Doing Business in China After Its Entry into WTO

By Zhi-Ying James Fang, Esq.

China, with more than one fifth of the world's population, is due to become the 142nd member of the World Trade Organization next year. China's entry into WTO will no doubt lead to an increasingly unfettered exchange of ideas and commerce between China and the rest of the world, and offer greater investment and business opportunities to foreign companies. For U.S. companies that wish to benefit from such opportunities, the China market is exciting and alluring. It is crucial, however, for such companies to understand the Chinese economic and legal landscape both as it exists now and as it may be affected by China's entry into the WTO, in order to make the correct investment choices that not only suit their strategic needs but also are feasible in an unfamiliar economic, and cultural environment. This article will briefly examine the overall Chinese market and China's unique business and legal environment, before moving on to a discussion of the statutorily permitted forms of business investment and activities for foreign companies in China, particularly in relation to China's entry into the WTO.

1. What Makes China an Attractive Marketplace?

In contrast to the recent slow-down in economic growth in Europe and the U.S., and recession in Japan¹, China's economy seems to have remained strong. Since 1992, China's GDP has been increasing at a rate of double digits until a brief slowdown during the Asian financial crisis in 1997. In 2000, China's economy bounced back, with the growth rate of GDP reaching over 8%, and the economic indicators in early 2001 show an even more dynamic growth for this year. The economic growth of the recent decade has given birth to a middle class in China, particularly in the coastal cities, with notable purchasing power. For example, for the year of 2000, in the city of Shanghai, the annual income per capita reached 3,000 United States Dollars; California Citrus, even with 35 to 40% import duties, has become a popular daily consumption of average Chinese families². China's semiconductor market, estimated to be a U.S. $8 billion per year market already, is growing rapidly and expected to become the third largest semiconductor market in the world in 2001, and the second largest by 2010³. China's market potential lies with its vast population and rapidly-growing purchasing power.

Furthermore, China offers one of the world's most competitive labor forces. While the cost of labor remains low, the quality of the labor force is improving dramatically. It was hard to find a qualified, good English speaking staff when China first opened up more than 20 years ago, but nowadays, the supply of people with language capability is abundant. China has many talented young computer engineers, software programmers and chip designers, and after proper training, China could become the most competitive provider of human resources in the world's high-tech industry. China has become a land not only for labor intensive processing, assembly and manufacture, but also for offering a pool of young talent to the R&D centers of many leading foreign high-tech companies for their cutting edge technologies.

Because of the business opportunities brought about by such economic growth and an attractive labor force, China has become one of the most popular areas for foreign investment in the world. In 2000, the total foreign investment that flows into China and Hong Kong has reached U.S. $102.8 billion, increased by 137% from U.S. $43.4 billion in 1995, and 13 times of U.S. $7.5 billion in 1991. With the further opening up of China's market after its entry into the WTO, more foreign investment is expected.

2. The Business Environment with "Chinese" Characteristics.

2.1. What are these Characteristics?

To develop and maintain a successful business in China, it is critical for American companies to understand not only the Chinese culture, but more importantly, its unique economic environment. The following are a few unique aspects of the Chinese business environment that American businesses need to keep in mind in formulating an investment strategy and selecting an entry structure in China.

2.1.1. "Understanding the Industry Policy". An overarching goal of China's open-door policy is to develop a self-sustained industrial system with the assistance of foreign capital and technology. Under this policy, the Chinese government agencies at the central and the local levels issue guidelines for foreign investment which specify the industries and product lines in which foreign investment is encouraged, permitted, restricted or prohibited. Although many medium to small sized manufacturing projects are welcomed, to ensure that China's industrial policy is well served, China's planning authority has tight control over foreign partner selection and the project approval process in key industrial projects. In certain industries, wholly foreign owned subsidiary is not permitted, and in some industries or areas, foreign participation in a joint venture is limited to the minimum extent necessary for the venture to obtain technology. Under this general guideline, any project that upgrades products, uses advanced technologies, or substitutes imports will be encouraged.

2.1.2. Understanding the "Integration Process". Despite the country's successful steps toward a market economy, China's bureaucratic apparatuses, whether local or central, continue to play a significant role in controlling and policing foreign investment activities. An important aspect of such control is the approval requirement for foreign investment. Every foreign investment project, whether an equity joint venture, cooperative joint venture or wholly foreign owned subsidiary, must be approved by the Ministry of Foreign Trade and Economic Cooperation ("MOFTEC") and its designated agencies before beginning its operation. More precisely, two approvals are required: One is the approval of the project proposal, which must be granted before actual substantive negotiation begins; the other is the final approval of the result of the negotiation, i.e., the feasibility study, joint venture contract, articles and other ancillary documents such as the technology licensing agreement. The purpose of China's approval process is to integrate a project into the national economy, and is the means through which the Chinese government exercises its control over foreign investment to ensure full compliance with its industrial policies.

To the foreign investor, the approval process can be a source of delay and bureaucratic red tape, a process that potentially may give the Chinese party with the right connections leverage in bargaining for more favorable terms than would otherwise be reached between the parties. But the process can also be one in which the government actually helps the foreign investor survive. Given that China is still dominated by economic plans, it is through government planning that the limited utilities and raw material resources of the country are allocated. In certain situations, even the market share will be determined through such a planning process. During the approval process (which is also a resource allocation and coordination process), the approval authority will work with all the government agencies and utility companies involved to pave the way for the new venture and "integrate" the investment project into China's economy.

2.1.3. Understanding the Limits to Business Scope. Unlike companies in the U.S., which can engage in all types of profit making businesses except perhaps in a few specialized industries, China businesses open to foreign investment enterprises are, to a certain extent, limited. For example, many foreign firms may wish to engage in foreign and domestic trade, but this is one area in which they are excluded. As a result of China's planned economy, import and export authority is traditionally a privilege reserved for state owned companies. Foreign investment enterprises are allowed only to import the raw materials and parts necessary for its manufacture; and export only its own product unless, in very rare circumstances, special approval has been obtained. Even in non-restricted lines of business, foreign investment enterprises should ensure they operate within the scope of business authorized by the approval authority and evidenced in the company's business license. Any participation in activities beyond its scope, directly or indirectly, may cause the company trouble, including fines and even suspension of its business license, because every aspect of its transactions in the areas of foreign exchange control, company registration, customs, etc. is closely watched by various government agencies.

2.2. Easing of Restrictions for Foreign Businesses After the WTO?

As mentioned above, there are varying degrees of barriers to or restrictions on foreign investment in certain areas of the economy. To live up to its promises and commitments made at its WTO negotiations, MOFTEC started its campaign of revisiting the existing laws and regulations, revising and abolishing those inconsistent with WTO rules. As of early this year, more than 1,413 sets of law, regulations, rules and treaties had been reviewed. Among those, 5 laws, 25 sets of administrative regulations and 90 sets of implementing rules have been or are scheduled to be amended; and over 500 sets of regulations and rules have been or are to be abolished. Among those laws and rules amended are the three basic laws and the implementing rules governing foreign investment.

In addition, MOFTEC has since late last year, jointly with other related ministries, promulgated a series of regulations opening up certain previously restricted industries, including movie theaters, healthcare, shipping and rail transportation. Progress has also been made in telecommunications, the most closely watched and controversial industry. On September 20, 2000, China's State Council promulgated the Telecommunications Regulations of the People's Republic of China, which marked the first effort by a national regulatory authority to standardize the administration of China's rapidly changing telecommunications industry, and pave the way toward a national law comparable to WTO principles and rules.

It could take many years before China will have established a fully transparent and fair legal system consistent with the WTO standards. It ought to be noted that China has committed itself to further opening up its market in a "phased" process. For example, pursuant to the November 1999 U.S.-China Market Access Agreement⁴, China agreed to phase out current restrictions on access to distribution services within three years of its accession to the WTO. For the wholesale and commission agency services, foreign companies will be allowed to form a joint venture with no more than 50% equity interest within one year of accession; majority stake and elimination of all geographic restrictions within two years of accession; and WFOE will be permitted within three years of accession.⁵

As the administrative apparatuses remain pervasive in China's daily life, approval and the licensing system will continue to function as a powerful weapon in limiting and restricting the benefit WTO brings to foreign businesses. Despite its compromise made at the negotiation, China may still be able to limit the market entry of foreign firms by setting forth the access threshold, applicants' qualification and many other restricted conditions. This can be evidenced by an unofficial draft circulated for comments in late 2000 concerning licensing of foreign-invested telecommunication operators. The rule suggests certain restrictive conditions and qualifications be imposed on the domestic and foreign applicants in granting the licenses. In some industries where foreign entry is limited to joint venture, the government can exercise its power in selecting the foreign player by "converting its will" into a "free act" of the Chinese company that is under its direct ownership and control. While varying degrees of governmental control or restrictions on foreign investment will probably remain a reality in China for a long time to come, the kind of efforts that China will make to realize its stated goals and fulfill its promises relating to becoming a WTO member and their effect remain to be seen.

3. Statutorily Permitted Business Forms for Foreign Investment in China.

Foreign companies wishing to do business in China have to do so through one of the several statutorily permitted forms or arrangements: representative office, sales through an agent, technology license, joint venture, wholly foreign-owned enterprises, or acquisition. A business needs to carefully consider the characteristics of each such form or arrangement before committing itself to one particular form or arrangement.

3.1 Representative Office. A foreign corporation or legal entity can establish a so-called "representative office" in China. A representative office is only permitted to engage in certain "liaison" type activities, i.e., consultation, market research, contacting prospective customers, negotiating on behalf of the headquarters, and contract administration. A representative office cannot market, distribute products, or provide pose-sale maintenance and repair services, unless an agency relationship has been established with a Chinese company with import and export authority, or a state-owned foreign trading company.

3.2 Sales Through a Chinese Import and Export Agent. To sell products through a Chinese import agent can be inconvenient and time-consuming. Furthermore, the requirement for buyers to pay in foreign exchange may further handicap foreign firms' distribution capabilities. This disadvantage, however, has been reduced to some extent by certain regulations which permit the establishment of joint ventures or wholly owned foreign trade subsidiaries by foreign firms in bonded areas, such as those located in Shanghai, Waigaoqiao, and Shenzhen Special Economic Zones. The foreign trading subsidiaries can rent or build a warehouse to store the imported supplies. Customs duties are not due until the merchandise crosses the outer boundary of the zoned areas. In addition, accounts can be settled in local rather than foreign currency. The establishment of such a subsidiary or a strategic alliance with a local trading company will benefit and substantially facilitate a foreign firm's sales and post-sale service activities.

China's entry into WTO will ultimately allow foreign companies to establish its own distribution channels, and dispense with the Chinese trading agencies, despite the approval process and capital requirement that might be involved, not to mention the logistics for establishing such distribution channels.

3.3 Technology License. This is an arrangement between a foreign firm and a Chinese manufacturer in which the foreign firm provides any combination of patent, copyright, trademark and technical information to the Chinese manufacturer for the latter to manufacture and market the products within the designated market in China, in exchange for fees in the forms of a lump sum payment and/or royalties. Such an arrangement provides market entry, does not require substantial capital commitment or management, and secures a relatively stable source of income to the licensor. However, certain disadvantages do exist. Among other things, this is a highly regulated area where every licensing arrangement requires approval, and territorial restriction is generally not permitted. Moreover, the number one reason that most foreign firms are reluctant to grant technology license to Chinese partners is the well-grounded fear of intellectual property piracy and infringement.

3.4 Joint Ventures. Joint venture is the investment model encouraged by the Chinese government, and has existed since China opened its doors in 1978. A joint venture company takes the form of an equity joint venture in which the parties share their profits, risks and liabilities in proportion to their respective equity holdings, or a cooperative or contractual joint venture in which the contract terms rather than the equity holding constitute the basis for profit distribution. Joint venture companies enjoy limited liability protection and the partners share profits, risks and liabilities. To a large extent the joint venture resembles closely held corporations in the U.S. in the sense that transfer of any equity interest is subject to the right of first refusal of the other shareholders.

Relatively less capital commitment and local access are the two fundamental appeals of Chinese-foreign joint ventures. However, there are also disadvantages to the joint venture, as foreign investors have come to realize with experience, e.g., difficult negotiations with Chinese partners and the government approving authority before the formation of the venture, as well as the difference in cultural, ideological understanding and management styles after its formation, which sometimes leads to disharmony and conflicts in the corporate management and decision-making process. Furthermore, problems often surface when the joint venture needs additional funding. The statute requires the Chinese party's consent for a capital increase while the cash tightened Chinese party, usually the declining state enterprise, may be unable or unwilling to make additional equity contributions, or have its equity interest diluted. In the worst scenario, this deadlock may halt the development of the venture.

For those reasons, the percentage of wholly foreign owned enterprises in the total amount of investment is on the rise, while the percentage of joint ventures is on the decline. Since 1997, the WFOEs established each year have continuously outnumbered the joint ventures.

3.5 Wholly Foreign Owned Enterprises ("WFOE"). In order to gain full control over the decision making process and daily management, more foreign firms are willing to establish wholly owned subsidiaries in China--WFOEs. A well-prepared articles of association of a WFOE may secure a centralized and streamlined decision-making process. A WFOE, however, requires relatively more capital and management commitment from the foreign firms. Many foreign investors tend to hire local managerial personnel to obtain the type of local access available under a joint venture structure, and to reduce the cost. It could be a challenge in China to identify, select, train and retain such an executive - one with western business sense and loyalty.

Up until last October, one of the disadvantages of the WFOE model is the restrictive prerequisites that to qualify for such a model, the WFOE must either be export-oriented (i.e., at least 50% of its products are for export), or technologically advanced, as certified by MOFTEC. In order not to violate the WTO rule that prohibits the requirement for "export performance", the recent amendments to WFOE law and its implementing rules in the wake of WTO entry abolishes such a restriction. Under the amended WFOE law and rules, WFOE should be permitted as long as its proposed business benefits the "development of the national economy of China".

This is a prominent and clearly discernible change, which is meaningful to the foreign investors and brought about by the efforts of the Chinese legislature and regulatory bodies last October to amend the three basic laws and implementing rules for joint ventures and WFOEs. Under the other changes, foreign invested enterprises ("FIEs") are no longer required to maintain a "foreign exchange balance" whereby the foreign exchange revenue received by FIEs must be at least equal to its expenditures paid in foreign exchange currency for procuring equipment and raw materials. FIEs now no longer have to give priority to China's domestic market for purchasing raw materials and supplies, as previously required, and filing business and operation plans with the government authority in charge has also become unnecessary . These changes merely confirm the existing practices, and are a gesture of the Chinese government toward its compliance with WTO obligations.

3.6 Acquisition of An Existing Chinese Entity. A foreign firm can acquire all or part of the equity interest, or the assets of, or merge with an existing Chinese enterprise. Such merger or acquisition, however, remains largely unregulated⁶. The only exception is in the area of acquisition of equity interest of an FIE. This type of transaction has been increasingly seen in China, particularly in recent years, as part of the M&A activities of many multinational parents in the international arena. There are only a few regulatory requirements relating to the subsidiaries in China: approval from the original approving authority, completion of the foreign assignor's contribution to the registered capital, and unanimous consent from the remaining shareholders and the board. In addition, the acquisition must not cause the aggregate foreign-owned equity interest to decrease to less than 25%.

Where the target is other than an FIE, the foreign related M&A transactions in China are governed by China's existing company law and the three sets of foreign investment laws concerning joint ventures and WFOEs. Under Chinese law, the permitted acquisition can take the form of an acquisition of the target's assets or its entire business.

3.6.1 Asset Purchase. Asset purchase refers to a transaction in which the foreign investor acquires the assets of the Chinese target, tangible and intangible, such as land use rights, buildings (or leasehold of buildings), machinery and equipment, inventories, accounts receivables, intellectual property and goodwill (if any) of the target. If all of the assets of the target have been purchased, then the target will, after the closing, either invest in other lines of business with the cash proceeds of the sale or wind up its business, settle with its creditors and debtors and dissolve itself. The foreign purchaser may use the acquired assets as its capital contribution to a newly formed foreign-invested enterprise or use the assets purchased for expanding the operation of its own subsidiary in China. The subsidiary of the foreign purchaser may set up a new division equipped with the assets purchased to engage in the same business activities as the target.

One of the advantages offered by asset purchase is liability insulation because it cuts off the entangled relationship of the target with its employees and creditors. The purchaser is not responsible for any obligations and/or liabilities of the target.

3.6.2 Acquisition of Business. Acquisition of a business as an ongoing concern refers to a transaction in which a foreign purchaser acquires the entire equity of another economic organization ("target") for certain considerations, often in the form of foreign exchange cash, and both organizations survive after the closing. The purchase price is payable to target's shareholders, usually a so-called "holding company" or the superior of target (i.e., the government authority in charge). Upon closing, the target maintains its operation but now under the control of the purchaser.

One fundamental difference that distinguishes business acquisition from asset purchase is that in an acquisition of a business, all the obligations and liabilities of the target remain unchanged. The purchaser will ultimately be responsible for these obligations and liabilities to the extent of the investment made (i.e., the purchase price paid). In addition, the acquisition must be structured within the permitted legal framework with its three common business formats for foreign investment. Therefore, business acquisition in this context is accomplished by the purchaser forming a new entity and merging the target business into the new entity. This form of transaction resembles a triangle merger familiar to U.S. companies. In China, it is called "converting an SOE into an FIE".

If the foreign acquirer is to acquire the business of the Chinese seller, it should enter into an investment agreement or equity purchase agreement with seller, whereby the foreign acquirer is to (i) purchase all the equity interest held by the seller in target company and (ii) convert target company from a SOE into a WFOE by registering target company as a new entity wholly owned by the foreign business. It is required to file with the government approving authority a new feasibility study report projecting business of the new entity and a substantially revised or new Articles of Association setting forth the corporate governance, and other documents as required for forming a WFOE. The requirement for new registration actually benefits the foreign acquirer because the new entity will be able to take advantage of a new round of tax holidays instead of merely stepping into the shoes of the target with all the tax holidays probably already used up.

The Chinese government has been encouraging foreign acquisition as a major means to bail out its money-losing state-owned enterprises. Thus, foreign businesses now have more opportunities for acquisitions. It is challenging, however, to identify a profitable target company and to convince the government authority to approve such an acquisition. If the target is losing money or is on the brink of bankruptcy, the acquisition would make sense only when a foreign investor can acquire the entity at a bargain price and fit it into its overall development strategy, after a meaningful due diligence investigation in an unfamiliar cultural and economic environment.

In conclusion, by understanding China's unique policies, its economic system and laws and regulations which are in flux especially in connection with China's entry into the WTO, foreign investors can turn the great potential of the Chinese market to their own advantage by selecting the appropriate form and channels for their investment and business activities, particularly after China's entry into the WTO.

ABOUT THE AUTHOR

Zhi-Ying James Fang is a partner and splits his time between Davis Wright Tremaine's Los Angeles and Shanghai offices. Jim has over 20 years of experience representing U.S. companies doing business in China, particularly, in structuring, documenting and negotiating strategic alliances, mergers and acquisitions, joint ventures, assets-based financing and BOT projects for U.S. and international clients in the automobile, retail, chemical, semi-conductor, machinery, computer and financial industries. His experience also includes advising U.S. technology clients on developing strategies and programs for intellectual property protection and licensing, distribution, joint R&D projects, troubled business work-outs and representing U.S. clients in judicial, arbitration and administrative proceedings in China. Jim also represents many Chinese companies doing business in the U.S.

Prior to joining DWT, Jim worked as a foreign attorney with Brown & Wood in New York and Preston, Thorgrimson, Ellis & Holman in Seattle (known now as Preston Gates & Ellis). He was also a law professor in International Business Law and a department director of the East China Institute of Political Science and Law. Jim also practiced law in China.

Jim is a frequent speaker at various conferences, seminars and training programs in the U.S. and in China. Some of these training programs were sponsored by the Ministry of Justice of China; Prince of Wales Business Leaders Forum, and others were for various provincial governments in China as well as speaking to students at the University of Washington Law School and the Willamette College of Law.

Jim received his Master of Laws (LL.M. equivalency) from the Shanghai Academy of Social Sciences Law Institute and his LL.M. (1986) and Ph.D. (1991) in Comparative Law from the University of Washington School of Law.

FOOTNOTES

1Caught in the Jaws, The Economist, June 21, 2001.

2Orange Growers at Both Sides Get Squeezed, Los Angeles Times, A-1, August 1, 2001.

3Semiconductor Industry Hails U.S. House Approval of China PNTR, http://www.semichips.org/news, May 25, 2000.

4 www.uschina.org/public/wto/factsheet/distribution.html.

5 Patrick Powers, Distribution in China: The End of the Beginning, The China Business Review, July-August 2001, p.11.

6 Long Zhang (Ministry of Justice), Format and Applicable Law for State-Owned Enterprise Reform and Acquisition with Foreign Funds, China's Foreign Investment Policy, April 25, 2001, p. 1

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