By Steve Dickinson and Mathew Alderson

In the first part of this two part series, in a post entitled “China’s Film Industry Promotion Law. A Discussion Of The Discussion Draft,” we discussed the Discussion Draft of the China Film Industry Promotion Law. Concern has been expressed about a provision of the law that would prevent online film download sites from providing unlicensed foreign films on their websites. In fact, however, this provision of the discussion draft would simply clarify existing law. It therefore does not reflect a substantive change. Much of the current regulation of film in China is based on agency regulations rather than statute. One purpose of the new law would be to take these regulations and increase their authority by raising them to the level of statute. Thus, some parts of the law are merely a codification and clarification of existing practice. The controls on download sites falls into that category.

The discussion draft would establish a two tier licensing system. Under current rules, all films produced in China must obtain a Film Production License. The script for such films must be approved by Beijing SARFT. After completion, the completed film must be reviewed by SARFT. Films that survive such review receive a Film Public Screening License. No film can be “publicly screened” or “shown” in China without such a license. This includes foreign films imported into China for screening.

The discussion draft simply repeats this basic rule, with some clarification, as follows in draft Article 26:

Article 26, Par 2: 未取得《电影公映许可证》的电影,不得发行、放映、参加电影节(展),不得通过互联网、电信网、广播电视网等信息网络进行传播,不得制作音像制品;但是,法律、行政法规另有规定的,从其规定。
With respect to films that have not received a “Film Public Screening License”, such films (1) may not be distributed, shown, entered into film festivals (exhibitions), (2) may not be broadcast over the telecom networks, such as the internet, telecom networks or broadcast television, and (3) and may not be manufactured into audio-visual products.

The commentators focus on Provision (3) from Article 26. It is our understanding that a vast amount of the online content provided by Tudou, Youku and others does not have a Film Public Screening License. Much of this unlicensed content consists of movies and TV shows from Taiwan and Hong Kong. Another substantial portion of this unlicensed online content consists of foreign films from North America and Europe. If China were to begin enforcing its ban on unlicensed content, we would expect the revenue of Tudou, Youku, and others to be substantially reduced.

The important point though is this. Article 26 does not change current law. Current film regulation provides that no film can be “shown” (fang ying 放映) absent a license. No one in China has any doubt that “showing” a film on the internet or on TV is any different from “showing” that film in a theater. Thus no one in China has any doubt that the current practice of Tudou and Youku providing unlicensed films and TV shows for download violates the law. Video sites like Tudou and Youku might argue that they don’t “show” any films at all. Rather they provide films for download and people “show” them in their homes. If that is a sound argument, then Section 26 of the new law would not apply to Tudou or Youku or to other download services. However, this argument fails. Both current regulations and the proposed Section 26 clearly provide that distribution of unlicensed film is also prohibited. Thus, if Tudou and Youku (which are reportedly soon to merge) are not “showing” films, then they are at least certainly distributing films. The fact that they are distributing them over the internet is entirely irrelevant.

We do not know why the Chinese government has chosen not to enforce the existing law with respect to Tudou, Youku and the rest, but we assume the reason is money. Tudou and youku make money and the government presumably benefits from this via tax collection or in some other way. Thus they do not shut Tudou or Youku down. The same is true regarding the illegal production of DVDs. The government knows who most of the illegal DVD producers are and it could shut them down tomorrow. But the government does not do it.

With respect to Tudou and Youku and other download sites, the discussion draft would only make even more bluntly clear what is already the law: it is illegal to distribute, show, broadcast, provide for download or manufacture into a disc any film that is not licensed. All of this illegal activity is a huge and profitable industry in China. Part of the high profit is based on this very illegality.

Foreigners who want to invest in companies like Tudou (NASDAQ: TUDO) or Youku (NYSE: YOKU) should know that they are investing in businesses that make at least a portion of their revenues from illegal content. The risk with Tudou and Youku is not insubstantial as they both show unlicensed film, foreign copyrighted content (which is also illegal under Chinese law) and they both are VIEs.  How much more risk do you want? These risks cannot be eliminated since they are, at least to some extent, built into the system. What will be the result of all of these risks is unknown, but they should at least be factored into any investment decision and our conversations with Wall Street analysts suggest that is not being done.

Comments are always welcome for everyone, of course, but we would particularly like to hear from investors in Tudou and Yokou this time.