Doing Business In China - New Horizons And Caveats

By John Frederick Karch
Partner at WHGC

Introduction

For American entrepreneurs or businesspersons prospectively seeking to establish business in China, one fundamental stands out: the abundance of enthusiastic capital funding in view of the unprecedented window of opportunity afforded in China, which is not currently available here in the United States. It is generally well known that China is the largest foreign creditor of the United States Treasury, holding some $1.2 Trillion or about 8% of total U.S. debt, which is approaching $16Trillion. The monthly interest paid to China in U.S. Dollars on that debt amounts to in excess of $2 Billion per month ($25.6Billon/year). That money accumulates in the Beijing treasury of foreign reserves, currencies of which collectively amount to on the order of $4 Trillion.

Therefore, in China, the influx of US Dollars has simply become another one of China's vast resources managed by the Central Government and its investment agency arms such as the China Investment Corp. ("CIC"), effectively an international venture capital firm, and by individual major Chinese corporations that are largely government controlled, such as the Huawei telecommunications network corporation. Herein lies the cardinal rule of China's economy: in China's system of "state capitalism," most of the nation's major companies are owned and operated either directly or indirectly by the government. There is no strict separation of the government from the economy in China. Thus, government control of China's vast resources, necessary for any corporation to operate in China, is in fact control of the corporation. Awareness of this fact, can create a tremendous upfront advantage for American entrepreneurs or businesspersons looking to establish business in China.

But it is also important to remember that China is yet a developing nation, transitioning from a communistic "command economy" to one of international quasi-laissez-faire, albeit still dominated by massive internal government funding subsidies and natural resources controls. To grow, it needs technology, and know-how in the application of that technology. Particular industries of emphasis are electronics, aviation, hardware and software, chemicals, pharmaceuticals, etc., which can create a firm infrastructure as a foundation on which to build its future vision: China's "New Horizon" as leading global powerhouse, and it seems well on its way so far. In spite of dire warnings (see for example, Gwynne Dyer, China's Impending Crash, Economics, Orange County Register, Sunday, March 18, 2012; Keith Bradsher, China's economy suffers 'sharp downturn', The New York Times (updated 5/25/2012)) proposing that unmitigated overexpansion will lead to inevitable impending collapse, there seem to be powerful considerations to the contrary.

In fact, China has not fallen into the pitfalls that have plagued the U.S. economy. Traditionally, the U.S. prints more dollars, contributing to greater inflation, or borrows existing dollars on the world market (going into greater debt... to China, among others) to utilize in solving problems abroad, in hopes of instilling "democratic ideals" in the great uninformed foreign masses, rather than end up in the personal pockets of U.S.- friendly foreign rulers and their families. China, on the other hand takes a more pragmatic and enduring approach by directing its exported money toward building infrastructure of schools, hospitals, and so forth, and toward investing in particular global industries of interest, in targeted countries into which it anticipates its influence will be more universally appreciated. Yet despite its vast human and natural resources, China lags in the great global industrial complex, but not for long... and herein lies the current window of opportunity for U.S. businesses to benefit from the New Horizons of China, before this limited window begins to close.

This article seeks to enumerate a number of common pitfalls and salient strategies in preparation for the prospect of doing business in China, under prevailing business conditions and despite the growing pains of its booming internal economic expansion.

Viable Forms of Doing Business

There are three fundamental alternative forms of business investment entry into China,
(1) forming a wholly foreign owned entity ("WFOE") by start-up new business in China under the Wholly Foreign Owned Enterprise Law of the People's Republic of China ("PRC"); (2) more commonly forming a joint venture ("JV") with a Chinese company either as an Equity JV or as a Contractual JV; or (3) structuring onshore/offshore hybrid which may well allow maximum flexibility and better understanding between or among business partners.

WFOE
The wholly foreign owned enterprise is a business founded in China exclusively with outside foreign capital (no Chinese co-investment capital), as a stand alone entity (not a division or subsidiary of another foreign entity), and subject to its own licensing, land use, facilities leasing or purchasing and other such entry necessities. Key advantages are relative worldwide operating autonomy and management control, independent of a Chinese partner; and easier safeguarding of intellectual property and technology. Apart from required development and training of personnel and professionals to facilitate operation and sales, major flip-side disadvantages are lack of insider (Chinese partner/"Guan Xi") relationships to assist in the licensing and authorizations within the local business bureaucracy, and to secure requisite production resources and government support. Furthermore, in certain sensitive economic sectors (energy, natural resources, weapons, etc.) WFOEs are simply prohibited; however, a joint venture with a Chinese co-venturer already involved in such economic sectors may yet be feasible.

Equity JV
The Equity Joint Venture is a co-venture among foreign and Chinese individuals or entities with a common enterprise, generally with equity interests of co-venturers held in a Chinese limited liability company. The entity form of a joint venture is required to be a limited liability company ("LLC") under PRC company law. Foreign party investment is restricted to on the order of 25% of registered capital of the joint enterprise (including non-cash intellectual property, technology, and other trade rights of value contributed as start-up capital); and risks, rewards, and losses are shared in proportion to the ratios of investment among the co-venturers. Similar to any partnership, while co-venturers will generally supplement and complement one another's skill sets, expertise and other contributions to the common enterprise, a Chinese partner must comply with State economic development programs and criteria.

Contractual JV
The contractual joint venture is a co-venture similar to the Equity JV, but with the sharp distinction that all rights, liabilities and responsibilities are specified by contract. Similarly, the risks, rewards, and losses are specified by the contract, and NOT necessarily shared in proportion to the ratios of investment among co-venturers.

Because of such flexibility in capitalization financing, management and profit sharing, the Contractual JV is the preferred method of China market entry. Furthermore, there are manifest efficiencies in using a Chinese co-venturer's existing licenses, personnel, local market knowledge and experience in facilitating start-up and on-going operations of the enterprise. However, the lack of autonomy of a foreign partner runs risks of required additional investment provisions, consensual management, strategic compromises and unambiguous communication. And with any joint venture, there are risks of tax and liability implications of the venture being legally deemed to be a traditional general or limited partnership.

Hybrid Structure(s)
Where a WFOE may be deemed too restrictive and a JV may place too much responsibility on the Chinese co-venturer or otherwise evidence unacceptable foreign control restraints, a more ideal hybrid structure may be appropriately utilized. This would primarily envision an off-shore entity (corporation or LLC) into which foreign co-venturers and Chinese co-venturers would respectively contribute technology/know-how and capital for the common enterprise. Creative structuring of the operation then becomes almost unlimited with international sales and marketing facilities in the offshore host country, foreign venturer licensing of technology to the Chinese venturer in China, which produces and then delivers worldwide on orders from the offshore venture.

Such offshore entities are readily susceptible to formation through the many varieties of mergers and acquisitions available globally, with implications and consequences governed by traditional contractual merger, or purchase and sale agreements between or among individuals or entities involved. Of course, Chinese participation may well be limited by various government restrictions, but again various creative techniques to circumvent issues of concern may well be available to eliminate or at least mitigate such restraints. For example, technology and intellectual property licensing may be fragmented into different entities in order to preserve the whole of the core technology or intellectual property.

As an aside, apart from a conforming WFOE, foreign investors are generally prohibited from investing in Chinese companies in certain industries. However a unique entity, the Variable Interest Entity ("VIE") has evolved. By pre-investment agreement, foreign investors are permitted to provide capital and share profit in a Chinese company, but they must forgo the right to own anything in the VIE.

Prudent Considerations in Negotiating a JV Agreement

Since the joint venture in one of its forms is most likely to be the choice of doing business, this article will elaborate on the issues and resolutions between or among the co-venturers as "partners" in the LLC. While many business relationship concerns are common sense and second nature to U.S. businesspersons, there are various counterintuitive or wholly unknown nuances to doing business with a Chinese joint venture partner, which may be alien to the traditional American norms, values and methods of business. And, Chinese law generally lends no sympathy to such customary U.S. business practices.

Certainly, the Chinese are eager to finance and conduct business in an obvious effort to contribute to the infrastructure of developing Chinese industry; therefore technology and the know-how to utilize and to promote the technology are the primary transferable commodities sought in any business venture. Obviously, the risks of losing ownership of such commodities and of possibly creating a future Chinese competitor present a legitimate concern; with that in mind, significant due diligence of prospective partners' background, motivations and character are of critical importance, before any terms of agreement for the JV may be effectively formulated. There is the need to know who controls a partner (relationships, influence of government and government groups) and who really controls the business (players, resources). In China, contacts and relationships are a critical success factor to efficiently getting things accomplished for the business. Above all, an overriding consideration of and sensitivity to "face" ("Mianzi") and to the "zero sum mentality" is critical in establishing business rapport.

Apart from government direct investment abroad, much of the Chinese venture wealth is concentrated in wealthy businesspeople that have generally accumulated their wealth by bargain purchases of assets from the government and then resale of those assets. Others have also profited from speculation in booming real estate construction or complementary supply and furnishings businesses. Such businesspeople are naturally protective of their wealth. So while dealings and negotiations may well take many turns with lip service to a variety of issues, success will likely be predicated on the mind set that they have gained what someone else has lost, and this is a "win" - a zero sum. There is no sense of "synergy" occurring where the result is greater than the sum of its parts (1+1=3). This runs generally contrary to American business predominately focusing on positive synergy of transactions. Nevertheless, with the perception of having gained and not lost, Mianzi of a Chinese counterpart remains intact, and resulting negotiations are deemed successful.

Where assets other than cash are contributed to the venture, actual titling must be confirmed. Stockholders in even U.S. stock exchange (AMEX, NYSE, Nasdaq and OTCBB) listed Chinese companies have been burned (costing tens of billions of dollars lost by investors) by discovery that assets represented as belonging to the company have in fact been titled solely in the name of individual Chinese principal(s) of the corporation, and not subject to claims of either creditors or shareholders of the corporation. Complaints to the SEC Enforcement Division for Foreign Corrupt Practices violations and allegations of such fraud as of the end of 2011 have already affected more than 80% of the in excess of 125 generally listed companies. And even if there was judgment on these complaints or lawsuit allegations, U.S. rulings are not enforceable in China.4

The facts and circumstances of which beg the obvious question: Since capital funds to develop Chinese business infrastructure abound in China, why do Chinese companies have to seek external investor funds through U.S. stock markets in the first place? Certainly more likely an effort to seek recognition of status, rather than some form of devious infiltration as implied by some pundits (Vide supra, Eckert and Stewart).

Accordingly, reliance on U.S courts or government agencies for complaints of Chinese business practices is practically ineffective. The consistent failure SEC oversight and enforcement is typical. Most critically, its debacle on SWAP enforcement for fraud (as opposed to mere regulatory restrictions enumerated by the Act) triggering the 2008-2010 (and yet on-going) Great Recession stemming from the Commodity Futures Modernization Act of 2000 signed by President Bill Clinton. The Act purported to facilitate financial markets "deregulation" engineered and/or promoted by Alan Greenspan, Robert Rubin, Tim Geithner, Ben Bernanke and Henry Paulson among others... many of whom are now in Washington, D.C. in critical economic positions of the current Executive Administration... an unabashed epitome of the fox safeguarding the henhouse!

JV Agreement Highlights

Accordingly, it is necessary to consider the JV Agreement merely as a mutually derived blueprint for long term conduct of the business, as opposed to an enforcement sword or shield of rights and liabilities between or among parties. Notwithstanding any conventional choice of laws by which the agreement may be interpreted and/or enforced, the bottom line is that almost any outside intervention by court, administrative agency or otherwise, will most likely not be the least bit enforceable against a Chinese individual or entity in China. The rule of law based on Western common or civil law principles simply does not exist in China. Accordingly, there are various issues and guidelines on which mutual cooperation must be obtained and "documented by agreement," or any business venture is most likely destined to failure.

Control Issues
The typical Western mindset is that 51% control is mandatory for majority rule to maintain influence over the enterprise. Such is simply not the case in Chinese based business as a practical matter and apparently as a matter of law, should one choose the predominately uphill battle of seeking enforcement through Chinese judicial means. For day to day management of operations, leverage in fact lies with the representative director and the general manager who are vested with authority under Chinese law. Power to appoint these key principals is critical. Furthermore, for contract validations and authorizations for banking and other such business services, the custodian of the company seal ("chop") is absolutely indispensable to operations (and duplicate or replacement chops are strictly regulated and nearly impossible to obtain).

In addition to "majority control," other measures of protection of interests may be afforded by veto rights in particular circumstances, or by mandatory buy-sell buyout rights subject to specified terms and conditions.

Define products and markets
Clearly delineate what products and geographical markets are to be target for the venture, and any exceptions which may be reserved for any partner's separate business. Confidentiality, non-disclosure and non-compete provisions may be useful as a deterrent, as long as specific damages and remedies enforceable in specified geographical areas are practical. And, terms of compliance for periods after the venture terminates should be included. As incentive, a form of bonding or escrowing of deposits as collateral should be considered as prudent, if not unpalatable as a matter of Mianzi 5

Technology/IP registrations rights & liabilities
In addition to the "divide and conquer" fragmentation strategy previously suggested for proprietary technology and intellectual property, it may be prudent to specify what technology might be registered, with what agency/country, and ownership designated.

Fundamental Compliance Matters
General compliance housekeeping issues should be enumerated and reporting responsibilities assigned. Such considerations relate to foreign exchange procedures and guidelines for arbitrage exposures and hedges, accounting conventions to be employed with auditors appointed as applicable, and obligations for tax matters. On the latter, Chinese tax laws are still evolving and sometimes appear conflicting, primarily because rule-making, oversight and enforcement are delegated to local city or provincial government authorities which manifest different objectives and facilitating policies.

Benefits and biases of political, regulatory and psychological barriers
To do business in China or with Chinese JV partners, PRC government, its agencies and bureaucrats rule. Traditional Western norms, values and methods of business for U.S. businesspersons and/or U.S. investors require acute realignment for success with Chinese business. Integrity by contracts is not the operative concept in China, and ultimately relationships are the factors that rule - relationships with Chinese partners, and those partners' relationships with PRC government principals and bureaucrats.

Conclusions

For a U.S. business to function and succeed in China or with Chinese JV partner(s), acute and thorough preliminary due diligence; documentation "agreement" of parameters for operation of the business, compliance and reporting; provisions for protection of technology/intellectual property and for long-term non-circumvention are absolutely critical. Obviously, unless the diplomatic landscape related to Sino-U.S. business comity and protocols significantly changes in the near future, there is virtually no chance of obtaining any meaningful enforceable recourse for wrong-doing, or even for simple transactional equity, from China or from any U.S. agency. The lesson learned rule: Understand the rules of the game and know your competition. Adapt your business practices with China and Chinese business partners accordingly. Thus, you may most certainly expand your business horizons with your Chinese business partner consistent with China's New Horizon and avert catastrophic pitfalls of which you are now aware from the numerous caveats of this article.

John F. Karch is a partner at WHGC, PLC.


[1Tom Murse, How Much U.S. Debt Does China Really Own?, Creators Syndicate, usgovinfo.about.com (2009); Wikipedia, United States Public Debt (May, 2012); Garrett Haake, When Debt Is the Message, Romney Employs A Powerful Visual Aid, firstread.msnbc.msn.com (2012/05/17).]

[Pual Eckert and Phil Stewart, Chinese entities world's biggest economic spies-Pentagon, Reuters (May 18, 2012)]

[Carson Block, Why Dealing with Chinese Companies is So Difficult, China Primer, chinaprimer.com, reprinted from Doing Business in China for Dummies (Wiley & Sons 2007)]

[Lou Kilzer, Fraud allegations, delistings could cost American investors dearly, Tribune-Review, triblive.com, Trib Total Media (2012)]

[Jonathan Hart, Pinsent Masons LLP, Successful joint ventures in China, Legal news and guidance from Pinsent Masons, OutLaw.com (updated August 2011)]