Chinese Regulation of Foreign Business James V. Feinerman James M. Morita Professor of Asian Legal Studies Georgetown University Law Center.

Chinese Regulation of Foreign Business

James V. Feinerman

James M. Morita Professor of Asian Legal Studies

Georgetown University Law Center

Introduction

Foreign Trade Foreign Investment in China China Investment Abroad Customs Commodity Inspection Taxation Civil & Criminal Laws Technical Standards of Different Countries International Practices & Treaties

China: Basic Facts

2004 GDP: $1.65 Trillion (7th in the World) 2004 PPP-Adjusted GDP: $7.26 Trillion (2nd in

the World) Average GDP Growth from 1992-2004: ~ 9.0% Projected 5-Year GDP Growth Average: 7.8%

(2X > U.S.) 2004 Foreign Direct Investment: $61 Billion

Selected 2004 FDI Recipients (Source: UNCTAD)

Destination Amount % change WORLDWIDE $648 Billion Up 2% AFRICA $18 Billion No

Change LATIN AMERICA $68 Billion Up 45% ASIA $148 Billion Up 47% EUROPEAN UNION $216 Billion Down

36% USA $96 Billion Up 68% INDIA $5 Billion Up 25% HONG KONG $34 Billion Up 143% CHINA $61 Billion Up 13%

Look Before You Leap

Market Access -- Restrictions and Investment Vehicles Intellectual Property Protection Legal System/Dispute Resolution/Corruption Foreign Exchange/Taxation Guanxi = “Connections” Dealing with State-Owned Enterprises Financial Transparency/Hidden Liabilities Employees and Employment Law Matters Land/Real Estate Corporate Governance and Corporate Culture Local vs. National Issues (local protectionism)

Brief History of Foreign Investment

Tight government control and “special treatment” of foreign investors moving towards loosening of control in light of World Trade Organization (WTO) agreements

1970’s: first foreign investment laws Foreign Invested Enterprises (FIEs) in distinct legal category More government control, but some special privileges

• Late 90’s and 00’s: New M&A and FIE laws -- Provisional Measures on Domestic Investment by Foreign Invested Enterprises (2000) -- Rules on Merger and Division of Foreign Invested Enterprises (1999, amended in 2001) -- Investment Regulations/Investment Catalogue (2002)

Current Investment Framework (1)

Important Sectors of China’s Economy Initially (Some Remain) Closed to Foreign Investment

Pre-WTO Liberalization Increases Availability of Wholly Foreign Owned Enterprises vs. Joint Ventures

Government Approval at Local, Provincial or National Level Required for All Investments

Level of Government Approval Depends on Amount, Location and Nature of Proposed Investment

Current Investment Framework (2)

Special Economic Zones (SEZ’s) Provide Additional Flexibility/Advantages, e.g., Pudong Waigaoqiao

Foreign Investment and Economic Development Concentrated on East Coast

Tax Advantages for Certain Foreign Invested Enterprises, but Regulations are Complex

RMB Still Not Fully Convertible (swap markets)

Market Access Foreign investment catalogue – 4 Categories

Encouraged Restricted Prohibited Unlisted = Permitted

Business scope narrowly defined WTO concessions

Improve trade & foreign investment environment Open new service sectors to foreign investment Modify intellectual property rights and technology

transfer rules Reduce tariffs and non-tariff barriers

New Foreign M&A Regulations Percentage restrictions Mandatory asset appraisals set floor on purchase

price Protection of existing creditors/guaranty of

payment Requirement for public notice Labor issues

“Employment Settlement Plan” approved by authorities Certain acquisitions must be approved by labor

organization Purchase Price

Form of consideration flexible Payment within prescribed period after approvals

Growth Factors for M&A Investments

Fast-growing number of qualified “target companies”

Foreign investors’ increasing interest in existing Chinese businesses instead of greenfield investments

State-owned companies being privatized Chinese companies seeking international

financing/tech expertise Global capital markets looking for “China

concept” Potential increase in China asset values if RMB

is revalued upward

Investment Vehicles (1)

Representative officeEquity joint venture (“EJV”)Cooperative joint venture (“CJV”)Wholly foreign-owned enterprise (“WFOE”)Limited Liability CompanyJoint Stock CompanyOthers (e.g., Holding Company, Branch

Office, Limited Partnership, Processing/Contractual Arrangements)

Investment Vehicles (2)

Representative Office• Quick to set up – registration vs. approval• Permitted activities include liaison, promotion, research, technical support• Not “really” permitted to engage in business, but 10% tax on deemed business income

Joint Ventures• Equity Joint Venture (EJV) used to be more common• Cooperative Joint Venture (CJV) can be more

flexible in structure, repatriation of investment, sharing of profits, etc.

Investment Vehicles (3)

Joint Ventures vs. WFOE Joint Ventures

Pros (1) Greater range of investment areas (2) Easier government approval (3) Operational facilities / infrastructure in place (4) Access to market, customers, etc.

Cons (1) Misunderstandings possible (2) IP protection concerns (3) Complicates exit strategies

Investment Vehicles (4)

Wholly Foreign Owned vs.JV Wholly Foreign-Owned Enterprises

Pros (1) No Chinese partner or JV Contract (2) Simple to establish (3) Better IP protection (4) Better integration with parent company

Cons (1) Legal and regulatory restrictions (2) Lack of existing sales and distribution network (3) No production site and workforce (4) Lack of local “guanxi”

Investment Vehicles (5)

Limited Liability Company Governed by Board of Directors subordinate to

equity owners Registered capital must be contributed in a lump

sum Profits must be shared in proportion to equity

contributions Perpetual existence Two-thirds majority to approve major issues Lack of implementing regulations hinders use by

foreign investors

Investment Vehicles (6)

Joint Stock CompanyMost closely resembles U.S. corporationOwnership represented by issued share

capitalTheoretically able to list on Chinese or

foreign stock exchange and issue debt instruments

Limited foreign participation due to complex requirements and approvals

Selecting the Chinese Partner

While foreign companies are increasingly likely to establish wholly foreign-owned enterprises in the PRC, most still seek a Chinese co-venturer. Typical reasons to opt for a joint venture include:

Chinese policy discourages or prohibits wholly foreign-owned enterprises in the sector in question.

The Chinese partner holds a dominant market position, which the proposed joint venture will inherit.

The Chinese partner has a distribution network, assets, relationships, or other advantages that will permit the joint venture access to markets, raw materials or quotas.

Due Diligence: Overview

Investor's first line of protection -- thorough business and legal due diligence

Experienced international businesspeople appear to ignore this basic tenet when investing in China

Professional due diligence in the PRC presents peculiar challenges less reliable information than foreign investors are used to obscure and volatile state of China's legal system Chinese companies’ lack of familiarity (and patience) with corporate

formalities and record keeping great breadth of authority afforded to China's bureaucracy.

Due Diligence: Key Points

Nature and Powers of the Partner Financial Records Employees Contractual Obligations Tax Ownership of Assets

Transition Issues for Transfers of Existing Facilities into Joint Ventures

If existing plant or facility will become part of the joint venture: mechanics and details of this transfer appendix listing all of the Chinese partner's assets and liabilities that are to

be transferred to the new entity land use rights, buildings and other fixed assets

"allocated" or "granted" state-owned land use rights Allocated land is transferred to the user for free (annual land use tax) user has no right to transfer; state may recover the land at any time

without paying compensation. When land is "granted," the user pays the state a land grant premium for

the right to use it for a stated period of years granted land use right is transferable (including by mortgage and lease),

and may not be abrogated by the state (except for compensation in the exercise of its right of eminent domain

inventory, receivables, intangibles and contractual rights

Valuation Issues – Cash and In-Kind

relative value of parties' contributions determines shares of profits value of non-cash contributions is usually a hotly-negotiated issue (Chinese

contributions in-kind; foreign usually cash or combination) value of such contributions must be set forth in the capital contribution

section of the joint venture contract non-cash contributions by foreign parties must also be valued by the State

Import and Export Commodities Inspection Administration actual contribution of both cash and non-cash inputs must be verified by a

licensed PRC accounting firm state-owned assets (such as assets owned by state enterprises) must be

valued by a valuation firm licensed by the State Assets Management Bureau localities have standards to value land use rights; foreign investors should

investigate whether Chinese side’s valuation falls within the official range investors should bear in mind that the official guidelines assume granted

land use rights rather than allocated land use rights.

Other Issues

Registered Capital Minimum of 1/3 total capital; cannot be reduced

Conditions to the Effectiveness of JVs Transfer of property Contribution of assets Necessary approvals

Feasibility Studies – Prior Approval Mandatory Objectives; sources of investment; sources of foreign exchange and

raw materials; site; technology requirements Economic benefit analysis; financial projections Labor requirements Marketing plans; distribution; export percentages; forex balancing

Non-competition clauses Geographic Product line(s) Marketing plans; distribution

Chinese Law Opinion Letters

Off-shore Holding Structures

Most foreign investors prefer to conduct their Chinese investments through a series of offshore, single purpose, limited liability companies:

Permits investors to limit China project liability to one offshore entity

Facilitates future transfers of the investment Where there are multiple foreign investors in a JV,

foreign parties may work out the details of their cooperation in a shareholders agreement

Chinese JV law does not provide for more complex corporate capital structures, such as preferred stock, redemption rights, or the like

Exit Strategies Most investors in China are strategic investors –

manufacturing firms wishing to establish long-term production facilities to service China and Asian regional markets.

They typically are not greatly concerned about the mechanics or financial consequences of disposing of their investments,

Growing group of financial investors in China investment funds, merchant banks, other financial institutions.

These investors are keenly interested in strategies for tax-efficient exit from their investments within a set time horizon.

Intellectual Property

IP Rights Violations Remain a Serious Threat IP violations are widespread in China

Infringing/counterfeiting (20%+ of consumer products) Piracy (90%+ of movies, software, games, books) Imitation of product designs IP theft by employees/partners

In the US, Canada, Japan and the EU, China is the No. 1 source of seizures of infringing goods

China government entities may acquiesce in infringing activities Local governments (sole source of funds and salaries for local

courts and judges) protect local taxpayers and employers National government determined to advance China’s technology

Intellectual Property Enforcement (1)

China IP Legal Enforcement - Dual Track System

Administrative EnforcementSpecial enforcement task forces in

administrative agenciesJudicial Enforcement

Civil litigation: IP tribunals in intermediate people’s courts to hear cases

Criminal prosecution for IP crimes

Intellectual Property Enforcement (2)

Administrative Enforcement More effective for Trademark infringement and counterfeiting

complaints than patent or copyright infringement – over 73,000 proceedings in 2004

No real equivalent in U.S. or other Western countries Fast in taking action and cost-effective More domestic parties than foreign parties use this system Administrative IP agencies participate in enforcement – “ public

interest” required in copyright cases Some agencies may conduct raids, confiscate infringing goods,

destroy equipment for making infringing goods, and impose fines Agencies may examine and copy infringer’ s accounting records Agencies cannot award infringement damages – aggrieved party

must file an infringement suit in courts to seek damages

Intellectual Property Enforcement (3)

Judicial Enforcement Civil Enforcement – 2004

9,323 IP cases filed (about 35% increase over 2003, comparable to U.S. - 9,558)

4,264 copyright cases (more than U.S. - 3007) 2,549 patent cases (comparable to U.S. - 3055) 1325 TM cases (fewer than U.S. - 3,496) 630 technology contract disputes 555 “others”

Criminal Enforcement -2004 653 individuals convicted for IP crimes 385 criminal cases

Intellectual Property Enforcement (4)

Foreign Party Practical Strategies Early filing necessary to protect rights Trademarks and Copyrights Utility and Invention Patents Design Patents Ensure the quality of Chinese translations and patent prosecution in

China Undertake careful due diligence on potential partners Aggressively monitor for infringements and take steps to enforce rights

before infringement spreads Require confidentiality/non-compete agreements with employees and

partners (BUT limited enforceability) Formulate proper investment and corporate structure in China Enlist political/media support – you may have Chinese allies!

Intellectual Property -- Conclusions

China’s IP Laws “Closing in” on International Standards IP Enforcement in China -- “Work In Progress” Foreign Companies Should File and Protect IP in China

Patents Trademarks and copyrights Non-compete and confidentiality agreements

Foreign IP Owners Can Successfully Enforce IP in China Don’t be afraid to sue in China Don’t wait too long – two year statute of limitations Choose counsel carefully