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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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