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Business Law Today

Are you ready for China?
The world economy has a new player
By Paul W. Boltz Jr.
Your client is considering investing in a Chinese company. Or your client may be a Chinese company venturing overseas for the first time. What does that entail? Prepare for a lesson in the New World Order.

In its 11th Five-Year Plan, announced in 2006, the Chinese government said that it intends to pursue a variety of policies designed to achieve a balance in five areas of Chinese society:
  • growth in domestic consumption and exports to international markets,
  • development of inland and coastal areas,
  • development of rural and urban areas,
  • promotion of a harmonious society and economic growth, and
  • the needs of both the environment and man.
This shift in focus from "growth at any cost" to a balance of economic and noneconomic interests signals an important shift in the leadership's thinking and will likely have long-lasting ramifications for China. The promotion of a harmonious society as a national goal also signals, at least in part, the government's concern over the widely reported uprisings by local citizenry throughout China over unjust treatment by companies or governmental authorities.

If this directive can be implemented in a meaningful way (an admittedly big "if" in an environment as complex as today's China), it could represent the first major revision to the late Deng Xiaoping's famous words "to get rich is glorious," which ignited China's economic opening to the world more than 25 years ago. It appears that the new aphorism may soon become "to get rich is glorious as long as society doesn't unravel."

While the 11th Five-Year Plan will undoubtedly affect China's economic and social development for the foreseeable future, it masks numerous other, more subtle, tensions in the Chinese capitalist system. These tensions — encompassing an array of competing government interests, as well as economic and social trends — directly shape the way Chinese companies operate, affecting everything from their corporate structure to their day-to-day operations and long-term planning.

These various tensions are felt all the more acutely by China-based companies, including both companies incorporated in China and offshore holding companies of Chinese businesses, when they list overseas. Following listing, they are often subject to much more rigorous regulations and governmental supervision than those within China. But, one might ask whether enough companies are in this situation to make this topic particularly relevant. Well, consider the following:
  • Hong Kong, which maintains and enforces its own securities regulatory regime separate and apart from Mainland China, is the most popular destination for overseas listings by China-based companies because of a number of factors, including physical proximity, investor support and Hong Kong's sophisticated financial infrastructure. On Oct. 31, 2006, the Main Board of the Hong Kong Stock Exchange had a total market capitalization of approximately U.S. $1.46 trillion, making it the world's 7th largest stock exchange. China-based companies accounted for 43 percent of this amount.

    Although compliance costs and litigation risk have increasingly become deterrents to going public in the United States in recent years, the U.S. markets remain a highly desirable destination for many China-based companies due in large part to potential higher valuations, larger investor base and deeper liquidity than is available in many other countries, as well as a prestige factor that remains strong in China. There are now more than 40 China-based companies trading on the New York Stock Exchange and Nasdaq, with dozens more companies trading on the American Stock Exchange, over-the-counter or on the "pink sheets." This is more than the total number of companies from France, Germany and Italy that are public in the United States.
  • The London Stock Exchange's AIM market, which was started in 1995 and caters to small, growing companies, has become an important market for China-based companies. Currently, more than 30 China-based companies trade on AIM.

    The proliferation of offshore listings by China-based companies heightens the importance of understanding the various tensions in China, which each in its own way has the potential to profoundly affect such companies' businesses and financial results at any time.

    For example, one of the most fundamental tensions arises from the conflict between the Chinese government's periodic policy initiatives and the realities of China's hyper-capitalism. The Chinese government's continued use of the term "five-year plan" conjures up Cold War era images of millions of workers being mobilized to build massive factories and other grandiose government projects.

    The fact that China still uses such plans as broad policy blueprints suggests that China remains a command-and-control economy and is continuing its experiment with "socialism with Chinese characteristics," which is the Communist Party's way of explaining how Marxism is not incompatible with the adoption of certain free market principles.
The reality is far different. Estimates as to the relative size of the private sector in China vary widely, but a quick stroll through any major Chinese city will confirm that the private sector is a big and growing part of the Chinese economy. In fact, a major portion of China has already entered a phase of "hyper-capitalism" where almost every type of compliance issue from worker safety to accurate labeling of products can, to varying degrees, take a back seat to profit growth. While the breadth of China's economy makes generalizing about corporate behavior difficult, it is fair to say that many China-based companies operate on a day-to-day basis with a lot fewer restrictions than companies in the United States despite the existence of numerous laws and regulations in China.

The result of this hyper-capitalist environment is that no one can predict if the Chinese leadership will actually implement the objectives stated in their five-year plan if, in turn, that means reining in the free-wheeling, high-growth portion of the economy. China's recent experience in attacking official corruption, which is an oft-stated goal of the government but has produced sporadic results, suggests that the leadership can no longer assume its edicts will produce tangible results.

For lawyers advising China-based companies that are listed overseas, this tension can create a range of problems that often have no clear solution. One typical scenario would arise if, for example, in order to promote a harmonious society as called for by the 11th Five-Year Plan, the government were to adopt new rules requiring companies to accrue a percentage of their profits to make minimum disability payments to workers injured on the job, who often now receive little or no compensation even for life-threatening injuries.

Let's further assume that you discover from your China-based overseas listed client that it has no intention of making any accruals or payments for disabled workers. Your client explains that it is an open secret that most companies are ignoring this directive, and your client does not want its profitability affected.

What should international legal counsel do in this entirely plausible situation? If the noncompliance could have a material effect on your client's business and your client fails to publicly disclose this risk, it could be subject to investigations and various forms of punishment by the applicable overseas securities regulator, as well as lawsuits from shareholders. On the other hand, full disclosure could make your client a target for government investigation and punishment in China.

Laws in China are sometimes drafted in a vague manner. Consulting with the local governmental authority that has responsibility for enforcing the law in the client's province or locality to clarify whether the company's inaction is punishable under the new law is one option. Many government offices are accustomed to being consulted about specific corporate questions.

Yet, as with other countries, asking three different officials will often yield three different answers. Moreover, in China, local governmental authorities can easily reverse their positions, even when the prior position was provided in writing.

As a practical matter, the fact that Chinese laws are not entirely clear in their meaning can justify a middle approach where the noncompliance is publicly disclosed, along with an explanation that it could possibly expose the company to various forms of punishment although the company cannot be certain because of the law's ambiguity. Nonetheless, even with such an approach, the company is operating in a gray area.

Another important tension springs from the Chinese government's sometimes inconsistent attitude toward foreign investment. Ever since the government opened its economy in 1978, it has allowed — and in many cases actively encouraged — foreign capital into China through venture capital, private equity and foreign direct investment. Yet, this cross-border investment activity creates considerable tension with the Chinese government's general preoccupation with understanding and controlling capital flows in and out of the country for macroeconomic and tax purposes.

Venture capital is one area of foreign investment that has been particularly problematic for the Chinese government. Foreign venture capitalists are often resistant to investing in companies incorporated in China for a variety of reasons.

These include the fact that China's Company Law makes it difficult for domestically incorporated companies to issue stock options — which is commonly used to retain and motivate key employees as in the United States — and that investors' "exits" from investments in such companies through an M&A transaction or IPO can be more complicated for a domestic company.

Accordingly, venture capitalists, as well as private equity investors, will usually require that the domestic company form an offshore holding company (typically in an offshore haven such as the Cayman Islands or the British Virgin Islands), into which the investors will place their money and receive shares. This offshoring activity has, in many respects, moved the funding and control of domestic assets out of reach of the Chinese government.

The government historically could not see the shareholding structures of the offshore companies or when or how they engaged in significant corporate transactions such as offshore IPOs. It also allowed Chinese shareholders to move their equity ownership outside of China and China's tax laws, which like the United States taxes its citizens on worldwide income but unlike the United States has limited means to enforce tax laws extra-territorially.

The resulting tension culminated in China's foreign exchange regulators in the first half of 2005 requiring approval of the establishment of offshore holding companies by persons in China and of previously established offshore holding companies. With approvals difficult to obtain, the practical effect of this requirement was to nearly halt foreign venture capital activity in China until the government realized it had perhaps overshot the mark.

In October 2005, the government announced that it would only require informational filings, rather than substantive approvals, when offshore structures are implemented and with updated filings to be provided when there are changes to the company's shareholding structure or other specified corporate events.

More recently, a group of Chinese ministries, including the powerful Ministry of Commerce — which is one of the principal ministries that regulates foreign investment in China — have jointly introduced new regulations that give government officials substantial leeway to block, among other things, offshore restructuring activities initiated to facilitate an overseas listing.

The new rules also apparently reintroduce the requirement that had been eliminated five years ago that Chinese companies, as well as the offshore listing vehicles of Chinese companies, may need to obtain approval of the Chinese Securities Regulatory Commission before listing overseas. Because these regulations are so new and their meaning is unclear, it is too soon to tell their long-term effect on Chinese companies seeking to list outside of China.

While there are hopes that the Chinese government will reduce capital controls and other legal restrictions over time, these recent developments show that the Chinese regulatory environment is subject to extreme and abrupt changes. Accordingly, local Chinese and international legal counsel must devote significant time to devise investment structures that comply with the ever-changing foreign exchange and investment laws.

In turn, China-based companies listed overseas must continually educate and update their shareholders on these risks, which are quite distinct from the typical risks facing companies operating in the United States and many other developed countries.

The Chinese government also faces a similar dilemma with its high-tech industry, the promotion of which has been a long-term economic priority for China. By most measures, this focus has worked extremely well, with Chinese manufacturers becoming increasingly competitive in a variety of high-tech industries, including semiconductor design and manufacturing, medical device production as well as software development.

Along with the boom in high-tech manufacturing, however, there has been tremendous growth in high-tech industries that facilitate the exchange of information, particularly wireless and Internet services. According to China's Ministry of Information Industry, as of Sept. 30, 2006, there were more than 443 million cell phone users in China, making it the largest cell phone market in the world. There were also more than 123 million Internet users in China as of June 30, 2006, according to the China Internet Network Information Center.

People's interconnections through e-mails, instant messaging, wireless text messaging and other technologies pose a direct challenge to the Chinese government's ability to control information. One well-known response to this challenge was official pressure on U.S. Internet companies such as Yahoo! and Google to screen their content for Chinese users.

The Chinese government also takes numerous other steps on the ground to maintain control including shutting down Web sites and banning wireless services for improper content. Many of China's overseas listed companies operate in these industries, including portals NetEase, Sohu and Sina and wireless service providers Linktone, Hurray!, KongZhong and Tom Online (all of which are listed on Nasdaq), and have been affected in various ways by these government actions.

Some investment bankers and legal counsel will, in the course of due diligence for an IPO or other transaction, attempt to audit the content of a service provider to determine if it is permissible. There are inherent limitations to the effectiveness of this type of diligence given that "improper content" is an amorphous concept. Moreover, many of these companies offer an enormous amount of content, some of which is prepared and distributed on a continuing basis by the users themselves.

As a result, due diligence is often better devoted to discussing with company management what guidance they have received from governmental authorities regarding the meaning of improper content and what systems they have put in place to ensure that content is adequately supervised. In turn, to effectively deal with securities regulators and shareholders of overseas listed companies, international legal counsel has a key role in developing a comprehensive understanding of the tensions that affect information-based, high-tech industries to create robust public disclosure.

While diligent lawyers and robust public disclosure can go a long way to addressing a number of the major tensions in China, some require a more comprehensive review of the way companies operate there. For example, perhaps the most common complaint of China-based companies that are listed overseas is that it is impossible to effectively compete in China while strictly observing all domestic and foreign anti-corruption laws. Subsidiaries and joint ventures of U.S.-based companies that operate in China often make this complaint as well.

Corruption in China is a significant issue, and it can take every form imaginable. China has adopted extensive anti-corruption laws that carry significant penalties, including potentially death for people convicted of accepting bribes or mishandling state-owned assets. But, enforcement of these laws is uneven and perceived to be driven more by political concerns than a genuine effort to cleanse the system.

In this environment, many China-based companies simply conclude that a certain amount of corruption is necessary to remain competitive, and they are willing to live with the risk of possible government action against them.

China-based companies that are listed overseas, particularly in U.S. markets, have a heightened burden of complying with foreign anti-corruption laws such as the U.S. Foreign Corrupt Practices Act (FCPA) which applies to any company whose shares are publicly traded in the United States. For these companies, corrupt conduct not only exposes the company to the risk of punishment by the Chinese authorities, but also to FCPA enforcement actions by the Securities and Exchange Commission (SEC) and Department of Justice (DOJ) as well as class-action litigation.

Companies in this situation face difficult choices. If a company's management and board of directors decide not to probe too deeply into, for example, how their sales managers in the field in China spend large discretionary expense accounts in a kind of "don't ask, don't tell" policy, then the company can never fully assess the nature or size of its risk exposure.

On the other hand, companies may become aware of questionable conduct within their organization, but stopping it may render the company uncompetitive. The argument that shareholders are better served by continuing the conduct rather than causing the company's business to fall apart can be very compelling to management and directors in this situation, although courts and regulators such as the SEC and DOJ are unlikely to be impressed with this logic.

The problem is exacerbated by the fact that even if the management and board of directors want to eliminate corrupt activity within their company, some corrupt practices may be so pervasive in their region or industry or in China generally that company staff may not realize that the practices are impermissible. Accordingly, the staff may not make a connection between the specific conduct at hand and the company's corporate policies on observing anti-corruption laws and reporting questionable conduct up-the-ladder within the company.

International legal counsel obviously cannot change the way business is conducted in China. Nonetheless, a focus on practical preventive measures can go a long way to avoiding future problems, particularly with respect to conduct that staff may not be aware is corrupt. Specifically, preparation of clear, easy-to-understand codes of conduct and other corporate policies and continuous training of management and staff, with specific examples that address the day-to-day situations that staff commonly face in China, can be cost-effective tools for promoting compliance.

Of course, this is just a small sampling of the numerous tensions at work in China. Many more words could be written on other tensions, including the government using state-controlled companies to affect public policies vs. the interests of overseas shareholders and rapid modernization and expansion of legal framework vs. arbitrary interpretation and enforcement. Moreover, all of these issues are subject to such rapid change that it is impossible to predict what companies' biggest concerns will be even just a few weeks or months from now.

The intersection of these numerous tensions with overseas securities and anti-corruption laws is an interesting area of practice for a lawyer as I have discovered first hand. Is China's unique brand of capitalism heading in the right direction from a legal compliance perspective?

I am cautiously optimistic that as China's economy and legal system continue to mature, coupled with China's integration with the world economy, the tensions will gradually lessen. Investors need to bear in mind, however, that an investment in a China-based company is in effect an investment in the entire Chinese system.
Boltz is a partner at Morrison & Foerster in Hong Kong. His e-mail is pboltz@mofo.com.

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