Chinese Regulation of Foreign Business

Chinese Regulation of Foreign Business - 2008 James V. Feinerman James M. Morita Professor of Asian Legal Studies Georgetown University Law Center

Introduction l l l l l Foreign Trade Foreign Investment in China Chinese Investment Abroad Customs Commodity Inspection Taxation Civil & criminal law Technical standards of different countries International Practices & Treaties

China: Basic Facts l 2006 GDP: $2. 668 Trillion (4 th in the World) l 2006 PPP-adjusted GDP: $10. 048 Trillion (2 nd in the World) l Average GDP Growth past decade: 10% l Projected 5 -year GDP Growth Average: 10% (almost 3 x US!) l 2006 Foreign Direct Investment: $63 Billion

Selected 2006 FDI Recipients (Source: UNCTAD) l l l l l Worldwide Africa Latin America Asia European Union USA India Hong Kong China $1. 230 Trillion $ 38. 8 Billion $ 99 Billion $ 229. 9 Billion $ 549 Billion $ 177. 3 Billion $ 9. 5 Billion $ 41. 4 Billion $ 70 Billion

Look Before You Leap l l l Market Access – Restrictions and Investment Vehicles Intellectual Property Protection Legal System/Dispute Resolution/Corruption Foreign Exchange/Taxation Guanxi 关系 = Connections Dealing with State-owned Enterprises Financial Transparency/Hidden Liabilities Employees and Employment Law Matters Land/Real Estate Corporate Governance and Corporate Culture Local v. National Isssues (local protectionism)

Brief History of Foreign Investment Tight government control and “special treatment” of foreign investors moving towards loosening of control in the light of WTO agreements l 1970 s first foreign investment laws l l Foreign Invested Enterprises (FIEs) a distinct legal category More government control, but some special privileges Late 90 s and 00 s: New M&A and FIE laws l l l Provisional Measures on Domestic Investment by Foreign Invested Enterprises (2000) Rules on Merger and Division of FIEs (1999, amended 2001) Investment Regulations Investment Catalog (2002 – new updates)

Current Investment Framework (1) Important Sectors of China’s Economy Initially (Some Remain) Closed to Foreign Investment l Pre-WTO Liberalization Increases Availability of Wholly Foreign-Owned Enterprises (WFOEs) vs. Joint Ventures (JVs) l Government Approval at Local, Provincial or National Level Required of all Investments l Level of Government Approval Depends on Amount, Location and Nature of Proposed Investment l

Current Investment Framework (2) Special Economic Zones (SEZs) Provide Additional Flexibility/Advantages, e. g. , Shanghai Pudong Waigaoqiao) l Foreign Investment and Economic Development Concentrated on East Coast l Tax Advantages for Certain Foreign Invested Enterprises, but Regulations are Complex l RMB Still Not Fully Convertible (swap markets; now bank account convertible) l

Market Access l Foreign Investment catalogue – 4 Categories l l Encouraged Restricted Prohibited Unlisted = Permitted Business Scope Narrowly Defined l WTO Concessions l l l Improve trade & foreign investment environment Open new service sectors to foreign investment Modify intellectual property rights and technology transfer rules Reduce tariff and non-tariff barriers

New Foreign M&A Regulations l l l Percentage restrictions Mandatory asset appraisals set floor on purchase price Protection of existing creditors/guaranty of payment Requirement for public notice Labor issues l l l “Employment settlement plans” approved by authorities Certain acquisitions must be approved by labor organizations Purchase price l l Form of consideration flexible Payment within prescribed period after approvals

Growth Factors for M&A Investments l l l Fast growing number of qualified “target companies” Foreign investors’ increasing interest in existing Chinese businesses instead of greenfield investments State-owned being privatized Chinese companies seeking international financing/tech expertise Global capital markets looking for “China concept” Potential increase in China asset values as RMB is revalued upward

Investment Vehicles (1) l l l l Representative office Equity joint venture (“EJV”) Cooperative joint venture (“CJV”) Wholly foreign-owned enterprise (“WFOE”) Limited Liability Company Joint Stock Company Other forms (e. g. , Holding Company, Branch Office, Limited Partnership, Processing/Contractual Arrangements)

Investment Vehicles (2) Representative Office l Quick to set up – registration v. approval l Permitted activities include liaison, promotion, research, technical support l Not “really” permitted to engage in business, but 10% tax on deemed business income Joint Ventures l Equity Joint Ventures (EJV) used to be more common l Cooperative Joint Ventures (CJV) can be more flexible in structure, repatriation of investment, sharing of profits, etc.

Investment Vehicles (3) Joint Ventures v. WFOE Joint Ventures l Pros l l l Greater range of investment areas Easier government approval Operational facilities/infrastructure in place Access to market, customers, vendors, etc. Cons l l l Misunderstandings possible IP protection concerns Complicated exit strategies

Investment Vehicles (4) WFOEs v. JVs Wholly Foreign-Owned Enterprises l Pros l l l No Chinese partner or JV contract Simple to establish Better IP protection (or less piracy) Better integration with parent company Cons l l Legal and regulatory restrictions Lack of existing sales and distribution network No production facilities or workforce Lack of local guanxi 关系

Investment Vehicles (5) Limited Liability Company l Governed by Board of Directors subordinate to equity owners l Registered capital must be contributed in a lump sum l Profits must be shared in proportion to equity contribution l Perpetual existence (potentially) l Two-thirds (2/3) majority to approve major issues l Lack of implementing regulations hinders use by foreign investors

Investment Vehicles (6) Joint Stock Company l Most closely resembles US corporation l Ownership represented by issued share capital l Theoretically able to list on Chinese or foreign stock exchange(s) and issue debt instruments (BUT quota system) l 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 include: l Chinese policy discourages or prohibits wholly foreignowned investment in the sector in question; l The Chinese partner holds a dominant market position, which the proposed joint venture will inherit; l 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 l Experienced international businesspeople appear to ignore the basic tent when investing in China l Professional due diligence in China presents peculiar challenges: l l l 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 China’s bureaucracy

Due Diligence: Key Points l Nature and Powers of the Partner l Financial Records (all sets of books) l Employees l Contractual obligations l Tax l Ownership – and division – of Assets

Transition Issues for Transfers of Existing Facilities into Joint Ventures If existing plant of facilities will become part of the JV: l Mechanics and details of this transfer l Appendix listing all of the Chinese partner’s assets and liabilities that are to be transferred to the new entity l Land use rights, buildings and other fixed assets l l l “allocated” or “granted” state-owned land use rights Allocated land is transferred to the use for free (annual land use tax) User has no rights to transfer; state may recover the land at any time without paying compensation For granted land, the used pays the state a land grant premium for the right to use it for a stated period of years Granted land use rights are 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 l l l l Relative value of parties’ contributions determines share of profits Value of non-cash contributions is usually a hotly negotiated issue (Chinese contributions usually in-kind; foreign usually cash or combination) Value of non-cash contributions must be set forth in the capital contribution section of the JV 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 l Registered Capital l l Conditions to the Effectiveness of JVs l l l l 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 l l Transfer of property Contribution of assets Necessary approvals Feasibility Studies – Prior Approval Mandatory l l Minimum of 1/3 total capital; cannot be reduced 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: l Permits investors to limit China project liability to one offshore entity l Facilitates future transfers of the investment l Where there are multiple foreign investors in a JV, foreign parties may work out the details of their cooperation in a shareholders’ agreement l 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 l They typically are not greatly concerned about the mechanics or financial consequences of disposing of their investments l Growing group of financial/portfolio investors in China l l l 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 l IP violations are widespread in China l l Infringing/counterfeiting (20%+ of all consumer products) Piracy (90%+ of movies, software, games, books) Imitation of product designs IP theft by employees/partners In the US, Canada, Japan and EU, China is the No. 1 source of seizures of infringing goods l Chinese government entities may acquiesce in infringing/counterfeiting activities l l l Local governments (sole source of revenue and salaries for local courts and judges) protect local taxpayers and employers National government determined to advanced China’s technological progress by whatever means

Intellectual Property Enforcement (1) l China IP Legal Enforcement – Dual Track System l Administrative Enforcement l Special enforcement task forces in administrative agencies l Judicial Enforcement Civil litigation: IP tribunals in intermediate people’s courts to hear cases l Criminal prosecution for IP crimes l

Intellectual Property Enforcement (2) l Administrative Enforcement l l l l More effective for trademark infringement and counterfeiting complaints than patent or copyright infringement – over 73, 000 proceedings in 2004 No real equivalent in US 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 counterfeiting 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 l Civil Enforcement – 2004 statistics l l l l 9, 323 IP cases filed (35% increase over 2003; comparable # in US – 9, 558) 4, 264 copyright cases (more than US – 3007) 2, 549 patent cases (comparable to US – 3055) 1, 325 trademark cases (fewer than US – 3, 496) 630 technology contract disputes 555 “others” Criminal Enforcement – 2004 statistics l l 653 individuals convicted for IP crimes 385 criminal cases

Intellectual Property Enforcement (4) Practical Strategies for Foreign Parties l Early filing necessary to protect rights l Trademarks and Copyrights l Utility and invention patents l Design patents l Ensure the quality of Chinese translations and patent prosecution in China l Undertake careful due diligence on potential partners l Aggressively monitor for infringements and take steps to enforce rights before infringement spreads l Require confidentiality/non-compete agreements with employees and partners (BUT limited enforceability) l Formulate proper investment and corporate structure in China l Enlist political/media support – you may have Chinese allies!

Intellectual Property – Conclusions China’s IP Laws “closing in” on international standards l IP enforcement in China – still a “work in progress” l Foreign companies should file and protect IP in China l l l Patents Trademarks and copyrights Non-compete and confidentiality agreements Foreign IP owners can successfully enforce IP rights in China l l l Don’t be reluctant to sue in China Don’t wait too long – two-year statute of limitations Choose counsel carefully

Chinese Regulation of Foreign Business — 2008 James