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

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Presentation on theme: "Chinese Regulation of Foreign Business James V. Feinerman James M. Morita Professor of Asian Legal Studies Georgetown University Law Center."— Presentation transcript:

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

2 Introduction Foreign Trade Foreign Investment in China China Investment Abroad Customs Commodity Inspection Taxation Civil & Criminal Laws Technical Standards of Different Countries International Practices & Treaties

3 China: Basic Facts 2004 GDP: $1.65 Trillion (7 th in the World) 2004 PPP-Adjusted GDP: $7.26 Trillion (2nd in the World) Average GDP Growth from : ~ 9.0% Projected 5-Year GDP Growth Average: 7.8% (2X > U.S.) 2004 Foreign Direct Investment: $61 Billion

4 Selected 2004 FDI Recipients (Source: UNCTAD) Destination Amount % change WORLDWIDE $648 Billion Up 2% AFRICA $18 Billion No Change LATIN AMERICA $68 Billion Up 45% ASIA $148 Billion Up 47% EUROPEAN UNION $216 Billion Down 36% USA $96 Billion Up 68% INDIA $5 Billion Up 25% HONG KONG $34 Billion Up 143% CHINA $61 Billion Up 13%

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

6 Brief History of Foreign Investment Tight government control and special treatment of foreign investors moving towards loosening of control in light of World Trade Organization (WTO) agreements 1970s: first foreign investment laws Foreign Invested Enterprises (FIEs) in distinct legal category More government control, but some special privileges Late 90s and 00s: New M&A and FIE laws -- Provisional Measures on Domestic Investment by Foreign Invested Enterprises (2000) -- Rules on Merger and Division of Foreign Invested Enterprises (1999, amended in 2001) -- Investment Regulations/Investment Catalogue (2002)

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

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

9 Market Access Foreign investment catalogue – 4 Categories Encouraged Restricted Prohibited Unlisted = Permitted Business scope narrowly defined WTO concessions Improve trade & foreign investment environment Open new service sectors to foreign investment Modify intellectual property rights and technology transfer rules Reduce tariffs and non-tariff barriers

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

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

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

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

14 Investment Vehicles (3) Joint Ventures vs. WFOE Joint Ventures Pros (1) Greater range of investment areas (2) Easier government approval (3) Operational facilities / infrastructure in place (4) Access to market, customers, etc. Cons (1) Misunderstandings possible (2) IP protection concerns (3) Complicates exit strategies

15 Investment Vehicles (4) Wholly Foreign Owned vs.JV Wholly Foreign-Owned Enterprises Pros (1) No Chinese partner or JV Contract (2) Simple to establish (3) Better IP protection (4) Better integration with parent company Cons (1) Legal and regulatory restrictions (2) Lack of existing sales and distribution network (3) No production site and workforce (4) Lack of local guanxi

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

17 Investment Vehicles (6) Joint Stock Company Most closely resembles U.S. corporation Ownership represented by issued share capital Theoretically able to list on Chinese or foreign stock exchange and issue debt instruments Limited foreign participation due to complex requirements and approvals

18 Selecting the Chinese Partner While foreign companies are increasingly likely to establish wholly foreign-owned enterprises in the PRC, most still seek a Chinese co-venturer. Typical reasons to opt for a joint venture include: Chinese policy discourages or prohibits wholly foreign- owned enterprises in the sector in question. The Chinese partner holds a dominant market position, which the proposed joint venture will inherit. The Chinese partner has a distribution network, assets, relationships, or other advantages that will permit the joint venture access to markets, raw materials or quotas.

19 Due Diligence: Overview Investor's first line of protection -- thorough business and legal due diligence Experienced international businesspeople appear to ignore this basic tenet when investing in China Professional due diligence in the PRC presents peculiar challenges less reliable information than foreign investors are used to obscure and volatile state of China's legal system Chinese companies lack of familiarity (and patience) with corporate formalities and record keeping great breadth of authority afforded to China's bureaucracy.

20 Due Diligence: Key Points Nature and Powers of the Partner Financial Records Employees Contractual Obligations Tax Ownership of Assets

21 Transition Issues for Transfers of Existing Facilities into Joint Ventures If existing plant or facility will become part of the joint venture: mechanics and details of this transfer appendix listing all of the Chinese partner's assets and liabilities that are to be transferred to the new entity land use rights, buildings and other fixed assets "allocated" or "granted" state-owned land use rights Allocated land is transferred to the user for free (annual land use tax) user has no right to transfer; state may recover the land at any time without paying compensation. When land is "granted," the user pays the state a land grant premium for the right to use it for a stated period of years granted land use right is transferable (including by mortgage and lease), and may not be abrogated by the state (except for compensation in the exercise of its right of eminent domain inventory, receivables, intangibles and contractual rights

22 Valuation Issues – Cash and In-Kind relative value of parties' contributions determines shares of profits value of non-cash contributions is usually a hotly-negotiated issue (Chinese contributions in-kind; foreign usually cash or combination) value of such contributions must be set forth in the capital contribution section of the joint venture contract non-cash contributions by foreign parties must also be valued by the State Import and Export Commodities Inspection Administration actual contribution of both cash and non-cash inputs must be verified by a licensed PRC accounting firm state-owned assets (such as assets owned by state enterprises) must be valued by a valuation firm licensed by the State Assets Management Bureau localities have standards to value land use rights; foreign investors should investigate whether Chinese sides valuation falls within the official range investors should bear in mind that the official guidelines assume granted land use rights rather than allocated land use rights.

23 Other Issues Registered Capital Minimum of 1/3 total capital; cannot be reduced Conditions to the Effectiveness of JVs Transfer of property Contribution of assets Necessary approvals Feasibility Studies – Prior Approval Mandatory Objectives; sources of investment; sources of foreign exchange and raw materials; site; technology requirements Economic benefit analysis; financial projections Labor requirements Marketing plans; distribution; export percentages; forex balancing Non-competition clauses Geographic Product line(s) Marketing plans; distribution Chinese Law Opinion Letters

24 Off-shore Holding Structures Most foreign investors prefer to conduct their Chinese investments through a series of offshore, single purpose, limited liability companies: Permits investors to limit China project liability to one offshore entity Facilitates future transfers of the investment Where there are multiple foreign investors in a JV, foreign parties may work out the details of their cooperation in a shareholders agreement Chinese JV law does not provide for more complex corporate capital structures, such as preferred stock, redemption rights, or the like

25 Exit Strategies Most investors in China are strategic investors – manufacturing firms wishing to establish long-term production facilities to service China and Asian regional markets. They typically are not greatly concerned about the mechanics or financial consequences of disposing of their investments, Growing group of financial investors in China investment funds, merchant banks, other financial institutions. These investors are keenly interested in strategies for tax-efficient exit from their investments within a set time horizon.

26 Intellectual Property IP Rights Violations Remain a Serious Threat IP violations are widespread in China Infringing/counterfeiting (20%+ of consumer products) Piracy (90%+ of movies, software, games, books) Imitation of product designs IP theft by employees/partners In the US, Canada, Japan and the EU, China is the No. 1 source of seizures of infringing goods China government entities may acquiesce in infringing activities Local governments (sole source of funds and salaries for local courts and judges) protect local taxpayers and employers National government determined to advance Chinas technology

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

28 Intellectual Property Enforcement (2) Administrative Enforcement More effective for Trademark infringement and counterfeiting complaints than patent or copyright infringement – over 73,000 proceedings in 2004 No real equivalent in U.S. or other Western countries Fast in taking action and cost-effective More domestic parties than foreign parties use this system Administrative IP agencies participate in enforcement – public interest required in copyright cases Some agencies may conduct raids, confiscate infringing goods, destroy equipment for making infringing goods, and impose fines Agencies may examine and copy infringer s accounting records Agencies cannot award infringement damages – aggrieved party must file an infringement suit in courts to seek damages

29 Intellectual Property Enforcement (3) Judicial Enforcement Civil Enforcement – ,323 IP cases filed (about 35% increase over 2003, comparable to U.S. - 9,558) 4,264 copyright cases (more than U.S ) 2,549 patent cases (comparable to U.S ) 1325 TM cases (fewer than U.S. - 3,496) 630 technology contract disputes 555 others Criminal Enforcement individuals convicted for IP crimes 385 criminal cases

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

31 Intellectual Property -- Conclusions Chinas IP Laws Closing in on International Standards IP Enforcement in China -- Work In Progress Foreign Companies Should File and Protect IP in China Patents Trademarks and copyrights Non-compete and confidentiality agreements Foreign IP Owners Can Successfully Enforce IP in China Dont be afraid to sue in China Dont wait too long – two year statute of limitations Choose counsel carefully

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