Some are even moving to Mexico and Central and South America. They are seldom completely happy with the results of their moves, but move they must.

After a number of discussions with Taiwan business people on China, I began to notice one strange feature of their plans: nobody mentions moving to Taiwan itself. Even though Taiwan was the export manufacturing powerhouse of the 1980s, the same Taiwanese who pioneered that development are not considering a return to Taiwan.

In my meetings with Taiwan trade officials, this issue was raised as a primary concern. Stated as a slogan, Taiwan’s conservative politicians want to follow the policy of the United States and “Make Taiwan Great Again.” They want to restore Taiwan’s place as a manufacturing powerhouse. They want to step back from being brokers of products made elsewhere and get back into direct manufacturing.

But how will this be done? One set of programs is being promoted by Han Guoyu, the new mayor of Kaohsiung. Working with Terry Guo, the chairman of Foxconn and newly announced presidential candidate, Han has been promoting a two-phased program.

In phase one, Taiwan companies will be provided incentives to return to Taiwan from China. For example, Foxconn is working on a proposal with the Kaohsiung city government to establish a large cloud networking center. This is planned as the initial move to attract other Taiwan owned electronics manufacturers to set up operations in what is planned as a major electronics industrial park. In phase two, the Taiwan government will revive the free trade zone system to attract foreign investors to move their manufacturing operations from China to Taiwan.

Many of these companies, both Taiwan and foreign owned, would be returning to where they started in Asia. It would be a return home. And it would make Taiwan great again.

The problem with this plan is that it will require substantial financial and policy support from the Taiwan government. To convince these companies to return to Taiwan, at least the following would be required:

  • Exemption from income and VAT tax.
  • Preferential tax policies for foreign management personnel.
  • Cheap land and buildings and subsidized rent.
  • Adequate power at subsidized rates.
  • Access to labor. Taiwan has a severe labor shortage. Manual labor from S.E. Asian countries and management from North America and Europe will be required.

The Taiwan government is fully aware of what policies are required. These policies were provided in the 1980s and Taiwanese business people saw how successful these policies were in China in the 1990s. But when Taiwan introduced those policies in 1980, Taiwan was a struggling, developing country. When China adopted these policies in 1990, China was a struggling, developing country.

The Taiwan of today is a prosperous, post-industrial country. It is not clear whether manufacturing incentive policies can be successfully adopted in an advanced country that has left behind physical manufacturing. Some would argue that Taiwan should accept its new role and imitate Hong Kong and Singapore to become a finance and services center for Asia and the world. As in many modern countries with a fully democratic political system, Taiwan has several competing visions of the future.

So it is not clear what direction Taiwan will take. Han Guoyu is running for president and if he is elected the “Make Taiwan Great Again” program will receive a boost. We are already seeing some moves in this direction in Kaohsiung. So as foreign companies continue looking to reduce their exposure to China, Taiwan will likely be included many lists of alternatives.

China's new foreign investment law

In China’s New Foreign Investment Law and Forced Technology Transfer: Same As it Ever Was and in China Approves New Foreign Investment Law to Level Playing Field for Foreign Companies. MEH. we wrote how we were not at all impressed with China’s new Foreign Investment Law 中华人民共和国外商投资法. Since then, a number of commentators (who near as I can tell cannot read Chinese) have hailed the law as a positive development for foreign companies doing business with China and in China. The impression these commentators are giving is that China’s new Foreign Investment Law (FIL) will raise up foreign companies to become equal to Chinese companies.

This is just not correct. The intent of the new law is actually the opposite and for people like me who have been doing business with China for decades even the idea that it would be otherwise is at least somewhat laughable. The intent and the reality of the FIL is to pull down foreign investors to the status of privately owned Chinese companies. At that level, foreign invested companies will be firmly under CCP control and they will operate at a permanent economic disadvantage to PRC state owned enterprises. In other words, foreign invested companies in China will be crushed by the PRC state in the same way nearly all private Chinese companies are crushed by the state.

Why any commentator views this as a happy fate is difficult for me to understand. One of my China lawyer friends who is even more cynical about China than I (perhaps because he has spent about 40 years of his life in China to my relatively paltry 20 years there) thinks that those who rave about this new law do so knowing full well that it will not lead to positive change, but do so anyway because their livelihoods literally depend on it. I prefer to trace it to their not understanding the law either because they are not lawyers or because they cannot read Chinese.

To understand the impact of the new FIL, some history is required. The core of the new FIL is the concept of “national treatment.” Under this principle, foreign invested companies will be treated the same as other privately owned Chinese companies. This demand for national treatment has not come from foreign investors; it has come from Chinese invested enterprises. So what is going on.

In 1992, the Deng Xiaoping government decided to attract foreign investment to China by offering significant incentives to foreign investors, including the following:

  • Exemption from corporate income tax.
  • Exemption from VAT and other business taxes.
  • Free/cheap land and rent.
  • Exemption from social welfare payments for employees.
  • Exemption from personal income taxes for foreign employees and executives.
  • Freedom from control by the CCP.
  • Freedom from worker unions.

These incentives encouraged a flood of foreign investment into China. These incentives did not apply to Chinese locally owned enterprises and at one point China imposed a 35% corporate income tax on Chinese owned businesses, while imposing no income tax on foreign owned businesses. This same sort of distortion applied to all the other foreign business incentives and in the early 2000s, private Chinese companies started complaining about finding it difficult to compete with foreign owned enterprises.

Beginning in 2005, the Chinese government started removing and reducing various foreign company benefits. Foreign owned enterprises were made subject to corporate income tax at the same rate as Chinese owned companies. The full personal income tax and social benefit system was imposed equally on both Chinese employees and foreign employees. Local governments were prohibited from offering land and tax breaks to lure foreign investment. By 2018, there were virtually no incentives left for foreign invested enterprises. The new FIL should be seen as the final nail in the foreign incentive coffin.

Foreign invested companies will now receive no incentives or benefits at all. They will be treated the same as any private Chinese company. They will pay tax at an effective rate of 60%. When they remit after tax profits to their shareholders, they will pay an additional withholding tax of 15%. They will be subject to the 17% VAT rate. They will pay the some of the world’s highest rates for land and office rent. Perhaps most importantly, they will be entirely under the control of the CCP and the Chinese government. No “special status” will shield them. Among other things, this will mean the following:

  • When the CCP arrives to set up a party branch in the foreign enterprise, compliance by the foreign enterprise will be required. When the CCP branch insists on reviewing confidential company business records, compliance will be required.
  • When the workers in even a five person office state that they will form a union controlled by the local CCP/government, compliance by the foreign company will be required.
  • When the local telecom/ISP service states that it will set up the foreign company’s Internet and email server, compliance will be required. When the foreign company is told it can no longer use its international VPN to get access to necessary news and information, compliance will be required.
  • When the company is told that all of its company data must be stored on a cloud server located in China accessible to the Chinese government, compliance will be required.
  • When the Chinese government/military arrives at the door and tells the foreign company that the PRC Cybersecurity Law mandates that it turn over its source code and other confidential information, compliance will be required.

Demands like those mentioned have been made on WFOEs and Joint Ventures since 2002. However, foreign invested enterprises have for the most part been able to fend them off on the basis that their WFOE/JV status provided them some sort of privilege or exemption. This argument was never a strong one, but it largely worked. Under the new FIL, the special status for WFOES and JVs has been eliminated and with that the last best  argument for protection from invasion and control by the PRC government and the CCP has been eliminated as well.

And yet, the new FIL does not really put foreign invested enterprises on an even footing with Chinese invested companies; that too is an illusion. The FIL makes clear that the PRC will continue with its negative list policy. Foreign investors will only be permitted to invest in business sectors not on the negative list and the new negative list will be virtually identical to the current list. This means many of China’s most attractive sectors will remain closed or mostly closed to foreign investment, including Internet and commercial networking (SaaS and e-commerce), banking, securities, insurance, logistics, online payment, media (film, TV, games, magazines, books), automobiles (JV still required), petrochemicals, mining and metals production, real estate and real estate development. The list is long and it will not be getting any shorter.

So it is not even accurate to say that foreign investors will be pulled down to the level of private Chinese companies since so many of the most attractive areas for investment in China will remain “off limits” to foreign investors. So to be accurate, the actual result of China’s new Foreign Investment Law will be to pull foreign investors down to a status even lower than that of private Chinese investors. The new FIL will not level the playing field between foreign and Chinese investors. It will instead consign foreign investors to their own tiny playing field, surfaced with gravel; no grass or even astroturf.

So why any analyst would claim these changes are a good thing for foreign companies doing business in China is hard to understand. We can argue about the motives and the abilities of those who are saying this all we like but I see that as pointless. I have devoted much of my life to helping foreign companies (mostly American and European and a smattering of Australian and Japanese companies) navigate China’s laws and I take no pleasure from saying this, nor does my saying this in any way help me or my law firm economically. But the truth is the truth and the truth is that things have again taken a turn for the worse for foreign companies in China.

I truly welcome anyone to prove otherwise.

China e-commerce laws

About a week ago, in China’s New E-Commerce Law and Its Foreign Company Impacts, I wrote how China’s new e-commerce law will likely impact foreign companies doing business in China or with China. Because the new law does not offer much practical guidance and has yet to be bolstered by official interpretations or implementation rules, it is difficult to state with precision how exactly it will be applied and implemented. Nonetheless, using what we have read in the official and unofficial press and our discussions with Chinese government officials and also using also what we have learned over the last decade from representing companies involved with China’s e-commerce industry, we below (and in a subsequent Part III to this post) seek to explain some basic aspects of the e-commerce law.

 

— What constitutes e-commerce activities under Chinese law?  Under the new e-commerce law, e-commerce activities encompasses the selling of goods or services via information networks. Goods sold via information networks can be tangible things, such as apparel, electronics, and cosmetics or intangible things like coupons you can redeem at a restaurant. Services via informational networks includes services performed online, such as telemedicine, and services sold online but performed offline, such as online sales of travel packages, rental car booking services, or tutoring. The law governs transactions completed using information networks, whether the actual service or delivery of goods happens online or offline.

 

— Are foreign businesses subject to China’s new e-commerce law?  It depends. The e-commerce law applies only to e-commerce business activities within China. Though “within China” is not clearly defined, a popular (albeit unofficial) view is that if the activity contains any Chinese element, it will be deemed to occur “within China.” Under this view, a China WFOE selling products of its parent company online would be considered a China e-commerce activity, as would the sale of products on a Chinese e-commerce platform by a foreign business without a Chinese entity. Even the sale of products on a foreign website by a foreign entity to a consumer in China will likely also be considered to have occurred within China and therefore subject to the e-commerce law.

Even a foreign business that is not subject to China’s new e-commerce law needs to pay attention to other Chinese laws when selling products to China, such as the laws regarding importing and exporting, customs, publications and cybersecurity.

 

— Further Impact on foreign brands.  Though the new e-commerce law is not aimed just at cracking down on daigou (See China’s Daigou Shopping Model: This is the End, My Friend….) and though it will obviously not stop Chinese consumers from seeking other channels from which to buy foreign goods, it will serve to reduce daigou/grey market sales and by doing so it necessarily will bolster legal e-commerce sales by foreign companies.

The daigous most likely to be negatively impacted are the “professional” daigous. These are the people who travel abroad regularly to bring back three (or more) suitcases full of products, or who live abroad and go to an outlet mall every weekend to send products back to their buyers/agents/compatriots in China. They usually have shops on e-commerce platforms such as Tmall or they regularly post pictures on their WeChat or other social media accounts to update their customers and then they communicate with those customers on WeChat and close their transactions via WeChat as well.

Because all e-commerce operators must report taxes and because it is clear China intends to enforce this taxation requirement, “professional” daigous will have a harder time operating. Their profit margins will be significantly reduced. As we previously wrote, defrauding Chinese customs is an essential part of many (most?) daigous’ profit margins because China has historically imposed significant duties on a range of luxury imports. Daigous often (usually?) do not report or pay taxes on the income they derive from their sales. If daigous were to pay their taxes and declare the actual value of the goods they are bringing into China and pay the customs duties on those goods, they would lose all or almost all of the cost/pricing advantages they currently enjoy. The online platforms/portals on which daigous traditionally operate will also play a role in the demise of daigous. Because the various online platforms/portals can be held liable for not taking action against those who operate illegally on their sites, they are incentivized to help the Chinese government crack down on illegally operating daigous. For example, if a daigou is selling Balenciaga purses on Tmall and Tmall receives complaints from Balenciaga that the daigou is an unauthorized reseller and is infringing on Balenciaga’s IP rights, Tmall will no doubt take action to stop the daigou from conducting its unauthorized sales

Thus, the law should greatly benefit foreign brands by bringing China’s online platforms/portals and daigous into compliance.

 

–Selling to China’s consumers via cross-border e-commerce 

Finally, rules accompanying the new e-commerce law allow foreign brands to legally sell to China at a retail level. According to a December 2018 notice (“Notice”) from six Chinese government agencies regarding cross-border e-commerce retail imports (the Notice about Market Regulation on Improving the Supervision over Cross-border E-commerce Retail Imports, 六部门关于完善跨境电子商务零售进口监管有关工作的通知, Shang Cai Fa [2018] No.486), products imported at a retail level from cross-border e-commerce companies are regulated as products imported for personal use and they are not subject to many approval, registration, filing or labeling requirements that would normally apply to regular imports for trade or resale.

Under this Notice, a viable method for foreign brands to sell to China’s consumers is to work with Chinese e-commerce platforms, which method we will discuss in our next post in this series.

Contract manufacturing listHere’s the reveal: We have no such list.

Pretty much every week, someone writes one of our manufacturing lawyers about the following:

  1. To ask about a particular overseas manufacturer;
  2. To complain about a particular manufacturer and to ask us to tell our blog readers about this company or report them to such and such government or embassy or to ask; and/or
  3. To ask us whether we have or know of a list that ranks manufacturers on their trustworthiness/reliability/quality;
  4. To ask if they buy “through” Alibaba whether they will “be protected.”

1. Our standard response to those seeking information about a particular manufacturer is as follows.

There are hundreds of thousands of contract manufacturers around the world and our international lawyers have worked with just a small sliver of those and we are not familiar with _____ company. We can though help you determine the reputation and the financial wherewithal of _____ company. See Basic China Due Diligence. Is This Chinese Company Legitimate? and China Partner Due Diligence. The fees for this very much depend on the depth of our investigation, which can range from just making sure the company actually exists and is licensed to manufacture the products you want it to make for you, to full-on credit reports and even talking with its vendors and customers. In turn, the scope and depth of the due diligence that will make sense for you will depend on the monetary and IP risks you will be taking by doing business with this particular company.

2. Our standard response to the request that we report bad suppliers on this blog or some embassy or to some government is as follows:

We do not list problem manufacturers (or great manufacturers) on our blog because we have no good and fast way to determine that what one person tells us about a particular manufacturer is accurate or not. To be blunt, much of the time when product buyers have problems with their overseas manufacturer, the fault does not lie solely with the manufacturer. As far as us reporting X manufacturer to Y government or Y embassy, that virtually never has any impact and so we would not feel right charging anyone for us to do that, but there is, of course, nothing stopping you from doing that.

3. Our standard response to whether we have or know about a list that ranks manufacturers on their trustworthiness/reliability/quality is that we have no such list nor is there any such list we recommend. I then usually suggest that if they do not deem it worthwhile to spend money for due diligence on their potential suppliers they should at least do a Google search on them.

4. My standard response on whether buying “through” Alibaba will “protect” them is no.

Finding the right manufacturer overseas is not easy and, if anything it is getting more difficult because it typically involves more countries than in previously.  See The China-US Trade War and the Winner is….MEXICO and The US-China Future: Meet Vietnam, Thailand, Mexico, Malaysia, Turkey, and the Philippines.

A few weeks ago, I got an email from a self-described “avid” reader of this blog with the following question:

I am looking to have ______ made in either China or Thailand but I don’t have enough money to hire anyone to help me with product sourcing or even to visit the factories before I choose one. I also cannot afford any legal help for my contracts. What do you advise I do to protect myself.

My response was the following sentence: “My advice is that you wait until you have more money and, if possible, you in the meantime start out strictly domestically.” The avid reader responded with one word: “Thanks.”

Whenever I speak about how to protect yourself when doing business overseas I talk about the following as the three keys:

  1. Good partner. In other words, be sure to choose a good supplier and the right supplier for you.
  2. Good contracts. Your contracts should be enforceable and protect you from key risks, such as IP theft and bad and late product.
  3. Good IP registrations. Trademarks, copyrights and/or patents.

I sometimes add a fourth: good quality control/good monitoring.

There are no shortcuts. And there is no list. Sorry.

President Trump and China

Now before anyone starts complaining, the letter grade in the title comes from the Council on Foreign Relations, truly one of the most august foreign relations think tanks in the world. Per Wikipedia:

The Council on Foreign Relations (CFR), founded in 1921, is a United States nonprofit think tank specializing in U.S. foreign policy and international affairs. It is headquartered in New York City, with an additional office in Washington, D.C. Its membership, which numbers 4,900, has included senior politicians, more than a dozen secretaries of state, CIA directors, bankers, lawyers, professors, and senior media figures.

That’s right, the Council on Foreign Relations says President Trump is doing a really good job with China. Don’t believe me? Go here and download the pdf and read it for yourself. This is not a joke and in fact, I am firmly convinced most who deal with China would roughly agree with that assessment. Wait you say, this cannot be. President Trump doesn’t understand foreign policy and his spouting off on Twitter is anything but diplomatic.

Well guess what, it’s not as though the Council thinks President Trump is doing a good job with foreign policy overall, as indicated by an overall D+ grade, based on the specific breakdowns below:

The grades for President Trump’s foreign policies just past the halfway point in his term are: China (B+), North Korea (B), Syria (B+), Saudi Arabia (B+), Israel (B), Iran (C), Afghanistan (B+), India (B+), Venezuela (B+), and trade (C); against his grades for climate (F), European security (D), Russia (F), policy process (F), character (F), American values (F), U.S. alliances and deterrence (F), and policy implementation (D). This report, heavily influenced by the president’s realistic approaches to China and the greater Middle East, gives him an overall foreign policy grade of D+, a substantially higher mark for his foreign policies than found on the Sunday talk shows, in the editorial pages of the New York Times and Washington Post, or among many U.S. national security experts.

So all you China people out there, step back for just a minute and list out what President Trump has handled badly with China and what he has handled well. And then let us know whether you think he deserves a B+ grade and why you have the opinion that you do. I’ll go first and say that I think the grades above are for the most part pretty accurate and I especially agree with the China grade.

China lawyers
Because of this blog, our China lawyers get a fairly steady stream of China law questions from readers, mostly via emails but occasionally via blog comments or phone calls as well. If we were to conduct research on all the questions we get asked and then comprehensively answer them, we would become overwhelmed. So what we usually do is provide a quick general answer and, when it is easy to do so, a link or two to a blog post that provides some additional guidance. We figure we might as well post some of these on here as well. On Fridays, like today.

A few weeks ago, I was discussing the need for one of our tech clients to have an NNN Agreement with its China counter-party before even sitting down to talk. The in-house legal counsel then asked me why an NNN Agreement was even necessary because she had read that China’s trade secret laws are very well written and very sophisticated. Like any experienced lawyer asked a really good question for the first time, my mind went blank and I responded with a time filler: “Great question,” I responded. I then mouthed something about how it is always better to have something in writing than to just rely on a law.

And then I got on a roll, explaining the below to her.

  1. Our NNN Agreements protect a lot more than just trade secrets. They protect whatever it is you want to protect. Trade secrets include only very specific things and it is not entirely clear even what those things are. If you want to be sure what you want protected will be protected, you need an NNN Agreement.
  2. Our NNN Agreements are contracts. Trade secret protections are not. China’s courts are very experienced in handling breach of contract cases. They are far less experienced in handling trade secret cases. If our NNN Agreement says Chinese Company cannot do this with X and it does this with X, they have clearly breached the contract. With a trade secret case we would need to prove that what you had was a trade secret (and that is not likely going to be easy) and that it violated China’s trade secret laws by doing so.
  3. Chinese companies know and fear NNN Agreements written in Chinese under Chinese law and with clear-cut and enforceable damages provisions. They don’t particularly fear China’s abstract trade secret laws.
  4. China’s trade secret laws are not that great anyway. Yes, what is there is good, but they are not as comprehensive as they should be and the lack of case law does not help either.
  5. I cannot underrate the difficulty in coming up with admissible evidence for China trade secret cases. Our international litigation team has many times been tasked with coming up with evidence for China trade secret cases and unless you have done this before, you probably cannot even grasp how difficult this is and whatever you use for evidence will be challenged by the other side, that much is pretty certain. I am going to make up a number here (there is no other way to do this short of analyzing thousands of cases) but I would estimate that Chinese courts accept as evidence less than half of what American courts accept. Because trade secret cases depend so much on evidence, this will likely be a problem.

Bottom Line:  China trade secret protection is something to look to only if you do not have a good NNN Agreement to protect you. Note also though that it does make sense (and can be very important) to have trade secrecy agreements with your employees.

 

China's Sputnik MomentThe Information Technology & Innovation Foundation just released an excellent report called Is China Catching Up to the United States in Innovation? It looks like the answer is “yes.”

The report concludes that China is making more rapid progress in innovation and advanced technology industries than the United States. The report says there is no reason not to expect China to follow the same path as the “Asian tigers,” (Korea, Taiwan, Singapore and Hong Kong) and rapidly evolve from copier to innovator. But with China, the implications of this for the United States will likely be far greater in terms of its impact on U.S. economic prosperity and national security.

The report says that even though China is presently behind in new-to-the-world or first-of-a-kind innovation, it would be misguided to draw conclusions based on an overly narrow definition of “innovation.” The report goes on to remind us that innovation includes more than just science and engineering and though China is right now in a “fast-follower” stage in those areas, it is making greater progress in other areas like customer-focused and efficiency-driven innovation.

According to the report, no other government in history has done more to promote an innovation-based economy than China. To ensure its continued leadership in innovation and advanced technology, the US needs to implement its own national innovation and competitiveness strategy. The report goes so far as to say that the US needs to react to China’s progress in much the same way it reacted to Sputnik in the 1960s. In other words, the United States needs another Sputnik moment.

Do you agree with this assessment? Will the United States react? How should the United States react? Has the United States already reacted?

 

China WFOE LawyersIn the last year or so, our China lawyers have been seeing a steady increase in emails from people inquiring about selling their China WFOEs and that has only accelerated in the last couple of months. I have gotten three or four of these in the last month alone, including the following one this week, which is fairly typical:

I have a shelf WFOE incorporated and I am looking to sell it and would be grateful if you could let me know whether you can assist. I look forward to hearing from you soon.

We have been getting so many of these lately that I’ve set up the following as my “push button” (literally) response:

It is the extremely rare WFOE that can be sold simply because they are so limited geographically and by business scope and because they come with so many risks. Here’s an article we wrote on this way back in 2014. What is your business and in what city is it located and does it have any employees and why are you seeking to sell it?

As China’s economy continues to contract and as doing business there continues to get more expensive and complicated, we expect the number of foreign companies looking to leave to continue growing. Leaving China for foreign companies often means trying to sell or shut down their WFOE, neither of which are at all easy.

Years ago we got the following question regarding selling a China WFOE:

Is there really a market for existing WOFEs? We have been operating for five years now and we are certainly fully aware of how hard it is, but I do not intend to quit, but certainly there will come a time when we need to exit China. One option is sale, but I really doubt that is possible. Does anyone know of examples? Also partial sale to key staff, for a peppercorn perhaps, seems to be a good idea from a business point of view. Does anyone know if this is possible?

We responded as follows:

Not much of a market at all. The problem is that to buy a WFOE requires that the buyer essentially want to do exactly what the seller has been approved to do. So for example, if I want to do a consulting business in Qingdao, I must buy a consulting business in Qingdao. And then I also have to make sure that the costs of my doing due diligence on the WFOE and the risks of buying into the liabilities and problems of the WFOE, do not outweigh the advantages of taking over a WFOE, as opposed to forming a new one.

We then wrote how it is indeed possible to sell a WFOE and of how our China M&A lawyers have been involved with a couple such sales and they are not difficult from a legal perspective, but they are difficult to justify from a business perspective. We sometimes see WFOE sales to employees (either expats or Chinese citizens or even combinations thereof) who want to see the WFOE keep going so they can hold onto their jobs. It is possible to sell a WFOE to a Chinese company or a Chinese citizen (and this would include to an employee) and then it converts to a Chinese domestic company. This too is not difficult legally, but such sales are rare because usually the employee knows exactly why the WFOE is closing and usually the employee can choose to essentially take over the WFOE after the foreign company has left, and do so “informally” and without any payment.

You can sell your WFOE to a foreign company looking to do business in China, but that too has all sorts of difficulties, many of which we detailed in a previous post, entitled, Buying And Selling China WFOE Shell Companies. Not In My Lifetime?

In that post, we talked of how our China attorneys are always getting emails and calls from someone asking us if any of our clients might be interested in buying a China WFOE and of how our usual answer is “no.”

The people trying to sell their WFOE usually tout it as being completely liability free and therefore ready to go much faster and at a much lower price than if someone were to have to form their own China WFOE. For what it takes to form a WFOE in China, check out the following:

If you read any of the above posts, you will no doubt conclude that forming a WFOE in China is a convoluted and time consuming process, and it is. Therefore, buying an off the shelf WFOE must be much easier, right?

Wrong.

To quote from our previous post on selling a WFOE:

The thing about off the shelf WFOEs is exactly that: they are off the shelf and not customized. And that is where all of the problems arise. Let’s take as an example a WFOE that someone tried to interest me in many months ago. That company was in the IT outsourcing business in a second tier city. So right there, its only real potential buyer is someone who is interested in doing IT outsourcing in that second tier city.  Because if the buyer of that WFOE is interested in doing anything other than IT outsourcing, it will need to petition the government to expand or change its business scope. Similarly, if the buyer is interested in doing IT outsourcing in some other city, it will need to petition the government to move its WFOE or it will need to set up a branch in that other city, and thereby have to maintain two offices. When you throw in the fact that anyone buying a WFOE will need to conduct due diligence on it to make sure it truly does not have liabilities of any kind (including, tax, employee, environmental, tort, etc.) you can quickly see why forming a WFOE is going to be safer and probably equally as fast and cheap as buying one. The biggest benefit in buying a shell WFOE would be speed, but it is going to be the rare instance where saving a few months will warrant the extra risk.

In the post, “How To Form a China WFOE. Scope Really Really Matters,” we discussed the importance of a WFOE having a proper scope:

BUT — and this is why I am writing this post now — if you under or overreach on the description of your business scope, you might find yourself in big trouble.  We are getting an increasing number of calls from American companies in trouble with the Chinese government for doing things in their business that they did not mention in the business scope section of their initial WFOE.

In some cases, the companies have admitted to us that they were never “really comfortable” with the business scope mentioned in their applications, but that the company they had used to form their WFOE had “pushed” them into it as it would “make things much easier.” In some cases, the scope of the business changed after the application was submitted and the company had failed to secure approval in advance for the change. And in some cases, the company probably would never have been approved at all had it been upfront and honest in its application. In nearly all instances, the companies had managed to secure local approval but were now in trouble with Beijing, which constantly is auditing these applications. In one instance, the local government went back and changed its mind, probably after conducting an audit of its own.

I cannot go into any more detail on these matters, but I can give this advice: applying for a WFOE in China involves a heck of a lot more than just filling out a form and getting approval. It does matter for what you get approved and you (or whomever you are using for your WFOE application) need to know China’s foreign investment catalog inside and out before applying. You then must tailor your application to meet both the requirements of the foreign investment catalog AND the reality of what you will be doing in China. A failure to comply on both fronts will lead to, at best, a rejection of your application and, at worst, being shut down months or years later.

The odds of a shell WFOE’s city and scope lining up perfectly with that of a potential WFOE buyer are low and we are not aware of any website that tries to match up WFOE sellers with potential WFOE buyers.

So yes, buying a WFOE is possible, but difficult. But we do find the idea of selling a WFOE to an employee appealing as it can make for a smooth transition all around. But the real question (again) is not the legalities, it is the practicalities and the desires.

What are you seeing?

Years ago, the China Business Hand [Steve Barru] wrote about his efforts to sell a WFOE in 2005. As he put it, he “could close the business and walk away or try to sell it, [but] …. it turned out that neither option was simple or straightforward.” [Editor’s Note: The China Business Hand Blog no longer exists and the below comes from one of our blog posts]

At first, Barru thought closing down his WFOE would be easy, but it being China, he was wrong about that:

Closing down the business and moving on seemed the easiest way out. Until I discovered that terminating a WFOE license involved getting approval to do so from the long list of government agencies that had approved the license in the first place. To make matters worse, shuttering the business would cost me around $2,000 in fees of one kind or another.

If I had been leaving China altogether in 2005, I would have settled up with my two employees, gone to Hong Kong to convert the company’s remaining Chinese funds to US dollars, and gotten on a plane home, letting Chinese government officials sort out what to do with an abandoned WFOE. Alas, my new job was in Beijing, so this was not an option.

I went to the primary licensing authority, the Bureau of Industry and Commerce, to ask if there was a formal procedure of some kind to make the company inactive (aka: a shell company). Nope. As long as the company existed, I would have to file monthly tax reports, complete the statutory annual audit and license renewal procedures, and meet all of the many reporting requirements of other agencies. The fact that the company would not be engaged in any business activity made no difference whatsoever.

It being so difficult and expensive to shut down his WFOE, Barru then sought to sell it, which too proved difficult:

Selling the company, even for next to nothing, quickly moved to the head of the line. But transferring the business license and my legal person status to the wannabe new owner involved far more than filling out a couple of forms.

It was the buyer who had to jump through the bureaucratic hoops. For all intents and purposes he went through the same process one goes through to establish a WFOE. With one key difference – he did not have to invest new capital in the company. The original US $70,000 in registered capital (that I had put in and had later managed, for the most part, to take out) was all that was required. Since registered capital for a WFOE had increased to US $200k by 2005, there were demands for additional investment, but rather convoluted negotiations eventually got around this obstacle. Fortunately, the buyer was located in Nanjing. The need to move the WFOE to a new locale would have been a deal breaker.

Eventually, after several months of discussions and chopping forms, all the questions about registered capital, business scope of the company, the good character of the new owner, and the license transfer had been answered and the sale was complete. The price probably covered my express mailing costs and bought me a couple of dinners. But I was out from under what had become an enormous, very time consuming headache.

As Barru so accurately observes, forming and running and even closing a business in China is going to require you to get up close and personal with your local bureaucrats:

The fact is, when you are doing business in China, the local government where you operate is your de facto partner. Chinese bureaucrats were involved in every aspect of my business over the years, sometimes in reasonable ways but on occasion as meddlesome pests sticking their noses into strictly business decisions. Even the end of my days as a WFOE owner involved getting government officials to, in effect, give me permission to let my business go.

The same holds true today. In a subsequent post we will discuss what it takes to shut down a China WFOE and why just “walking away” from your China WFOE is usually not a smart thing to do.

China lawyers

Way back in 2011, we wrote a post on how what your company does outside China can impact how it is viewed and even how it does in China. Logical, right? We titled that post China Business And Glocalization. Should What Goes Around Come Around? 

What spurred that post was a multinational client of ours who had sought our help in “harmonizing” its China product return policies with those of the United States and Europe. This company had given Americans and Europeans six months to return its product, while giving Chinese customers only 30 days out of concerns that “too many” Chinese customers would take advantage of the six months. Soon though this company was getting reports from China that its customers were not happy about being treated worse than their American and European counterparts.

In that same post I talked about how the China lawyers at our firm were very much used to hearing and dealing with the above sort of thing, but how it had not really occurred to me how a company’s actions inside China might impact it outside China. That was until I read a Newsweek article (from 2010) entitled, Back to the Days of Blackface, which discussed the fallout Colgate-Palmolive incurred from its ownership stake in a product/brand that would be considered offensive to the overwhelming majority of Americans:

Of all the unfamiliar products in a Chinese supermarket, one of the most shocking to American visitors is a toothpaste featuring the logo of a minstrel singer in a top hat, flashing a white smile. Even more shocking: the paste, known as Darlie in English and as Black People Toothpaste in Chinese, is a product of the Hawley & Hazel Group, a Hong Kong–based company established in 1933, which is now owned in part by the Colgate-Palmolive Co.

Darlie used to be called Darkie. According to the book America Brushes Up: The Uses and Marketing of Toothpaste and Toothbrushes in the Twentieth Century, the CEO of Hawley & Hazel saw blackface performer Al Jolson in the U.S. and thought, “Jolson’s wide smile and bright teeth would make an excellent toothpaste logo.” He was right: the firm now claims to be one of the market leaders of toothpaste products in China, Hong Kong, Taiwan, and Southeast Asia.

Colgate purchased 50 percent of the company in 1985 and, after three years of criticisms, switched the name “from Darkie to Darlie and modified the logo to a less crude version of a black man.” In 1989, Colgate-Palmolive’s chairman stated, ‘’It’s just plain wrong … The morally right thing dictated that we must change [in a way] that is least damaging to the economic interests of our partners.’’

“Yet the Chinese name of the product has remained unchanged.”

This product’s name and imagery is simply no big deal in China, where “it wouldn’t even occur to [most people] them that Black People Toothpaste [another brand of toothpaste in China] is offensive.”

But Colgate is a Western company:

Yet Colgate is a Western company, and as such, “should know better,” says Kwame Dougan, an African-Canadian living in China. Colgate declined NEWSWEEK’s interview requests, instead releasing a statement saying, “There are different perspectives on this issue.” Hawley & Hazel also declined an interview request. Darlie doesn’t exactly advertise its relationship with Colgate; Colgate’s Web site has only two mentions of Darlie, which both talk about how the brand is driving growth in the Asia-Pacific region. Darlie products examined in China for this story featured no mention of the Colgate label.

“I think that the brand should simply be retired,” says Laura Berry, executive director of the Interfaith Center on Corporate Responsibility, one of the organizations that originally pressured Colgate to fix its Darkie brand. Until then, Darlie smiles on.

I then went on to talk about how Colgate’s actions bothered me and I could certainly imagine those actions bothering others.

American and European companies have for a long time been concerned with how their China employment practices can impact their reputation outside China. One only need read pretty much any multinational’s requirements on child labor to get a sense of how important the big companies view this issue.

There has in the last six months or so been a growing uproar regarding foreign companies that help China’s surveillance capabilities but it has only been in the last couple weeks that China’s treatment of its minority religious populations (one in particular) has really been coming front and center in terms of how it can impact business worldwide. The following three things have brought this home to me:

1. Facebook. I am seeing people talking about “how something needs to be done about this” and I am seeing the b-word — boycotts — being bandied about.

2. Clients. Actually just one client, a company known for its progressive stance on such things as employee relations and the environment. This company told me that it is “accelerating” its cessation of China manufacturing because its employees are starting to complain about its China connections on “moral and political” grounds. I am reluctant to explain exactly what aspect of China policy it is that has spurred on these complaints (for fear of what might happen to this site in China), but if you have been reading the news and if you follow the link in the next paragraph you will know.

3. The News.  You really must read this BBC article on Volkswagen to believe it. Of all the companies to essentially deny this particular reality, VW has to be it. Let me just say that pretty much every car I have bought and owned in the last ten years has been German and I have had to defend those purchases from time to time to others, including to one of my own daughters. My defense has always been simple and unequivocal. Germany, perhaps as much as any country in history, has recognized the evil it did (in WWII) and has very much sought to make up for that. And we should not punish the kids for the sins of the parents. But when the CEO of a company like Volkswagen — which was so intimately tied in with Hitler’s regime — makes a comment that is hard to believe (or if believed is equally horrific), I do not think it unfair to highlight its past ties with Nazis or its incessant dishonesty. 

I bring all of this up because I see things bubbling and I am just curious who else has been seeing these things and I am also curious regarding what sort of impact you see these things having on businesses worldwide and, most importantly, on your business. What are your employees and customers telling you? Is all this just more incentive for companies to decouple from China? Or will just not saying incredibly stupid things to the press be enough to protect you and your company? Has China — as a number of clients keep telling us — become “just too difficult” or “no longer worth all the hassle”?

You tell us.