[Note: below is Chapter 10 from Great Wall of Numbers]
I have been more or less fortunate not to have any problems with government authorities at any level (yet). However whenever you put a group of laowai (foreigners) into social setting you will eventually hear a story or two – sometimes embellished – about legal problems. The one personal story that I have involves visa delays. About two months into my most recent teaching position I received a notice from my HR director that my visa was being delayed by the PSB – Public Security Bureau (equivalent to the Immigration Services). They wanted me to come in person for a face-to-face interview at a local police station with an officer. My director said while this was unusual we could prepare for it and analyze what they may inquire about. At around 2pm on a June weekday I went in and met a number of plain-clothes inspectors. One handed me a worn book of immigration laws covering the sections I possibly had violated. After a few questions and three hours of sitting next to their terminals, one of them – Zhang (not his real name) – approached me and after a brief exchange allowed me to leave without any recourse.
Fortunately the paperwork had been merely misplaced and nothing came of it. But what should foreign firms and expats expect when starting a business? Always be prepared.
There are several ways in which you can proactively protect both your physical assets and employees. The first almost goes without saying: hire a legal advisor to analyze and asses any liabilities, risks and loop-holes in your contracts and business model.
For example, Dan Harris is an American attorney at Harris & Moure who frequently travels to China and publishes the popular ChinaLawBlog. In an email exchange in October 2012, he noted “that the most common challenge for US service-oriented SMEs is getting paid. Chinese companies are reluctant and slow to pay for services. Most service companies do not have much IP [intellectual property] so that is not always a big issue for them. And thus I would have to say contracts is their biggest issue, which gets us back to getting paid.”
Dan and his co-blogger Steve Dickinson, who lives and works in China, have written a number of excellent overviews of contract law in China and about protecting your assets, your employees and even your IP.1
Why is professional advice such as theirs important?
Ten years ago when China’s Railway Ministry elicited bids for building a nation-wide high-speed network (called the CRH, HSR or 高速铁路), several foreign companies from France and Japan submitted bids. As part of the deal to do business on the mainland, the Ministry required that foreign firms set up joint ventures (JV) with domestic suppliers and provide technology transfers to these firms.23 Japanese firms, unfamiliar with the nebulous legal framework in China, ultimately handed over their ‘best practices’ and engineering techniques to the JV. Their Chinese partner (CSR, 中国南车集团) then quickly replicated and reverse-engineered the technology using domestically sourced parts and labor. As a consequence the Japanese companies were edged out of the Chinese market by the very machinery they had originally designed.4
Another example is General Motors which, wanting to gain access to China’s car market (now the world’s largest), transferred and exchanged technology to their JV partner, SAIC. While GM still operates in China (hitting a record 2.54 million in vehicle sales in 2011), they have found themselves between a rock and hard place with China’s new policy regarding electric cars.5 This policy mandates that foreign firms provide technology transfers to their JV partners in order to have access to the Chinese electric car market.6 Since foreign firms are holding out – not wanting to part with their trade secrets and proprietary information – Chinese firms now have a distinct advantage because the national government is offering nearly a 50% subsidy to consumers for each sale of an electric car in China.78
Let’s discuss this over dinner
As noted in Chapter 1, guanxi, or personal connections, can be a very tricky and hard to fully describe to those who have never lived or worked in China. For example, compared with thirty years ago, contracts are relatively more ironclad in legal disputes – yet the “rule of law” today is not quite the same as it is in Western countries. This presents a challenge to any firm wanting to do business in China and thus building guanxi, personal connections with suppliers and even buyers is sometimes just as important as the resources spent in drafting contracts, subpoenas and lawsuits.
While guanxi can work for you – you might land a deal with a mere handshake at a KTV (Chinese businessmen typically dine and sing in contrast to discussing business deals on golf courses in the West) – not having enough guanxi, or not having guanxi with the right people could prevent your company from exporting your goods to consumers outside of China.9
Can you just “grease some palms” and make things happen? Over cocktails with other laowai it may be common to hear insinuations various businesses that used bribes to improve their guanxi. I should point out that the Foreign Corrupt Practices Act (FCPA) and UK Bribery Act deals specifically with bribery. To better understand this law and its enforcement, it is highly advised that you consult a lawyer because the FCPA is actively enforced and the penalties for violating it are quite stiff. Furthermore, as I mentioned in the first story in Chapter 1, even if you know the right people and make the right connections this does not immediately translate into success.
If you do decide to operate a business in China, what legal structure will you use? Should you try to start up a Wholly Foreign-Owned Enterprise (WFOE), Variable Interest Entity (VIE) or some other joint-venture structure?10 Stephen Dickinson, the Beijing-based American attorney above, has written a number of primers on what legal structures foreign businesses should and should not create. Because of Chinese regulations that prevent foreign ownership of companies from being directly involved in “sensitive” areas of the economy (e.g., for national security reasons), one way to skirt such limitations was to set up a VIE.11 Yet due to new regulations issued last year, VIEs are no longer an option and the SEC itself is rumored to be investigating how they operate as well.12 While this was not particularly surprising to lawyers and serial entrepreneurs, it may have come as a surprise to the uninformed and those who failed to carry out thorough due diligence.
Similarly, during the summer of 2011 several shareholders of Yahoo were ‘surprised’ when the Alibaba Group (owner of Alibaba, Tmall and Taobao) transferred the ownership of Alipay.13 Alipay is an online payment method (similar to Paypal) that is currently the domestic marketshare leader, at 47%.14 According to Chinese law, online payment processing companies cannot be owned by foreigners, something that a VIE structure was considered as a means to get around. What resulted was a high-profile, very vocal series of discussions that headlined the business press for several months between May to July of 2011. The lesson here is that, as Dan Harris noted, this was not unprecedented. His law firm “has been involved in probably a dozen similar matters.”15 So once again, talk to a legal advisor before you set up any kind of presence in China, even if it is as “simple” as a minority shareholder position.
What kind of opportunities are there for legal professionals?
I asked a couple of Chinese lawyers this question. They both quickly noted that experienced practitioners can find a number of opportunities in areas such as FDI and M&A. For example, in addition to Harris & Moure discussed above, King & Wood Mallesons is an international legal firm with offices in China that specializes in more than a dozen areas of law including, Import/Export Credit Facilities, M&A, FDI and PE deals.16 Their foreign expertise allows them to provide services like FDI that local firms – lacking in international experience – sometimes cannot fully provide.
Yet before getting on an airplane with your fresh JD and Bar certifications consider the following challenges. In order to practice on the mainland you need to be licensed in China as well. That means you need to take the National Judicial Exam (国家司法考试) which means you not only need to be fluent in Chinese but because of sovereignty issues, at this time the only people legally eligible for sitting for the exam are citizens from the mainland plus Hong Kong, Macau and Taiwan. For comparison, in the US, each state has its own residency and citizenship requirements. Some such as California and New York currently allow foreign nationals to take their bar exams and set-up practices.17
A frequently asked question from friends overseas is if there are many licensed lawyers in China? Yes. In fact, according to their new 2012 White Paper on judicial reform, the State Council Information Office states that there are nearly 220,000 lawyers and 18,200 law firms in China (this is substantially higher than the 200 lawyers in 1980).1819 These same lawyers acted as counselors for 392,000 clients and handled 2.315 million litigation cases in 2011.
A legal professional I know in New York recently asked me if there is a work-around for this to provide paralegal services instead. Perhaps, but you probably would not be able to access large portions of information that have restricted access. For example, currently in China only licensed lawyers can look up internal business records (e.g., shareholder meeting minutes, the shareholders list, the composition of the board, the balance sheet and other related financial reports). And there are conditions for even licensed lawyers to access this information. Currently, the authority granted to lawyers must be justified by some “reasonable concerns.” Access is allowed only for the appropriate purposes – for example, if a shareholder wants to exercise his inspection right, his lawyer then could claim the right to see the company records on the shareholder’s behalf.20 Similarly, doing investment research on the mainland as a WFOE (Wholly Foreign Owned Entity) is not currently legal.21
In contrast, in the US just about anyone can look up the full company records of any public company. In addition, the domestic legal profession on the mainland has run into a number of barriers that some have called a “clawback” relative to reforms implemented in the 1980s and 1990s.22 Thus the nebulous uncertainty and dynamism for legal professionals is something to consider before establishing a permanent physical presence on the mainland.
Explicit and implicit rules
While many expat companies will set up a Hong Kong office to reduce the tax burden and liability on incomes earned on the mainland (e.g., your workers are paid through the Hong Kong subsidiary and are thus taxed at the lower Hong Kong rates), many Chinese companies also have set up Hong Kong subsidiaries to reduce their tax burden. For example, in the Chinese energy industry, several companies that manufacture hydrocarbon drilling equipment on the mainland will ship and sell (e.g., “export”) their physical products to a Hong Kong controlled subsidiary, and then re-import them. In some cases they can reduce their taxes by up to 20%.23
According to Chinese law, the maximum amount of funds that any individual can move out is $50,000. Thus how to repatriate your assets is another key issue. The Wall Street Journal has published several reports this past year about the labyrinthine difficulties that both Chinese and foreigners face when attempting to move funds outside of China.24 While not explicitly encouraged, the Hong Kong legal system protects certain activities including money transfer agents who essentially move capital across the border. It is highly recommend that you consult with an attorney or tax expert before attempting to do the “Hong Kong shuffle.”25 Failure to do so could result in being (temporarily) arrested, like Yan Suiling – who was accused of money laundering in China (because the process she used is illegal on the mainland) but was later acquitted (because the process she did it by was legal in Hong Kong).26
Another example of legal issues and lawful avoidance involves real-estate purchases.27 In an effort to “cool down” the property market, over the past several years larger cities like Beijing and Shanghai have implemented a number of regulations that place restrictions and “curbs” on individuals purchasing multiple homes.28 This move into multi-home ownership was done in part because strict capital controls prevent domestic savers from investing overseas. As a consequence many savers have few places to park their assets. Depending on the region, one of the areas where they can typically invest more freely is real-estate. So in addition to suppressed (low) interest rates set by the central bank which have incentivized construction projects and capital consumption, many savers in the past decade have had few investment choices and thus have purchased, invested and speculated in real-estate markets.29 And due to a perceived “bubble” in the real-estate market, several cities subsequently enacted laws that make it increasing prohibitive to buy multiple homes (e.g., by increasing down payments from 20% to 50%). In an attempt to legally circumvent this, some prospective home buyers will pool their resources together and purchase housing units in a “group buy” method (e.g., like GroupOn).
Takeaway: While there are numerous opportunities to do business in China there are also a number of challenges, including legal uncertainties. This includes the legality of contracts, movement of assets, protecting IP and lowering tax liabilities. In addition there is a cultural practice called guanxi, or personal connections, which can directly impact many (if not all) business transactions on the mainland. While there may be opportunities for experienced legal professionals to work in niches, before moving to the mainland it is highly recommended that you do your due diligence to find out what specific niches areas are in demand. In addition, all proprietors are encouraged to speak with and perhaps hire a legal counsel that is proficiently versed in both the mainland legal system as well as the culture. Failure to do so may result in being unable to protect your assets and possibly even forfeiting them as well as the market access that your firm had hoped to achieve.
- For their series on protecting your IP in China, see How To Protect Your IP from China from ChinaLawBlog [↩]
- For their discussion on technology transfers and legal statutes in China see How To Handle Chinese Negotiating Tactics. Part Three. from ChinaLawBlog [↩]
- For more regarding legal issues surrounding joint ventures on the mainland see, China Joint Ventures. Watching The Sausage Get Made. from ChinaLawBlog [↩]
- See Japan Inc shoots itself in foot on bullet train from Financial Times and IPR fears won’t derail bullet train exports from China Daily [↩]
- General Motors closest competitor is Volkswagen, who sold 2.81 million cars in 2012 but initiated one of the largest recalls beginning April 2, 2013. See Volkswagen recalls over 384,000 cars in China: watchdog from Reuters [↩]
- General Motors in China: Coping with the Changes in the Automobile Industry from ICMR [↩]
- GM and SAIC join forces on electric cars from Financial Times [↩]
- See Road Gets Bumpy for GM in China from The Wall Street Journal and GM and SAIC’s Open Marriage from China Bystander [↩]
- There are endless amounts of anecdotes retold by colleagues and coworkers over the years. One notable story involves a friend who wanted to buy natural and artificial hair in China and ship it to the US targeted specifically for African hair salons for use as braiding. She spent several hundred hours traveling across Shandong, filing the necessary paperwork, building guanxi, buying hair samples and contacting US hair salons. Yet due to the thin margins, legal fees related to permits, import & export duties on both sides of the Pacific and transportation costs, her business plan would prove to be unprofitable. Thus collecting all of the necessary requirements and doing due diligence is highly recommended before investing any significant capital into an overseas endeavor. [↩]
- For a step-by-step guide on forming an WFOE see China’s Approval Process for Inboud Foreign Direct Investement from the US Chamber of Commerce. See also Forming A China WFOE. How Long Will That Be Going On? from China Law Blog and Selling In And Into China. Four Good Tips And Mine. from China Law Blog [↩]
- VIEs In China. The End Of A Flawed Strategy. From ChinaLawBlog [↩]
- Variable interest entities in China from China Accounting Blog [↩]
- Yahoo gets short end of stick in Alibaba deal from Reuters [↩]
- According to Analysys research and consulting, as of Q2 2012, Alipay leads with 47.3%. This is up from 46.9% in Q4 2011. See Alipay Lead China 3rd Party Internet Payment Market 2011Q4 from Analysys [↩]
- Yahoo/Alibaba/Alipay/Jack Ma/Carol Bratz: What Really Happened And What It All Means. from ChinaLawBlog [↩]
- See Harris & Moure and King & Wood Mallesons [↩]
- See Chart 4 on p. 14 in Comprehensive Guide to Bar Admission Requirements 2012 from National Conference of Bar Examiners [↩]
- See p.5 in Judicial Reform in China from the State Council Information Office [↩]
- China has 220,000 lawyers from China Daily [↩]
- There are other requirements as to the eligibility of the shareholder for claiming the inspection right as well. In addition, the restrictions on this and on accessing full company records will vary city by city. [↩]
- On Doing Investment Research In China As A WFOE. Not Legal. from ChinaLawBlog [↩]
- China’s Turn Against Law by Carl F. Minzner [↩]
- In some ways this is similar to retailers in Western countries that practice “rolling inventory” at the end of the year. Speak with a legal professional before conducting this type of transaction. [↩]
- In Reversal, Cash Leaks Out of China from The Wall Street Journal [↩]
- This issue was directly discussed in Getting Money Out Of China. That’s Illegal. from ChinaLawBlog [↩]
- The Mechanics of Moving Cash Out of China from The Wall Street Journal [↩]
- Another area that may change in the near future is capital gains tax on returns for private equity firms investing in China. See Tax Experts: China May Crack Down on Capital Gains from The Wall Street Journal [↩]
- Property curbs to stay from Global Times [↩]
- One of the reasons this rate incentivizes real-estate speculation is that the interested earned at a bank is usually lower than CPI or inflation. Thus merely placing funds into a savings account will actually net a loss once adjusted for inflation. Readers may also be interested in the analysis from Michael Pettis, a finance professor at Peking University and Patrick Chovanec, a finance professor at Tsinghua University as well as Animal Spirits with Chinese Characteristics by Mark DeWeaver. [↩]