Since the inception of this blog, one of our recurring themes has been the need for foreign companies to follow China’s laws. We are always writing of how China does have laws, those laws apply more strictly to foreign companies than to domestic companies, and those laws apply whether or not some local governmental official assures you that they will not be enforced. We have also consistently extolled the virtues of setting up your business in a second tier city.

Phil Taylor, writing for the International Bar Association Journal, has just come out with an excellent article combining these two themes. Mr. Taylor is a law student at the University of London who freelance reports on the side. The article is entitled, “The Risks of the Middle Kingdom,” but its real focus is on foreign businesses in China’s second and third tier cities.The article talks of how China’s smaller cities are usually cheaper and less competitive than the first tier cities, but riskier as well.

It then zeroes in on the legal risks in these cities and how even though these cities are often less stringent on law enforcement, foreign companies should still comply with the law. Or as Ronan Diot, chair of the legal working group of the European Union Chamber of Commerce in China, so nicely puts it:

Too many foreign companies have run afoul of the local rules and it is a really bad idea to think that it’s OK because “most companies are doing it” or “there is no other way”. This is simply not true.

The article notes how “it can often be much easier to get away with [illegal] things in smaller cities that would be impossible in somewhere like Shanghai, and this can lead to a false sense of security.” It then quotes me on why disobeying Chinese laws is a bad idea, even in second tier cities and even when it seems so easy to do so:

“Oftentimes, the smaller cities will allow foreign companies to bypass certain laws in an effort to get the foreign company into their town as quickly as possible,” explains Harris, speaking by phone from Beijing. “The foreign company goes along with the shortcut, figuring it must be OK if the city itself is signing off on it. This can be a big mistake as it is exactly these sorts of cities that tend to be subject to audits at the provincial or maybe even the national level.”

Harris mentions by way of example two foreign companies that were formed in very small cities, even though they had not satisfied all the requirements for forming a wholly foreign-owned enterprise (WFOE). They ended up being shut down within a year due to audits that came down from the central government.”

“This is a very real risk that businesses are simply missing,” says Harris

The article then does as good a job as I have ever seen at concisely explaining (and to a certain extent explaining away) guanxi. The article starts out by making clear “that creating and maintaining good relationships with regulators and local officials can be a very important element of business success” but then quotes Violet Ho of the Kroll company on how “people don’t pay enough attention to dissecting it. Not all guanxi is created equal.” Ms. Ho then goes on to beautifully explain various types of guanxi and the particular risks and rewards each can engender:

She [Violet Ho] divides guanxi into several types. Inherited guanxi is exemplified by the influence of government officials’ offspring (known as princelings). This type is often very dangerous as it is susceptible to political volatility. Personal guanxi – where a company relies on one person for its success – can be very risky, particularly where little is known about that person. A foreign business that falsely believes a connection with a single influential political figure will keep it out of trouble can quickly find itself operating in a legal grey area.

A more positive type of guanxi is what Ho calls institutional guanxi – support from a particular government agency – which she says should be carefully developed. She also describes “a new generation of guanxi” whereby a company receives strong government support because it is considered a leading enterprise in the local area.

“An enterprise that has contributed to local development, paid a lot of taxes, and employed a lot of local people can find itself in a win-win situation where it is being recognised and supported by the government for its contribution,” says Ho.

Ronan Diot then lays out how so-called guanxi can so easily backfire:

“Many people can tell you of their formerly rich and successful friend who is now serving 16 years for bribery and embezzling company property,” says Diot. “Generally speaking, it is often a strategic mistake to rely on one well-connected individual for the development of one’s business in China.”

A powerful local figure can also become a liability when they start to use their connections to override a contract or exert influence on a local judge. For these reasons, a foreign company may go too far in its attempts to nurture what it perceives as an important relationship. Lavish gifts or extra cash payments make a company easy prey for extraterritorial anti-corruption laws such as the US Foreign Corrupt Practices Act, the OECD Anti-bribery Convention, or the UK’s new Bribery Act.

“In addition to purely legal aspects, our advice to clients is to take their home jurisdiction as guidance: if you would not feel comfortable doing what you plan to do in China back home, then do not do it,” says Diot.

Taylor then uses me to summarize:

Harris is more direct: “Making good connections makes sense but running afoul of anti-bribery legislation does not. Know what the laws are and do not violate them, no matter what.”

The article moves on to discuss the differences in risks for businesses between China’s first and second tier cities. Kent Kedl, Control Risks’ managing director for Greater China and North Asia, says that foreign companies are rushing into China’s second and third tier cities and in doing so, they are ignoring many of the risks:

“[T]his mirrors what happened 20 years ago: then, American companies became very excited by the fact that Chinese factory workers were about 30 per cent cheaper than those in the US, and failed to take into account the efficiency and infrastructure issues that would also have to be overcome.

I think we’re in danger of making the same mistake this time; we didn’t learn the lessons, and people are just blindly looking West,” he says.

Second and third tier cities present greater overall IP risks:

Although the risk of IP theft itself may not be any higher in the provinces, the difficulty of dealing with the aftermath is usually greater. Take the case of a foreign company that agrees to license its IP to a Chinese company for a year. If the Chinese company keeps on using the IP, the chances of being able to stop the company will be greater in Shanghai than in a smaller city like Chengdu. A risk factor like this, although hard to quantify, should influence a foreign company’s decision regarding where to locate. Harris talks of a software company that wanted to set up in Chengdu and employ five people to write software there. It turned out that this would only have saved the company about US$25,000 a year.

‘If they were making widgets, then I wouldn’t have raised the issue with them, but is it worth it for the IP risk?’ asks Harris.

I love how the article then describes the difficulties in finding good lawyers in China’s smaller cities:

The quality of advice and the depth of understanding of a foreign investor’s perspective can be variable in the provinces, to say the least. (Even the label ‘law firm’ can sometimes be misleading. A former journalist who spent time travelling around several smaller Chinese cities while carrying out research for a legal directory tells of her surprise when visiting some law firms. Although describing themselves as firms offering a range of services, at least one turned out to be nothing more than a one-man shop operating from a smoky room above a supermarket.)

The difficult question of guanxi appears again here. Some investors may be tempted to rely on a local Chinese lawyer who claims he or she has important connections. This may yield results in the short term but will not provide a stable, long-term base on which to build a business. Harris cites the example of a company that took advice from a local lawyer and rented a property in a small city from a landlord who was not legal. Things went well until the Beijing tax authorities said the company would not be able to claim its rent as a tax deduction because of its illegal landlord.

“I said [to the company], if you want to feel really bad, the tax authorities might tell MOFCOM [the Ministry of Commerce, which regulates foreign companies’ operations in China] that you’re not operating legally there and you may be shut down.”

The article concludes with me extolling foreign companies not to abandon their common sense:

“First off, think. That’s right, think,” writes Harris in one of his blog entries. “Secondly, do not do anything you would not do in any other country. Just because your Chinese partner and/or your Chinese partner’s lawyer tell you this is how things are in China does not mean you have to believe them and it certainly does not mean you have to abandon your common sense.”

This really is a highly informative article with a whole slew of excellent advice and I urge you to go here to read it in full.

What do you think?