China Law Insight : China Law Insight: China Commercial and Intellectual Property Lawyers and Attorneys, Full Service Law Firm: King & Wood

        商务部对未依法申报经营者集中的调查分为两个阶段。在初步调查阶段（“第一阶段”），被调查的经营者应当在立案通知送达之日起30日内，向商务部提交与被调查交易是否属于经营者集中、是否达到申报标准、是否已实施且未申报等有关文件、资料。自收到被调查的经营者所提交的文件、资料之日起60日内，商务部应当作出书面决定：如属于应报未报的，应进行进一步调查（“第二阶段”）；如不属于应报未报的，应作出不实施进一步调查的决定。

        在第二阶段，被调查的经营者应当向商务部提交一整套完整的经营者集中申报材料。商务部应在180日内完成实质性评估，这一时限与正常经营者集中申报的最长审查时限相同。

        对未依法申报经营者集中的，商务部可以对被调查的经营者处50万元以下的罚款，并可责令被调查的经营者采取措施恢复到集中前的状态，如停止实施集中、限期处分股份或资产、限期转让营业等。

        与正常的经营者集中申报程序相比，调查程序对未依法申报经营者集中的被调查经营者有一系列的严重影响。调查程序可能比正常经营者集中审查持续时间更长。商务部的两个调查阶段可能达到10个月甚至更久。一旦商务部作出进入第二阶段的决定，被调查的经营者就应当暂停实施集中。此外，由于这一过程属于调查程序，商务部有权采取《反垄断法》第39条规定的措施，包括：进入营业场所或其他有关场所进行检查；询问被调查的经营者、利害关系人或其他有关单位或个人；查阅、复制被调查的经营者、利害关系人或其他有关单位或个人的有关单证、协议、会计账簿、业务函电、电子数据等文件、资料；查封、扣押相关证据以及查询经营者的银行账户。商务部也有权委托省级商务主管部门协助调查本地区内的未依法申报经营者集中。

        在最近召开的商务部“2011年反垄断工作主要情况”专题新闻发布会上，商务部反垄断局局长、国务院反垄断委员会办公室主任尚明提到，对未依法申报经营者集中的调查处理是反垄断局2012年的执法重点之一。¹ 尚明局长提到，为提高企业的反垄断法律意识，商务部一直在对中国的国有企业和民营企业进行普法宣传。他进一步提到颁布暂行办法的目的之一就是提醒各企业，经营者集中申报是反垄断法规定的强制性要求。有理由相信，在不久的将来，商务部将展开对暂行办法的执法活动。

         以下是商务部调查处理应报未报的经营者集中的流程图：

         商务部未依法申报经营者集中调查处理流程

¹商务部“2011年反垄断工作主要情况”专题新闻发布会全文请见：http://www.mofcom.gov.cn/aarticle/ae/slfw/201112/20111207901483.html

There are two phases to such an investigation.  In the initial investigation stage ("Phase 1"), the company under investigation shall, within 30 days from case acceptance, submit materials regarding whether the transaction is a "business concentration" under the AML, whether the filing thresholds have been met, and the status for implementation of the transaction.  MOFCOM then has 60 days to decide (i) to start an in-depth investigation ("Phase 2"), if it finds that the transaction is a notifiable transaction under the AML; or (ii) otherwise to close the case. 

In Phase 2, the company shall submit a complete package of materials for MOFCOM to review the competitive effect of the transaction.  MOFCOM has 180 days to complete the substantive evaluation, same as the maximum time limit in a normal merger control notification. 

Penalties for failure of notifying a concentration may include a fine of no more than RMB500,000, and an order for the company to take actions to rewind the transaction, such as ceasing implementation of the concentration, disposal of shares or assets, and transfer of business.
 
Compared to the normal merger review process, the investigation process has various serious implications on the companies who fail to honor the mandatory notification obligation under the AML.  The investigation process may last longer than a normal review: the two phases can take 10 months or even more.  Once Phase 2 starts, the company shall suspend implementation of the transaction no matter what.  Besides, since this is an investigation procedure, MOFCOM is entitled to take various measures provided under Article 39 of the AML, including entering the company's business premises for inspection, interviewing the relevant personnel from the company, reviewing and making copies of the company's accounting books, business letters and electronic data, seizing the relevant evidence, and checking the bank accounts of the company under investigation.  MOFCOM is also entitled to authorize its provincial counterparts to assist with investigation of cases within their jurisdictions.

At a recent MOFCOM press release, Mr. Shang Ming, Director General of MOFCOM's Anti-monopoly Bureau ("AMB") and Chairman of the General Office of the State Council's Anti- monopoly Commission, said that enforcement against failure of notifying a notifiable transaction is one of the top priorities for AMB in 2012.²   Mr. Shang mentioned that MOFCOM has been educating Chinese companies, both state-owned and private, of the AML.  He said that promulgation of the Interim Measures intends to work as a reminder to the companies that merger control notification is a mandatory requirement under the AML.  It is reasonable to expect that we will see MOFCOM enforcing the Interim Measures soon.

Set forth below is the flowchart of MOFCOM's investigation procedures.

MOFCOM Investigation Procedures Regarding Failure to Notify a Concentration 

¹A copy (in Chinese) of the Interim Measures (MOFCOM Decree [2011] No. 6) is available at: http://www.mofcom.gov.cn/aarticle/b/c/201201/20120107914884.html?test.

²The complete text of the press release is available at: http://www.mofcom.gov.cn/aarticle/ae/slfw/201112/20111207901483.html (in Chinese).

1  Governmental Structure

1.1 China's Political System

Political System of China refers to the political structure, fundamental laws, rules and regulation and practices that are implemented in China, and which control the state power, government, and the relationships between the state and society.  Being a socialist country, based on the worker-peasant union and practicing people's democratic centralism, the primary system in the country is the socialist system.

The main political structure of the PRC is comprised of two vertically integrated, but interlocking institutions: the Chinese Communist Party (the "CCP" or "Party"), headed by the Party Politburo and its Standing Committee; and the state government (the "state" or "government") apparatus, headed by the premier, who presides over the State Council, a de-facto cabinet.  Throughout China, Party and government structures closely parallel one another, with Party committees and representatives present not only in government agencies, but also in most organizations and institutions, including universities and foreign owned enterprises.

Two other major institutions play roles in Chinese politics.  One is the National People's Congress (the "NPC").  According to the PRC Constitution, the NPC of China is the highest organ of state power.  Its highest officers are the president and vice president of the NPC, who are directly elected by the members of the NPC.  Articles 85 and 92 of the Constitution state that the State Council is the executive arm of the government and reports to the NPC.

The other is the Chinese People's Political Consultative Conference ("CPPCC").  The CPPCC is an organization of the patriotic united front of the Chinese people.  It is also an important organ of multi-party cooperation and political consultation under the leadership of the CPC, and an important instrument of democracy in the nation's political life.  The CPPCC exercises the functions of political consultation, democratic supervision, and participating in the administration and discussion of state affairs.  This is a key link for the CPC and the governments at all levels to ensure that decision-making is scientific and democratic.

Another key institution in Chinese politics is the People's Liberation Army ("PLA"). The distinction between civilian and military leadership in the PRC is tenuous. There are, for instance, two authoritative bodies ostensibly tasked with authority over military policy and decisions: the Central Military Commission of the PRC, a state entity; and the Central Military Commission of the Communist Party, a party organ.  Although the former is nominally considered to be in supreme command of military and defense affairs, including the formulation of military strategy, in reality it is the Party-controlled Central Military Commission ("CMC") that exercises command and control over the PLA.  Since the membership of the two 11-member commissions is usually identical, it has become customary to refer to the CMC alone without distinguishing between the two.  The CMC is chaired by the Party general secretary, emphasizing that leadership of the military is a Party prerogative.

1.2 Government

The PRC is governed under the leadership of the CCP.  The PRC government is organized in two tiers.  The central government, State Council is the highest administration authority of PRC and leads various departments, bureaus and public service units, while local governments have authority over the provinces, autonomous regions, centrally governed municipalities (Beijing, Shanghai, Tianjin and Chongqing), and special administrative regions (Hong Kong and Macau).

The PRC's legal system, administrative apparatus, policy-making and government organizations are broadly divided into three levels, namely, the central government level, provincial or municipal government level, and local municipal or county government level.  Foreign investors need to understand which authorities are relevant to their particular activities and it is important to appreciate that the role of government is very significant in PRC business matters.

1.3 Foreign Investment Approval Authorities

There are several authorities responsible for overseeing different aspects of foreign investment through their central and local branches.

(a) Project Approval involves the National Development and Reform Commission (the "NDRC")

The NDRC co-ordinates development policy and also takes a major role in approving foreign investment projects.  Along with the project approving procedure, opinions from other relevant authorities (such as the opinion from the Ministry of Environment regarding the environmental protection for a plant project) are often involved in this process.

(b) Approval of establishment of foreign invested enterprises (the "FIE") by the Ministry of Commerce (the "MOFCOM")

MOFCOM is responsible for examining and approving the establishment of FIEs, including the form of their constitutional documents and the approved areas in which they will be permitted to conduct business. 

(c) Special Industry Approvals

Although the main approving authorities are the NDRC and MOFCOM, other authorities may also be involved in approving procedures particularly where there is some limitation on the entrance by foreign investors into a special industry.  For example, the pre-approval from the State Food and Drug Administration ("SFDA") or its branches is needed if the investment involves the pharmaceutical production.

(d) Registration with the State Administration for Industry and Commerce (the "SAIC")

All business entities need to maintain records of corporate documents with local branches of SAIC including basic information regarding registered capital, directors, shareholders and the constitutional documents.  SAIC also oversees initial approvals for special industries such as advertising.

(e) Other business administrations relevant to foreign investors

The tax bureau, the administration of foreign exchange, the finance bureau, the customs and the administration of quality supervision, among others, are all involved in the routine management of FIEs.

1.4 Constitutional Protection

A number of constitutional changes have occurred in recent years.  Businessmen have been allowed to join the CCP since November 2002 which is indicative of the importance now placed on the private sector in modern China.  The amendment to the state constitution in March 2004 and enactment of the PRC Property Law in 2007 both demonstrated the PRC government's commitment to the protection of property rights and investors' interests.  Measures such as these have also helped to strengthen foreign investors' long term confidence in China.

2  Legal System

Shortly after its founding in 1949, the PRC government dismantled the former legal system and created a socialist legal system. The modern Chinese legal system mainly consists of seven (7) branches and four (4) levels of law.  The seven (7) branches of law are: the Constitution and laws related to the Constitution; civil and commercial laws; administrative laws; economic laws; social laws; criminal laws; and litigation and non-litigation procedural laws.  The four (4) levels of law are: the Constitution; laws; administrative regulations; local regulations, and autonomous regulations, specific rules and rules.

Amendments to the Constitution are rectified by a two-thirds majority vote from all deputies of the NPC.

Laws on the following matters are enacted exclusively by the NPC and its Standing Committee: state sovereignty; the formation, organization, functions and powers of state organs; the system of regional autonomy by ethnic minorities, the system of special administrative regions and the system of autonomy at the grass-root level; criminal offences and punishment; the deprivation of citizens' political rights and mandatory measures and penalties involving the restriction of personal freedom; the expropriation of non State-owned property; the basic civil system; the basic economic system and basic systems of finance, taxation, customs, banking and foreign trade; the litigation and arbitration systems and other matters for which laws must be enacted by the NPC or its Standing Committee.  The Standing Committee of the NPC follows the "system of three deliberations" in the enactment of laws, which means that a bill should be deliberated at three (3) meetings of the Standing Committee of the NPC before it is voted on.  An important or controversial bill may undergo more than three (3) deliberations.

The State Council enacts administrative regulations in accordance with the Constitution and the laws.

The people's congresses of the provinces, autonomous regions and municipalities directly under the central government, or their standing committees, have the power to enact local regulations.  The people's congresses of the ethnic autonomous regions have the power to enact autonomous region regulations and also other specific regulations based on local political, economic and cultural conditions.

Ministries and commissions of the State Council and other organs endowed with administrative functions directly under the State Council, such as MOFCOM, SAIC and the China Securities Regulatory Commission (the "CSRC") may, in accordance with the laws and administrative regulations, enact departmental rules within the limits of their power.  The people's governments of the provinces, autonomous regions, municipalities directly under the central government and larger cities may, in accordance with the laws, administrative regulations and local regulations of their respective province, autonomous region or municipality, enact local rules.

Bills are usually deliberated on a non-public basis.  The process is not published in government publications, nor are the bills announced to the public.  However, in recent years, laws, regulations and rules that are controversial or will have a significant social and economic impact on Chinese society, such as the PRC Property Law, the PRC Labor Contract Law, the PRC Food Safety Law and the Administrative Regulations on the Registration of Resident Representative Offices of Foreign Enterprises, have been released on the Internet to solicit public opinion.  Public seminars and public hearings have also been held, for example, in respect of revisions proposed for the PRC Individual Income Tax Law and the PRC Intangible Cultural Heritage Law, as well as the formulation of the Regulations on the Expropriation of Houses on State-owned Land and Compensation.  These signify a major change in the PRC legislative system.

In general, legislative bodies are entitled to construe and interpret the laws and regulations that they have enacted, although such laws and regulations are also subject to the construction and interpretation by other legislative bodies of a higher level.  The PRC body of laws has undergone a comprehensive overhaul since 1979 with the passage and revision of many major pieces of legislation, including laws and regulations applicable to foreign investment.

3  Establishing a Business Vehicle in China

3.1 General Policy

Provisions on Guiding the Orientation of Foreign Investment promulgated by the State of Council came effective on 11 February 2002, which classifies foreign investment areas into four (4) different sectors, the encouraged, permitted, restricted and prohibited.  In the Catalogue of Industries for Guiding Foreign Investment (the "Catalogue") jointly published by the MOFCOM and NDRC further specifies which areas are prohibited, restricted and encouraged for foreign investors, and those areas which are not provided in the Catalogue should be permitted for foreign investors.  According to the Catalogue, we understand the prohibited are areas which cannot be invested by foreign investors, the restricted may have some investment requirements or limitations such as only permitting cooperation jointly by Chinese and foreign investors, or only permitting foreign investor to hold minority interests of the proposed company (or other kinds of organizations) up to 49% etc., and the permitted and encouraged are areas which permit the structure wholly invested by foreign investors.

3.2 Types of Foreign Investment Vehicles

Companies that desire a permanent presence have to set up operations as an appropriate legal entity, depending on the intended business scope, and be compliant with Chinese legal and tax requirements.  The most common legal structures used for establishing a presence in the PRC are:

•  A Representative Office (the "RO")
•  A Wholly Foreign-owned Enterprise (the "WFOE")
•  An Equity Joint Venture (the "EJV")
•  A Contractual Joint Venture (the "CJV")
•  A Foreign-invested Partnership Enterprise (the "FIPE")

Each of these structures has unique advantages, restrictions and drawbacks, and it is essential to choose the option best suited to your business aims.  Among of the above forms, the WFOE, EJV, CJV and FIPE are collectively referred to as FIEs.

(a) RO

ROs are often the first step taken by foreign companies when establishing a permanent presence in China.  ROs can undertake market investigation, display, publicity activities in connection with the products or services of foreign companies, and liaison activities in connection with the products sales, services provision, domestic procurement and domestic investment of foreign companies.  However, ROs are not permitted to engage in any profit activity which means that they cannot sign contracts, receive income, or issue invoices and business tax receipts.  Under PRC law, an RO is considered to be an extension of its establishing company, and does not have the status of a legal person.

To establish an RO in China is relatively easy.  Generally, a foreign company only needs to register with the SAIC to establish an RO.  Law firms, financial and insurance companies and other certain industries may require substantive approvals, but for most industries no substantive government approval is required.  In addition, ROs are not subject to the capital contribution requirement imposed on companies and their investors.

(b) WFOE

A WFOE refers to a company incorporated in China with limited liability that is owned by one or more foreign investors.  Where permitted, a WFOE is now a popular option for foreign business, as the investor may completely control over their business entity as well as enjoy the full profit from its operation.  Moreover, WFOEs also provide a better protection to the investor's intellectual property rights in comparison to other types of entities.

The WFOE is an appropriate structure for companies whose main activities in China are to manufacture and sell products, or provide services such as research and development or business consultancy.  A WFOE allows the foreign investor to issue invoices and receive revenues in Renminbi (the "RMB") that can then be converted and repatriated out of China.

Compared to an RO, to establish a WFOE is a little more complex and time consuming, since generally the WFOE has to get the approval from MOFCOM prior to registration with SAIC.  In addition, besides the approval from MOFCOM, the WFOE usually should obtain approvals from other governmental authorities such as NDRC and SFDA etc., depending on the WFOE's business scope.

(c) EJV

An EJV is typically used for long-term projects and is formed by foreign companies, enterprises, other economic organizations or individuals and Chinese companies, enterprises or other economic organizations.  An EJV is typically a limited liability company.  The proportion of an EJV's registered capital contributed by the foreign investors shall not be less than 25%.

The board of directors is the highest authority of an EJV, which should decide all major issues concerning the EJV.  An EJV must have at least three (3) directors, including a chairman and a vice chairman.

For foreign investors who are not familiar with Chinese market, an EJV may be beneficial for such foreign investors.  A good local partner may contribute market knowledge and strong marketing and distribution channels, and they may help reduce the costs and risk of market entry.  In certain restricted sectors, such as automotive and insurance, forming an EJV with a Chinese company is still the only permitted route for establishing a permanent presence in China.

The challenge of establishing and running a successful EJV is finding and nurturing the right partnership.  Partners have to overcome issues such as mismatched expectations and differences in business culture and practices.  The ability to maintain effective communication, and control where necessary, is also crucial.

(d) CJV

A CJV is often adopted for shorter-term projects or built-operate-transfer projects, and are formed with join capital or terms of cooperation between foreign enterprises, other economic organizations or individuals and Chinese enterprises or other economic organizations.  CJV can be registered as a limited liability company which owns the status of legal person, but it is not mandatory.  A CJV should set up a board of directors (a CJV which has the status of legal person) or a joint management committee (a CJV which has no status of legal person) which is the authority of CJV.

CJVs are similar in many ways to EJVs but have the potential to be more flexible in certain aspects.  Unlike EJVs, the profits, risks and losses of CJVs may be allocated between the parties in a proportion that differs from the equity contributions by the parties.  It may also be possible for the foreign investor to recover its investment before the end of cooperation term of the CJV.

(e) FIPE

On 1 March 2010, Administrative Measures on the Establishment of Partnership Enterprises in China by Foreign Enterprises or Individuals came into effect, allowing foreign individuals or organizations to participate in partnership enterprises, offering a further alternative to the RO, WFOE, EJV and CJV.  FIPEs allow for partnerships between two or more foreign enterprises or individuals, or a combination of foreign enterprises or individuals and Chinese individuals, legal persons or other organizations.

FIPEs do not need to obtain the approval from MOFCOM.  They only require registration through the local branches of SAIC.  However, businesses in certain sectors will need to comply with other specific regulations and the FIPE should submit approvals from relevant authorities when applying for its registration.

The types of FIPEs include foreign-invested general partnership and foreign-invested limited partnership.  Solely State-owned companies, State-owned enterprises, listed companies and public welfare institutions and social organizations shall not be general partners of FIPEs.  Limited partners cannot be the executive partner of a FIPE.

The FIPE provides a good channel to enter into Chinese market for foreign investors, especially for those private equity firms.

(f) Branch Office

Besides the above forms, a foreign company can set up a branch office in China if certain prerequisites, which may vary for different industries, can be met.  Such branch office does not have independent legal person status and its parent company will be held liable for all of its business activities in China.  Generally, in practice not all industries are permitted to establish a branch office by the foreign company in China.

The approval authority for the establishment of branch offices is generally MOFCOM or its local counterparts, while for certain regulated industries, it is the industry administration authority, such as China Insurance Regulatory Commission ("CIRC") or China Banking Regulatory Commission ("CBRC") that is charged with the approval responsibility.  Following the obtaining of approval of establishment, a branch office must apply to the local branch of SAIC for a business license.

3.3 Investment Process

(a) Establish a New Company

As analysis in Item 3.2, there are several different choices for foreign investors if they want to establish a new company in China.  Foreign investors may select a proper vehicle in accordance with their business considerations.

(b) Merger and Acquisition (the "M&A") of Domestic Chinese Enterprises

(i) General rules

Instead of setting up a brand new company, a foreign investor may acquire the equity interest in or the assets of a domestic Chinese company, assuming that such domestic company is engaged in an industry which is open to foreign investment under the Catalogue, and the shareholding ratio of foreign investors is compliant with the relevant rules and regulations.  There are two ways of achieving this, namely: ⑴ by establishing a FIE with the purpose of using such FIE to purchase assets from a PRC domestic company, or by directly acquiring assets from a PRC domestic company and then using those assets to establish a FIE; and ⑵ by acquiring the equity interest in, or by subscribing for new equity in a PRC domestic company, resulting in the conversion of such PRC domestic company to a FIE.

(ii) Special provisions on State-owned Enterprises

If the subject matter of the M&A involves the equity interest or assets of a State-owned enterprise (the "SOE"), a qualified asset valuation company must be appointed to carry out a valuation of the State-owned equity interest or assets in question.  The valuation result must be approved by or filed with the appropriate level of the State-owned Assets Supervision and Administration Commission of the State Council (the "SASAC"), and will be used as a reference for the determination of the transfer price of the State-owned equity interest or assets.  Where the agreed transfer price falls below 90% of the valuation, approval from the relevant property rights transfer government authorities must be obtained before the transaction may continue.  Moreover, the sale of State-owned equity interest or assets to foreign investors must be conducted publicly through holding public tender, or by listing or being auctioned on a recognized property rights exchange.

(iii) M&A  procedures

When acquiring the equity interest in or assets of an existing domestic company, it is necessary to conduct a thorough due diligence investigation on the Chinese target company or the assets to be acquired.  It is important to confirm that the target company was duly organized and are validly existing, and to investigate any loans borrowed or extended, and the title of any assets (including but not limited to land use rights, intellectual property rights etc.) owned by the target company.  The results of such thorough due diligence can provide guidance to the foreign investor when negotiating the contractual terms of the acquisition.

As the completed M&A will result in the conversion of the domestic company into an FIE, it is essential to obtain approval from the government authorities at the correct level.

If the proposed M&A by foreign investors of a domestic company satisfies the reporting standards as stipulated in the Rules on Standards of Reporting Business Operator Concentration promulgated by the State Council, the foreign investors shall report to the MOFCOM beforehand, and no transaction shall be conducted without reporting.

In 2011, the State Council released certain rules on the national security review.  Where the target domestic enterprise is involved in a business that concerns national defense security issues or national economic security issues, the national security review process will be conducted by the Joint Committee led by NDRC and MOFCOM.  If the proposed transaction is determined by the Joint Committee that it has or is likely to have a major impact on national security, the merging parties will be required to terminate the transaction or to undertake certain remedies such as the transfer of relevant shares, assets to eliminate any impact on national security.  It's worth noting that the variable interest entities mode (the "VIE") which was common used in foreign investments will face restrictions for certain industries in the future.

Following the obtaining of governmental approvals, registration with the local branches of SAIC and other relevant governmental authorities, such as tax administration authority, customs administration authority and foreign exchange administration authority, will have to be conducted within specified time periods.

(c) M&A of FIEs

Alternatively, a foreign investor may acquire the equity interests of a FIE held by another foreign investor.  Acquiring the equity interests in an already established FIE requires the consent of all other original shareholders, approval by the government authorities which initially approved the establishment of the FIE, and re-registration with SAIC.  In the case of an EJV, unanimous approval of the EJV's board, or in the case of some CJVs, the "joint management committee", is also required.

(d) Merger and Division of FIEs

Merger and division of FIEs are allowed in the PRC.  The merger of two or more FIEs requires approval from the relevant PRC government authorities that originally approved the establishment of each of those FIEs.  Similarly, the division of a FIE requires approval from its original examination and approval authority.

(e) Purchasing Shares in PRC Public Companies

Shares in PRC companies listed on the Shenzhen or Shanghai stock exchanges are classified into "A" shares, which can only be sold to Chinese citizens and organizations, Qualified Foreign Institutional Investors (the "QFII") and strategic foreign investors, and B shares, which can be sold to foreign citizens and organizations, including persons from Hong Kong, Macau and Taiwan, and (since February 2001) also to Chinese nationals residing inside the PRC.

3.4 Government Approval

(a) Approval Level

According to PRC law, the foreign invested projects should be submitted to NDRC or its local branches for the project review (if necessary) and the contract and articles of association (the "AOA") should be submitted to MOFCOM or its local branches prior to registration with SAIC.  The following chart shows which level of government approvals should be obtained.

Moreover, for the approval of an investment company by MOFCOM, if its registered capital is less than USD300 million, the approval level should be provisional or local MOFCOM, and only if its registered capital is or exceeds USD300 million it should obtain the approval from central MOFCOM.

(b) The Basic Approval Process

An FIE may be established only with the approval of the Chinese government.  The approval process for forming new entities or for acquiring existing companies (thereby converting them into FIEs) is largely the same.  The approval process begins with a name reservation application to the SAIC to check on the proposed name for the FIE.

After the company name has been reserved, the applicant must obtain substantive examination and approval of the investment by MOFCOM.  Examination and approval by MOFCOM is the key stage in the approval process.  It requires submission of the full definitive documents for the proposed FIE to MOFCOM, and may also require a feasibility study report describing background on the project, along with other supporting documents.  MOFCOM has the flexibility to request documents not expressly set forth in the statutes if they believe such documents would be helpful to its decision.

Project Verification from NDRC is technically required for any foreign investment project, but in practice, the NDRC's approval is critical only in certain industries, such as automotive industry, oil exploitation industry, etc.

After approvals from MOFCOM and NDRC (if necessary), the FIE may be registered with SAIC for issuance of a business license.  Under PRC law, the date of issuance of the business license is the date of incorporation of a company.  After obtaining the business license, the FIE should complete remaining registrations with relevant authorities including branches of State Administration of Foreign Exchange (the "SAFE"), General Administration of Customs of the People's Republic of China (the "Customs") and State Administration of Taxation ("SAT"), etc.

(c) Special Approvals

For some certain industries, the FIE should obtain special approvals.

Environmental approval from State Environmental Protection Agency (the "SEPA") may be required prior to applying to MOFCOM for manufacturing enterprises, or for any investment project that entails a construction project.  Before registration with SAIC, for companies involving food or pharmaceutical production, they have to get the approval from SFDA.

The approval from SASAC will be required for investments involving Stated-owned assets.
Some typically regulated industries (including, for example, securities, banking and insurance) involve special approval regimes in addition to, or in place of, MOFCOM examination and approval.  CSRC reviews applications to set up or acquire securities companies, CBRC covers banks, and CIRC reviews insurance company applications.

4  Operating in China

Whereas the previous parts addressed the basic political and legal system of China and the entry into Chinese market, this part will outline the principle business and commercial regulations governing the operations of FIEs in China.

4.1 Taxation

(a) Tax System

Under the current tax system, the PRC imposes about twenty (20) types of taxes, including enterprise income tax (the "EIT"), value added tax (the "VAT"), business tax, property tax, consumption tax, land appreciation tax (the "LAT"), land use tax, deed tax, stamp duty and individual income tax (the "IIT").  PRC has signed income tax treaties and arrangements with more than 80 countries and regions, including two special administrative regions of the PRC, Hong Kong and Macau.

(b) EIT

On 1 January 2008, the new unified PRC Enterprise Income Tax Law (the "EIT Law") became effective.  It consolidated the previous two separate income tax regimes for domestic enterprises and FIEs into one single income tax regime. The new EIT Law introduced the concept of resident enterprises, unified the tax rate for Chinese domestic enterprises and FIEs, replaced the old tax incentive system with a new model and addressed special tax adjustments, such as adjustments made pursuant to transfer pricing, or thin capitalization rules.

(i) Resident Enterprises vs. Non-resident Enterprises

A resident enterprise refers to an enterprise which is legally established in accordance with PRC law, or an enterprise which is legally established in a foreign country or region whose actual administration institution is in China.  The actual administration institution refers to the institution that actually and comprehensively manages and controls the production and operation, staff, account, property and other aspects of the enterprises.  A resident enterprise should pay EIT on its worldwide income, i.e., income derived from sources both inside and outside the PRC.

A non-resident enterprise refers to an enterprise which is legally established in a foreign country or region whose actual administration institution is outside China, but which either has an establishment in the PRC or has no establishment in the PRC but derives PRC-sourced income.  A non-resident enterprise which has an establishment or place in the PRC pays EIT on income which is derived from sources inside the PRC, as well as on income which, although derived from sources outside the PRC, is effectively connected with such establishment.  If a non-resident enterprise has no establishment in the PRC, or has an establishment in the PRC but has derived income not effectively connected with such establishment, it pays EIT only on income derived from sources inside the PRC.

(ii) Tax Base and Tax Rate

The taxable income of an enterprise is defined as the amount remaining from its gross income in a year, after non-taxable income, tax-exempt income, various expenses and losses have been deducted.  Losses incurred by an enterprise may be carried forward for a period of five (5) years.  No carry-back is permitted.  Reasonable expenditures which have actually been incurred and are related to the generation of income, including costs, expenses, taxes, losses and other expenditures are deductible.

A PRC resident enterprise is subject to EIT at a rate of 25% on its worldwide income.  A non-resident enterprise having an establishment in the PRC is subject to EIT at a rate of 25% on its PRC-sourced income received by the establishment as well as its non-PRC-sourced income actually connected with the establishment.  Where a non-resident enterprises that does not set up an institutions or establishments in China, or where institutions or establishments are set up but there is no actual relationship between the income and such institutions or establishments, the non-resident enterprise should pay EIT at a rate of 10% in relation to the income originating from China, which should be subject to tax withholding at source with the payer as the withholding agent.  Under certain tax treaties between China and other countries and/or regions, non-resident enterprise may enjoy more preferential tax treatment depending on the provisions of such treaties.

(iii) Tax Incentives

Various EIT incentives are provided in the EIT Law.  Preferential treatment is generally granted to industries and projects, the development of which is supported and encouraged by the State.

Qualified high-new technology enterprises (the "HNTEs") enjoy a 15% preferential tax rate nationwide.  Further, in respect of HNTEs established in the five special economic zones (Shenzhen, Zhuhai, Xiamen, Shantou and Hainan) and Pudong New Area of Shanghai, a tax holiday of a two-year exemption of EIT and a three-year half reduction of EIT will apply commencing from the first profitable year.

Venture capital investment enterprises enjoy a bonus deduction equaling 70% of the investment made to qualified medium and small sized high-tech enterprises, upon reaching two (2) years of ownership.  A bonus deduction or amortization of 50% of expenses incurred for research and development activities for new technology, new products, or new craftsmanship is also available to most enterprises.

Incomes earned from projects of agriculture, forestry, husbandry and fishery, incomes earned from business operations of important public infrastructure investment projects supported by the state, and incomes earned from eligible projects of environmental protection, energy and water saving may be exempted or reduced.

(c) IIT

China has a progressive IIT ranging from 3% up to 45%.  Generally, an individual who has a domicile in the territory of China or who has no domicile but has stayed in the territory of China for one (1) year or more should pay individual income tax for his/her incomes obtained in and/or outside the territory of China.  An individual who has no domicile and does not stay in the territory of China or who has no domicile but has stayed in the territory of China for less than one (1) year should pay individual income tax for his incomes obtained in the territory of China.

An FIE must generally serve as a withholding agent for its employees, and withhold and pay IIT on their behalf each month.  China relies principally on withholding to collect IIT, and only those individuals whose annual income is RMB120,000 or more, whose income from outside the territory of China, who receive wage and salary income from at least two (2) sources within the territory of China, or who receive taxable income but have no tax withholding agent, are required to file separate annual tax returns to the competent tax authorities.

(d) VAT

VAT is levied on the sale of goods inside the PRC, the import of goods into the PRC and the provision of processing, repair and maintenance services in the PRC.  The standard tax rate for most goods is 17%, though a concessionary rate of 13% applies to certain goods such as agricultural machinery, books and utilities.
The PRC VAT regime distinguishes between general VAT taxpayers and small scale VAT taxpayers.  The threshold to qualifying for general VAT taxpayers are those whose annual sales are above RMB 0.5 million for manufacturing enterprises and above RMB 0.8 million for trading enterprises.  The small VAT taxpayers should pay VAT at a lower rate of 3%.

(e) Business Tax

Business tax is levied on the provision of most services within the PRC, the transfer of intangible property in the PRC and the transfer of real property in the PRC.

Business tax rates

(f) Consumption Tax

Consumption tax is imposed as a measure to monitor the consumption of goods deemed as luxury or unhealthy.  It is charged to any person or unit engaged in the manufacturing, subcontracting, importing or processing of the prescribed goods.  The rate varies, depending on the exact taxable items.

(g) Stamp Duty

Stamp duty is levied on specific documents executed or obtained in the PRC. The rates generally range from 0.01% to 0.003%, depending on the type of document. To the extent that a document is a contract to which there is more than one contracting party, each party needs to pay stamp duty at the full statutory rate.

(h) Deed Tax

Deed tax is levied on the transfer of land use rights and real property.  The rate is 3% to 5%, depending on the location of the land or property.  Deed tax is payable by the transferee.

(i) LAT

LAT is levied on the gain from the transfer of State-owned land use rights and the property situated on the land.  The rates are progressive ranging from 30% to 60%, depending on the percentage of the appreciation.

(j) Property Tax

Property tax is levied on the ownership of real property in urban areas.  It is assessed at an annual rate of 1.2% of the original cost of the building with less a 10% to 30% deduction (this percentage of deduction is determined by the relevant local authorities and thus may vary from location to location) or at a rate of 12% of the annual rental income.  From 1 January 2009, Chinese companies or individuals have stopped paying property tax; however, FIEs, foreign enterprises and organizations and foreign individuals continue to pay property tax.  In early 2011, Chongqing and Shanghai has begun to levy property tax again.

(k) Urban Land Use Tax

Urban land use tax is levied on the ownership of land use rights in urban areas.  The exact rate depends on the location of the relevant land.  According to the national regulations, the applicable rates per square meter are RMB 1.5 to RMB30 per year for large cities, RMB1.2 to RMB24 per year for medium-sized cities, RMB0.9 to RMB18 per year for small cities and RMB 0.6 to RMB12 per year for counties.

(l) Customs Duty

Customs duty is levied on the imported and exported goods and articles entering or leaving the territory of the PRC. Customs duty is payable according to a tariff schedule.  With free trade agreements (the "FTA"), goods traded between the PRC and the FTA signatory countries qualify for lower customs duty rates.  Qualified enterprises enjoy duty reduction or exemption as a tariff preference measure.

4.2 Employment

(a) Regulatory Environment

The foundation for China's employment laws, rules, and regulations is the PRC Labor Law, which was enacted on 1 January 1995 by the NPC.  Another milestone in the development of China's labor and social security legislation is the PRC Labor Contract Law, which was passed by the NPC and came into force on 1 January 2008.  Later, the Regulations of Implementation on the PRC Labor Contract Law became effective on 18 September 2008, which specifies certain issues on labor.

Employment matters, including those of FIEs, within the territory of the PRC are all subject to the PRC Labor Law, the PRC Labor Contract Law, and other laws and regulations issued by the NPC or the central government.  There are also local regulations and rules issued by provincial, municipal, and other lower level government authorities that are only applicable to the relevant local regions.

(b) Contract of Employment

PRC law allows the employer to engage a part-time employee with an oral contract.  However, in case of any employment of full time employee, the parties are required to enter into a written labor contract within one month from the date of commencement of employment.  Failure to comply with this provision results in the employer being required to pay to the employee twice the amount of the agreed remuneration as salary.

(c) Minimum Wage

There is a system of guaranteed minimum wages and salaries for Chinese workers.  Local people's government will formulate its own specific standards for minimum wages and salaries.  The payable wages and salaries (exclusive of any overtime pay, social insurance/housing fund contributions borne by the employee, or any allowance for middle/night shifts, high/low temperature etc.) shall be in no case lower than the local minimum wage and salary standards if the workers have provided "normal work" pursuant to their labor contracts.

(d) Working Day and Overtime

There are three kinds of work hour systems, i.e., standard work hour system, comprehensive work hour system and indefinite work hour system.

(e) Social Insurance

The employer is obliged to have their PRC employees enrolled in the applicable social insurance schemes provided by the local labor authorities, and withhold the contributions borne by the employee (referred to as the "Individual Contributions" below) from his/her monthly salary and pay the individual contributions as well as the contributions borne by the employer (the "Company Contributions") to the local social insurance institution each month.

The rate and contribution basis of social insurance premium depends on the relevant local regulations.  Different localities provides for different categories of social insurance schemes, which mainly depends on the localities of the domicile of the employees.

(f) Health and Safety

Employers are required to strictly implement the rules and standards of the State with regard to occupational safety and health, carry out relevant education among employees, prevent accidents in the process of work, and lessen occupational hazards.  Facilities of occupational safety and health must meet the standards set by the State.

(g) Termination of Employment and Economic Compensation

(i) Termination initiated by employer

The employer is generally not allowed to unilaterally terminate the labor contract at will or without cause.  The termination of employment initiated by the employer is not allowed unless some specific conditions (i.e., the statutory termination grounds) have occurred, for instance, the employee seriously violates work rules and regulations of the employer.

If the employer terminates the employment of the employee in violation of law, the employee may request for specific performance, i.e., reinstatement to his/her job position.  If the employee does not so request or the contract is no longer capable of being performed, the employer shall pay twice the usual severance pay amount as damages to the employee.

(ii) Termination by mutual consent

If the employer proposes to terminate the employment of the employee, and the employee so agrees after negotiation between the parties, the labor contract can be terminated, which is referred to as the "termination by mutual consent" in the PRC employment law.

(iii) Termination initiated by employee

The employee may: ⑴ unilaterally early terminate the labor contract without cause as long as he/she gives a 30-day prior written notice to the employer (in case such employee is in probationary period, such prior notice period is three (3) days); or ⑵ immediately terminate his/her labor contract without any prior notice under some specific circumstances, such as when the employer does not pay the employee in full and on time.

(h) Labor Secondment or Contractual Worker

The ROs set up by foreign companies are not allowed to employ staff directly in the PRC but may only obtain the staff through certain designated labor agencies (the "Agency") like Foreign Enterprise Services Corporation (the "FESCO"), which is generally referred to in China as the labor secondment arrangement.  Local labor bureau are in charge of monitoring compliance.  Under this arrangement, the RO as the Secondee Company signs a service contract with the Agency for engagement of their labor secondment services, and the employee as the Seconded Employee, who may be appointed by the Secondee Company or the Agency, signs labor contract with the Agency and is seconded to work in the Secondee Company.

(i) Employment of Foreigners

In most cases, employers must recruit Chinese nationals if at all possible.  In order to bring in a foreign employee, the employer must first apply to the local labor bureau for an employment permission certificate to bring in the intended employee.  Once the employer has received the employment permission certificate, the foreign employee must apply for a work visa at his local Chinese consulate.  After entering China, the employee must obtain a work permit and residence card prior to commencing employment.  Foreign experts, off shore petroleum workers, cultural and artistic performers, and representatives of ROs enter China under different procedures.

4.3 Antitrust & Competition

(a) Legislation

A broad range of PRC laws contain one or more provisions prohibiting anti-competitive practices such as price-fixing, market-sharing and below-cost sales. These include the Anti-Unfair Competition Law and the Price Law.  Many of these provisions have not been widely enforced, and the fragmented structure of the competition legislation reflects the historical absence of a cohesive competition policy in the PRC.

However, a comprehensive Anti-Monopoly Law (the "AML") came into effect on 1 August 2008.  A number of provisions in the AML overlap with pre-existing competition provisions, but it is expected that the AML will be the primary law used to tackle anti-competitive conduct going forward.  The AML regulates three (3) main areas of business conduct: monopoly agreements, the abuse of a dominant market position, and concentrations (i.e., M&A deals and certain other transactions) with anti-competitive impacts.  These prohibitions are understood to apply to nearly all businesses, although SOEs may receive some special treatment under the AML, and certain activities of agricultural producers and farming entities are exempt from the law.

(b) The Development Nature of the PRC Competition Regime

Prior to the commencement of the AML, most PRC competition-related provisions were rarely enforced.  The main exception was the merger control regime under the M&A regulations.  However, the commencement of the AML, and the introduction of significant new legal liabilities relating to anti-competitive practices, reflects an increasing focus on competition issues in China.  This suggests that, going forward, competition provisions may be enforced with more vigor than historically has been the case – particularly once further detailed implementing regulations and guidelines regarding application and enforcement of the AML are released.

It should also be noted that many of the laws prior to the AML that incorporate competition-related provisions remain in force.  While many of these provisions overlap with the AML, in some cases they may have a potentially broader application.  Additionally, some competition provisions are sector-specific, relating to industries such as banking and telecommunications.  It is possible these provisions may still be applied going forward, either in conjunction with the AML or on a stand-alone basis.

4.4 Intellectual Property

Intellectual property protection is a key consideration for foreign investors entering Chinese market.  The PRC has a comprehensive regime of intellectual property laws which provide a wide range of remedies and channels for enforcement, including civil and criminal courts, several different administrative enforcement authorities, prosecutors and polices.  Legislation facilitating private prosecution by intellectual property owners came into effect in 1997.  These intellectual property laws are compliant with the requirements under the Agreement on Trade-Related Aspects of Intellectual Property Rights (the "TRIPs Agreement") of the World Trade Organization.  Also, China is a party to most of the international conventions on intellectual property rights, including:

•  the Paris Convention for the Protection of Intellectual Property Rights
•  the TRIPs Agreement
•  the Berne Convention for the Protection of Literary and Artistic Works
•  the Universal Copyright Convention
•  the WIPO Copyright Treaty
•  the Locarno Agreement for International Classification for Industrial Designs
•  the Madrid Agreement for the International Registration of Trademarks
•  the Nice Agreement for the International Classification of Goods & Services
•  the Patent Co-operation Treaty
•  the Strasbourg Agreement for International Patent Classification
•  the Budapest Treaty for Deposit of Micro-organisms
•  the Geneva Convention on Unauthorized Duplication of Phonograms
•  the WIPO Performances and Phonograms Treaty

Although the laws are there, the level of infringement and the inadequacy of enforcement has been the subject of disputes with Chinese trade partners, particularly the United States of America.
In China, PRC law provides protection for the patent, trademark and copyright.

(a) Patent

There are three (3) types of patents in China: invention patents, utility model patents and design patents.   Invention refers to any new technical solution relating to a product, a process or improvement thereof.  Utility model refers to any new technical solution relating to the shape, the structure, or their combination, of a product, which is fit for practical use.  Design refers to any new design of the shape, pattern or their combination and the combination of color and shape or pattern, of a product, which creates an aesthetic feeling and is fit for industrial application.

Patents may be assigned or licensed, but only upon registration with the State Intellectual Property Office of the People's Public of China (the "SIPO").  Invention patents are the most robust of the three (3) kinds of patents, involving a meticulous review process that takes several years to complete, and providing protection for a period of twenty (20) years from the date of filing to SIPO.  Utility model patents and design patents have a less meticulous and lengthy review process, and also provide a shorter period of ten (10) years after the date of filing.  China's patent system works on a first to file basis.

(b) Trademark

In China, trademarks include registered trademarks and unregistered trademarks.  Only if trademarks are registered with the Trademark Office of the State Administration for Industry and Commerce of the People's Republic of China (the "Trademark Office") can such trademarks seek protection under the PRC Trademark Law, unless the unregistered trademarks are be defined as well-known trademarks.  The period of validity of a registered trademark is ten years commencing from the date of approval for the registration, with subsequent ten-year extensions being available.  Registered trademarks may be assigned or licensed provided such assignments or licenses are registered with or approved by the Trademark Office.

(c) Copyright

The PRC Copyright Law provides protections for creative works, including software.  The National Copyright Administration of the People's Republic of China (the "NCAC") oversees the copyright system.  The NCAC oversees a non-mandatory registration process covering the both registration of copyrights themselves and of assignments or licenses thereof.

4.5 Real Property

(a) Overview

In China land in urban areas shall be owned by the State, and land in rural and suburban areas, unless otherwise prescribed by the State, shall be collectively owned by farmers, including land for houses and private plots in fields and on hillsides.  Neither domestic companies nor FIEs can own land, although they may hold land use rights.

For State-owned land use rights, there are two (2) different types, allocated land use rights and granted use rights.  Generally, the State-owned land use right shall be obtained by paid means such as grant.  However, upon the approval from the government at or above the county level, the State-owned land may be allocated for government institutions or the military; urban infrastructure or public welfare projects; or energy, transportation and water conservancy projects as well as other infrastructure projects supported by the government.  In general, allocated land use rights cannot be transferred or leased without first being converted into granted land use rights (for which a grant fee must generally be paid to the government).  The government may reclaim allocated land use rights at any time without compensation. 

Granted land use right is the right to use land for a specific purpose for a fixed term, seventy (70) years, fifty (50) years or forty (40) years, depending on the purpose of land.  A grant fee must be paid to the government for granted land use rights.

Buildings on land generally should be owned by the same person that holds the corresponding land use rights.  Nevertheless, land use rights and buildings on the corresponding land are sometimes owned by different persons.

(b) Land use rights transfers

Under PRC law, only granted land use rights may be transferred.  Nobody will obtain title to allocated land, even if someone purports to sell it to you, provided that it is first converted to granted land use rights (for which a grant fee must first be paid to the government).  Vacant land is required to be at least 25% developed before the corresponding land use rights can be transferred.  The government may reclaim vacant land if development is not started within two (2) years of transfer.

(c) Renewal of land use rights

From 1 October 2007, the term of residential land use rights will be automatically renewed upon expiry.  This is a welcome relief to those owning residential properties in China.  It will also ensure that financing remains available for residential property approaching expiration of its land use right term.  Non-residential land use right terms are not granted automatic renewal under the Property Law.  Rather, renewal will be subject to other laws and regulations.

(d) Easements

The creation of easements has been recognized since the PRC Property Law became effective on 1 October 2007.  The ability to create easements recognized by law is likely to be of particular importance for infrastructure projects that involve the construction of pipelines or other networks requiring access to land over which the project owner does not hold the land use rights.

(e) Leasing

Land must generally have been developed before it can be leased.  A lessee is required to comply with the terms and conditions of the land use rights grant contract.  A registered lease with authorities will gain priority over any unregistered lease.

(f) Expropriations

Land may be expropriated by the government only in special circumstances and in the public interest.  Compensation is required to be paid if land is expropriated.

4.6 Foreign Exchange

China's currency, the RMB, is not fully convertible.  The RMB is ultimately monitored and controlled by China's State Administration of Foreign Exchange (the "SAFE").  In the past, all foreign currency transactions involving the purchase or sale of RMB were subject to SAFE's review and approval.  Since China became a member of the WTO in 2001, China's foreign currency policy has become increasingly less restrictive.

Under PRC law, foreign currency transactions are categorized as the capital account transactions and the current account transactions.  Capital account transactions refer to the transaction items in the balance of payments leading to changes in external assets and liabilities, including capital transfers, direct investments, portfolio investments, derivatives, loans, etc.  Current account transactions refer to the transaction items in the balance of payments involving goods, services, income, and current transfers, etc.  Compared to payments of capital, current account items may face relatively easier control.

An FIE may, subject to SAFE approval, open a foreign exchange account with a designated foreign exchange bank.  Usually, the account must be opened within the same area in which the FIE is registered.  The approval is required to open an account in another area.  An FIE may purchase foreign exchange if it has insufficient funds in its foreign exchange account to meet a foreign exchange obligation.  Foreign currency accounts of FIEs are subject to annual inspections by SAFE.  Moreover, foreign investors without an FIE in China may open a multicurrency account with a bank to fund the pre-establishment expenses of an FIE.

4.7 Environmental Regulation

The PRC Environmental Protection Law is the national law governing all environmental protection matters in the PRC.  In addition to the Environmental Protection Law, other laws and regulations such as the Prevention of Atmospheric Pollution Law and the Prevention of Water Pollution Law have been enacted to regulate different parts of the environment.  Different provinces and municipalities have also implemented their own environmental protection regulations which are of regional application.

It should be noted that the PRC government has not separately formulated a set of rules and regulations concerning environmental protection for FIEs and FIEs within the territory of the PRC are subject to the same regulatory regime as domestic enterprises.

It's also worth noting that China's recent green policy link benefits in other areas to environmental compliance.  Green insurance policies require enterprises in certain sectors to insure against environmental damage.  Green trade policies may result in higher export taxes on products made in pollution-intensive industries.  The EIL Law also contemplates green taxation polices, providing tax incentives and sanctions concerning the environment.

4.8 Product Safety

China does not have a single, codified product safety law.  Manufacturers and sellers of products and other stakeholders in this area must follow legal requirements as set out in various laws and regulations, including the General Principles of the Civil Law, the Law on Protection of the Rights and Interests of Consumers, the Criminal Law, and laws on the Administration of Pharmaceuticals and on Product Quality.  China issued important legislation on food and product safety in the past several years, including the Law on the Quality and Safety of Agricultural Products in 2006; several sector-specific regulations covering the recall of vehicles, toys, food, and drugs in 2007; and the Food Safety Law and its implementing rules in 2009, which represented a milestone in the formation of China's product safety regime.  These laws and regulations responded to the public's rising concern about product safety in China.  Despite these laws and regulations, China has experienced a number of significant product safety issues in the recent years.

4.9 Dispute Resolution

As an increasing number of foreign investors penetrate the Chinese market, commercial disputes are expanding quickly both in number and in scale.  China has made significant progress in increasing the integrity and reliability of its courts.  The formal processes available for resolving such disputes in China have, in recent years, become increasingly similar to those elsewhere in the world.

If a dispute cannot be settled through negotiation between the parties, the case must be submitted for litigation or arbitration.  Under PRC law, it is permitted for the parties to choose for binding arbitration to resolve their disputes and the courts will generally enforce arbitration judgment without inquiry into the merits.  It is worthy noting that arbitration is only possible if the parties expressly agree to arbitrate. In practice, the arbitration is favored by many foreign investors in China.

(a) Litigation

The PRC courts consist of four (4) layers: the People's Court (at the district or county level), the Intermediate People's Courts (at the municipal level), the High People's Courts (at provincial level), and the Supreme People's Court (at the national level).  The level of the competent court should be generally subject to the nature and size of the disputes.  In most cases, disputes with a foreign connection may be initially in the Intermediate People's Courts.

Court judgments may be appealed once, but the judgment of the second instance is final and binding upon the parties immediately.  Under the PRC Contract Law, it is permitted to select a foreign law to govern the contract with a foreign connection and to provide for exclusive jurisdiction in foreign courts.  In fact, it may be difficult for Chinese courts to enforce a judgment made by a foreign court, but Hong Kong's judgments are exceptions.

(b) Arbitration

In comparison to litigation, the arbitration seems much quicker, more efficient and more reliable, thus major foreign investors would like to include an exclusive arbitration clause in their contracts.

 Under PRC law, an express clause clearly indicating the parties' selection of binding arbitration is enforceable, which should be in writing and contain a clear statement of the parties' intention to submit the dispute to arbitration, the scope of disputes subject to arbitration, and the specific arbitral commission to resolve the dispute.  In addition, it is possible for the parties to reach an arbitration agreement after a dispute arises, but in most cases an arbitration clause is included from the outset in the operative contracts.

The China International Economic and Trade Arbitration Commission (the "CIETAC") is one of the most frequently selected arbitration forums when the arbitration will be held within the PRC.  Foreign investors sometimes do not agree to arbitration in PRC, including arbitration at CIETAC, because they believe that Chinese parties will have a home advantage, meanwhile, Chinese parties concomitantly often object to arbitration aboard.  Therefore, Hong Kong seems as acceptable compromise to both parties.  Of course, to select a third country's jurisdiction for arbitration is also common in practice.  Since China is a party to the United Nations Convention of Recognition and Enforcement of Foreign Arbitral Awards, it is generally possible to obtain the enforcement of an arbitration award issued by a panel in any member country.

Being a lawyer himself, Mr. Liu filed a complaint against Dongfeng Nissan and the 4S store alleging that it constituted an abusive conduct for the defendants to refuse to sell the spare parts and repair services separately.  According to Mr. Liu, the spare parts sold by the 4S store were three times more expensive than the market price; and the repair services offered by the 4S store were 7 times more expensive than the market rate.

The key issue in this litigation is whether Dongfeng Nissan and its 4S store have dominant market position.  Dongfeng Nissan argued that with a market share of less than 50%, it did not hold a dominant position in the automobile market.  Moreover, Dongfeng Nissan argued that it was an industry practice for 4S stores not to sell auto parts alone, in order to ensure the quality of the auto parts and the safety of customers.  The plaintiff counter-argued that the defendant had dominant position (nearly 100%) in the market for the supply of spare parts of Nissan cars and that it was not an industry practice for "4S" stores to refuse to sell spare parts alone. 

The court eventually ruled against the plaintiff on the ground that the plaintiff failed to provide sufficient evidence to define the relevant market at issue here and to establish the defendants' dominant positions.  The plaintiff has lodged an appeal against this decision and claimed that the defendants tied the excessively expensive services to the sale of "original spare parts" of Nissan cars.

Comments

This lawsuit is the first decided AML private action after the Supreme Court published the draft judicial interpretation governing AML private actions in April ("Draft Litigation Rules") . ³ Although the Draft Litigation Rules have not yet been finalized, it appears that some of the rules have been adopted in practice.  For instance, the case was first brought before a district court in Changsha and then referred to Changsha Intermediate Court for hearing.  This is in line with the provisions in the Draft Litigation Rules regarding the jurisdiction of AML private actions.

Moreover, it appears that the Chinese courts are getting more sophisticated in trying AML private actions.  The Changsha Intermediate Court indicated in its decision that to properly define the relevant market and establish defendants' dominance, the plaintiff should conduct market research and provide evidence relating to the existing substitutable products and services in the market, their market shares and the competitiveness of the competing operators.  It shows that the court had endorsed the demand-side substitutability test in defining the relevant market and required a full analysis on the competition dynamics in the relevant market. 

This, of course, makes it more difficult for plaintiffs, especially in case of individual customers, to establish their cases.  Noticeably, the Draft Litigation Rules set forth some rebuttable presumptions of dominance to alleviate such burden.  For example, public utility enterprises or enterprises having exclusive legal authorization to supply certain products or services can be presumed to have dominance in a relevant market.  Another potential solution could be to bring a "joint action"  ⁴ which bears some resemblance to the US class action regime, so that individual consumers can come together to share resources and costs.

Back to this case, the plaintiff tried to establish a relevant market for parts or services for Nissan-brand passenger cars.  This reminds us of the Kodak case in the United States in which the Supreme Court has held that a single brand of product or service, namely Kodak parts or services for Kodak copiers, could be a relevant market under the Sherman Act as the customers were "locked in" to the "aftermarkets" for parts and services designed specifically for those copiers.  ⁵ It will be interesting to see how the plaintiff will further develop this as well as the tying argument in the appeal.

¹ See, for example, Plaintiff Lost First AML Civil Action in Automobile Industry, Legal Daily, December 17, 2011, available at http://epaper.legaldaily.com.cn/fzrb/content/20111217/Articel08007GN.htm.
²4S store refers to shops which sell vehicles and spare parts, and provide services and survey ("Sale, Spare part, Service and Survey").
³For more details, please refer to our previous article entitled Supreme People's Court Issues Draft Rules Governing Private Actions under the Anti-Monopoly Law.
⁴ For a brief introduction of the AML joint action, please refer to our article entitled AML Class Actions and The Draft Litigation Rules.
⁵Eastman Kodak Co. v. Image Technical Services, Inc., 504 U.S. 451 (1992).

Relevant Market 

According to the Announcement, the relevant market is the worldwide HDD market. Although MOFCOM found that the HDD market could be further divided into narrower market segments based on the end use application (such as desktop computers, mobile computers), it considered the HDD market as a whole and carried out competition analysis only in the HDD market.

Competitive Assessment 

MOFCOM mainly considered the following factors in its analysis:

Market Structure. MOFCOM noted that the worldwide HDD market is highly concentrated with only five players, i.e. Seagate (33%), Western Digital (29%), Hitachi (18%), Toshiba (10%) and Samsung (10%), whose market shares are similar in China. It found that the HDD market is very transparent. Since the HDD products are homogenous and large computer manufacturers as the main downstream customers are relatively few in number, it is easy for HDD manufacturers to gain competitor' s information.

Purchasing Pattern. MOFCOM emphasized the importance of the current purchasing pattern on the maintenance of competition in HDD market. In order to ensure stable supply, large computer manufacturers procure through a confidential bidding process and split the order among two to four HDD manufacturers based on the competitiveness of their prices. This model incentivizes HDD manufacturers to compete for larger orders.

Buyers' Bargaining Power. MOFCOM found that large computer manufacturers generally will not oppose price increases and will instead shift such price burden to end consumers that have little countervailing buyer power. As pragmatic evidence, MOFCOM cited an example indicating how the recent price increases by Western Digital due to its impaired production by the floods in Thailand were passed on to end consumers.

MOFCOM also found that the capacity utilization rate of the HDD manufacturers are very high (90% in the fourth quarter of 2010), entry barriers are significant (no new entry into the worldwide HDD market in the past 10 years) and that innovation is quite important for HDD manufacturers to obtain competitive advantages.

Taking into account the above, MOFCOM was of the view that this merger will cause negative impact on Chinese consumers. It is likely to restrict competition by removing an important competitor from the market, undermining the effect the purchasing pattern has on bringing competitive pressures on HDD manufacturers and increasing the possibility of coordination among the remaining players considering the relative transparency of the HDD market.

Remedies
 
According to MOFCOM's decision, Seagate shall have the following obligations:

(1) Seagate shall adopt measures to keep Samsung's brand as a separate competitor, such as establishing an independent subsidiary for independent pricing and sales of Samsung products, creating firewalls to avoid information exchange etc.;

(2) Seagate shall keep its promise to expand the Samsung production capacity within six months of the decision, and reasonably determine and report the production capacity and volumes of Samsung's products thereafter;

(3) Seagate shall not materially change its current business model, forcing customers to buy HDDs exclusively from Seagate or its controlled entities;

(4) Seagate shall not force TDK (China) Investment Co. to supply magnetic pickup head for HDDs to Seagate or its controlled entities exclusively or restrict the quantity TDK sells to other HDD manufacturers; and

(5) Seagate shall invest at least USD800 million per year for three years in R&D.
 

It is interesting to note that Seagate is entitled to apply to MOFCOM for release of the first two of the above obligations after the elapse of 12 months from the date of the decision. MOFCOM will then decide whether to approve based on the market conditions.

Comments

The decision is the most comprehensive decision MOFCOM has published to date. Whereas MOFCOM still relies heavily on market share and market structure, it also takes in account a comprehensive set of factors as well as pragmatic evidence in its analysis.

Moreover, this deal was also notified in the U.S. and the EU. But MOFCOM is the only authority that has imposed remedies, showing that MOFCOM is getting increasingly independent in reaching its own decision. This raises another interesting issue: how and to what extent would antitrust authorities in different jurisdictions cooperate with each other in the face of a cross-jurisdictional merger filing if significant divergence is likely to happen?  

In relation to the remedies, it is also interesting to note that for the first time, MOFCOM included a periodic review clause in its clearance.  Western Digital/Hitachi, the other major transaction in HDD market, obtained conditional approval from the European Commission in November. MOFCOM may have considered that the Western Digital/Hitachi transaction and the divesture commitments made by Western Digital may eventually change the competitive landscape of the HDD market and therefore Seagate's obligations may merit review at a later stage.

 1. A copy of MOFCOM' s Announcement [2011] No. 90 could be found here(in Chinese): http://fldj.mofcom.gov.cn/aarticle/zcfb/201112/20111207874274.html
 
2. The Extended Phase II lasted 62 days in this case.The statutory Extended Phase II should be 60 days; however, since the last day of the review period was a Saturday, MOFCOM extended the period for another 2 days.

According to the report, the NDRC is not satisfied with China Telecom's current proposal because it is "too vague and too difficult to monitor".  The NDRC required China Telecom to specify more details in its commitments such as the extent and timelines of its proposed bandwidth expansion and price reduction.  The detailed plans were required to be disclosed to the public for supervision. 

The NDRC appears to be uncompromising in this investigation of the two large SOEs.  In fact, after the previous Department of Price Supervision of the NDRC was renamed in August as the Price Supervision and Anti-monopoly Bureau and restructured to include three divisions dedicated to antitrust enforcement, the NDRC has been actively pursuing after companies for price-related monopolistic conducts².   The three divisions are: the First Division of Anti-price-related Monopoly Investigation, the Second Division of Anti-price-related Monopoly Investigation and the Division of Competition Policy.  The total number of officials was increased from 26 to 46. 

The local price administration agencies have also been undergoing similar restructuring in an effort to intensify antitrust enforcement.  In September, the previous Guangdong Provincial Price Bureau was officially renamed as the Guangdong Price Supervision and Inspection and Anti-monopoly Bureau with more officials recruited to beef up antitrust enforcement forces (see our article entitled "Guangdong Provincial Price Bureau Renamed, Reflecting Strengthened Antitrust Enforcement Authority"). 

¹NDRC Investigation Ongoing, China Telecom Likely to Release More Detailed Proposal This Week, Economic Observer, December 13, 2011, available at http://www.eeo.com.cn/2011/1213/217897.shtml.

²Last month, the NDRC fined two domestic pharmaceutical companies for abusing their dominant positions in the promethazine hydrochloride market. Please refer to our previous article entitled "NDRC Fined Two Pharmaceutical Companies for Abusive Conducts".

Facts

The penalized companies, Weifang Shuntong Pharmaceutical Co. Ltd. ("Shuntong") and Weifang Huaxin Pharmaceutical Trading Co. Ltd. ("Huaxin") are both pharmaceutical distribution companies in the business of selling promethazine hydrochloride, the key ingredient for "compound reserpine tablets", a popular hypertension medicine listed among China's national essential drugs.

According to the NDRC, Shuntong and Huaxin entered into exclusive sales agreements with the only two manufacturers of the ingredient in June 2011, thereby gained full control of the domestic supply of promethazine hydrochloride. Shuntong and Huaxin then raised the sales price of promethazine hydrochloride from less than RMB200/kg to RMB300-1350/kg and further required the downstream medicine manufacturers to raise the price of compound reserpine tablets from RMB1.3/bottle to RMB5-6/bottle.

As a result, the compound reserpine tablets manufacturers could not afford the excessively high ingredient cost and were forced to suspend production, causing shortage of supply in the market. Upon receipt of complaints from these medicine manufacturers, the NDRC initiated investigations over Shuntong and Huaxin. Shuntong was imposed a punitive fine of RMB6.5 million on top of confiscation of illegal income of RMB0.377 million (about USD1.06 million in total). Huaxin was imposed a fine of RMB100,000 on top of confiscation of illegal income of RMB 52,600 (about USD23,800 in total). The NDRC also ordered the companies to terminate their exclusive sales agreements with the promethazine hydrochloride producers.

Comments

The NDRC's news release did not clearly indicate which article(s) of the AML the two companies have violated. Based on publicly available information, we understand that Shuntong and Huaxin abused their dominant position in the promethazine hydrochloride market by charging excessively high price and by imposing unreasonable conditions without valid reasons.

Dominant Position

Assuming there is no effective substitute for promethazine hydrochloride as a key ingredient of compound reserpine tablets, promethazine hydrochloride could be considered to constitute a separate relevant product market under the AML. The relevant geographic market could de defined as China-wide, given that the NDRC is only concerned with the domestic supply and demand of the product.

According to the NDRC, Shuntong and Huaxin controlled the entire supply of promethazine hydrochloride by entering into the exclusive sales agreements with the only two manufacturers of promethazine hydrochloride. The exclusive sales agreements effectively ruled out the possibility for other distributors to purchase and resell the relevant product. Moreover, it was reported that the two companies had cross shareholding relationships. Therefore, adequate competition between the two suppliers would not be expected to exist.

Pursuant to Article 19 of the AML, in case that two operators hold over 2/3 of market shares in the relevant market, the operators can be deemed to have a dominant position. In this case, it appears that the NDRC considered Shuntong and Huaxin to be dominant players in the relevant market.

Abusive Conducts

There is no evidence showing that the aforesaid dramatic increase of promethazine hydrochloride price was resulted from a rise in its cost. According to Article 17(1) of the AML and Article 11 of the NDRC's Rules on Anti-price Monopoly ("Price Monopoly Rules"), where a dominant operator increases price beyond a reasonable range when the product cost remains stable, it could be deemed as charging an unfairly high price, which is a type of prohibited abusive conducts.

Additionally, we understand that by requiring the compound reserpine tablets manufacturers to raise the price of the medicine may also constitute a violation of Article 17(5) of the AML by imposing unreasonable trading terms on trading counterparts.

It appears that in its antitrust enforcement, the NDRC is targeting not only large SOEs but also smaller companies having control over supplies of important products. Its successive actions have also indicated that the NDRC is ready to take a stronger stance in its enforcement of price-related monopoly conducts.     

1. For the original news release on the NDRC's website (in Chinese), please refer to: http://jjs.ndrc.gov.cn/gzdt/t20111115_444599.htm.

Both companies disclosed that they have submitted to the NDRC "proposal(s) for enhancement initiatives" and applications for suspension of investigation.  They both committed to improve the internet interconnection quality, adjust the pricing management of internet dedicated leased line access service and continue to invest and upgrade construction of broadband network in China.  China Telecom particularly mentioned that it would reduce the price for direct interconnection with China Tietong (a smaller backbone operator who also competes in the internet access retail area) and promised to lower the internet access unit price for public customers by approximately 35% within 5 years with higher access speed.

Later the same day, the NDRC confirmed that it has received and is reviewing the applications from the two companies.

China Telecom and China Unicom are the two largest backbone network operators in China.  On November 9, the NDRC announced that it had launched investigations into the two companies' broadband access businesses.  Ms. Li Qing, the Deputy General Director of the Price Supervision and Anti-monopoly Bureau of the NDRC, commented that by charging their competitors much higher prices than non-competitors, the two companies could constitute "price discrimination" (one of the abusive conducts) under the AML (for details, please check out our previous articles entitled "Chinese Antitrust Enforcement Agencies Ready to Show Teeth to Large State-owned Enterprises?" and "Earlier Rumor Confirmed: China Telecom and China Unicom under Antitrust Investigation".

Comments

China Telecom and China Unicom filed the application for suspension of investigation pursuant to Article 45 of the AML.  According to Article 45, if a company under antitrust investigation undertakes to take timely measures to eliminate the consequences of its alleged monopolistic practices, the AML enforcement agencies may decide to suspend the investigation.  Upon fulfillment of such commitments, the AML enforcement agency may make a decision to terminate the antitrust investigation.  Investigation may nevertheless be resumed if (a) the company fails to perform its commitments, (b) the facts based on which the suspension decision was made changed materially or (c) the information provided by the company based on which the suspension decision was made was incomplete or unauthentic. 

Both the NDRC and the State Administration for Industry and Commerce have provided similar procedural guidance relating to suspension of antitrust investigation.

If an application is successful, the company that applied for suspension can benefit from relatively speedy closing (at least temporarily) of the investigation. Moreover, we understand it would be reasonable to infer that once an application is granted, the company will not be imposed antitrust fines that could have ranged from 1-10% of its turnover for the previous year.  Nevertheless, it is not entirely clear under the AML what implications the company's undertakings may have in an AML private litigation.  We however notice that the draft rules governing AML private actions released by the Supreme People's Court in April expressly provided that such commitments made by a company cannot be used in support of direct presumption of monopolistic conducts.

Will NDRC accept the commitments and decide to suspend the investigation? We will keep a close watch on this milestone antitrust investigation.
 

¹For China Telecom's announcement in HKEx, please refer to http://www.chinatelecom-h.com/eng/announcements/announcements/a111202.pdf. For China Unicom's announcement in HKEx, please refer to http://www.chinaunicom.com.hk/files/doc/News-2011/a120200-tc.pdf.

The Provisional Measures have not been officially released to date, and are expected to be published early next year. 

A draft of the Provisional Measures was published for comments on June 13, 2011 (see our previous article entitled "MOFCOM publishes draft rules on investigation procedures re failure to notify on concentrations" for more information).  According to earlier report, the Provisional Measures are among the three new rules on merger control that are expected to be released within this or next year.  The other two new rules deal with merger remedies and notification of concentration below notification thresholds respectively.

¹ MOFCOM's press release can be found here (in Chinese): http://bgt.mofcom.gov.cn/aarticle/c/d/201112/20111207869504.html.

Parties and Transaction. The proposed transaction was announced as early as January, 2011 as part of President Hu Jintao's state visit to the United States ³.  GE China and CSCLC are to establish a 50/50 JV mainly to license coal-water slurry (CWS) gasification technology to industrial and power projects in China. GE Infrastructure Technology, another subsidiary of GE will license GE's CWS gasification technology to the proposed JV.

The parent company of CSCLC - Shenhua Group Corporation Limited (Shenhua Group) is a State-owned mining and energy company in China. Its core businesses include production and supply of coal, electricity and heat, as well as rail and port transportation services.

Relevant Market. MOFCOM paid close attention to the market in which the proposed JV will be active, and found that this transaction might exclude or restrict competition in the CWS gasification technology licensing market. Considering the significant differences between CWS gasification technology and other coal gasification technologies, MOFCOM was of the view that CWS gasification technology licensing market constitutes a separate relevant product market.

Since the propose JV will only be active in China and the Chinese licensees only acquire such technology on the China market, MOFCOM found that the relevant geographic market is China.

Competitive Assessment. Apparently, market share, market concentration level and market entry are still the major factors MOFCOM considered in its competitive assessment process.

MOFCOM indentified that China's CSW gasification technology licensing market is highly concentrated with only three major players – CWS gasification technology provided by GE Infrastructure Technology, multi-nozzle-mounted CWS gasification technology jointly developed by Yankuang Group and East China University of Science and Technology, and multi-component slurry gasification technology provided by the Northwest Research Institute of Chemical Industry. It was noted by MOFCOM that GE's CWS gasification technology has the highest share in this market.

MOFCOM further looked into an adjacent market involved in this transaction. Since CWS gasification technology has specific requirements for the properties of the raw coal, operators of CWS gasification projects need to have a reliable supply of the specific coal. MOFCOM noted that in 2010, Shenhua Group was the largest supplier of raw coal that is suitable for CWS gasification projects.

MOFCOM also found that there are significant barriers for entry into the CWS gasification technology market due to the complexity of the technology, high investment cost, existing IP rights and long R&D and industrialization cycles. 

In light of the above, MOFCOM concluded that the proposed JV is likely to restrict competition in the CWS gasification technology market by making use of the dominant position of Shenhua Group in the raw coal market.

Remedies.  In order to solve the competition concerns, MOFCOM requested CSCLC and Shenhua Group not to compel licensees of CWS gasification technology to use JV's technology by restraining the supply of raw coal, or by conditioning such supply on licensing of JV's technology, nor to raise the cost of such supply for those using other technologies.

Comments
 
There are a few points about this decision that are worth mentioning. As mentioned above, it is the first conditional merger control decision where an SOE is involved. If read together with the recent antitrust probe of China Telecom and China Unicom by the National Development and Reform Commission⁴, it appears that contrary to protectionism accusations from overseas, Chinese antitrust enforcement agencies are indeed increasing their antitrust scrutiny of SOEs.

It is also the first conditional clearance of a joint venture project. Whether JV is caught by China's merger control regime is not expressly stipulated in the AML. However, based on our experiences, MOFCOM considers joint ventures to be a type of notifiable transactions under the AML. This decision officially affirmed MOFCOM's position in this regard.

Furthermore, this is the first time MOFCOM defined a technology licensing market. This decision (as well as the previous decision on Alpha V/Savio deal) has become more detailed in terms of competitive analysis. It is also interesting to note that MOFCOM imposed behavioral remedies in this case after it requested divestiture in the Alpha V/Savio case. All these suggest that MOFCOM is getting increasingly sophisticated and holds a flexible and pragmatic approach towards merger remedies.

1. See our article entitled MOFCOM's 8th Conditional Clearance - Alpha V/Savio Deal.    

2. A copy of MOFCOM's Announcement [2011] No. 74 could be found here (in Chinese): http://fldj.mofcom.gov.cn/aarticle/zcfb/201111/20111107824342.html.

3. See the press release of the deal on GE's website:

http://www.genewscenter.com/Press-Releases/GE-and-Shenhua-Announce-Formation-of-Cleaner-Coal-Technology-Joint-Venture-in-China-2ddd.aspx.

4.See our article entitled Earlier Rumor Confirmed: China Telecom and China Unicom under Antitrust Investigation  on details of this incident.

The news

The news was released by News in 30 Minutes, the daily midday news program of CCTV (China's state television broadcaster) on November 9.  According to the exclusive interview with Ms. Qing Li, the Deputy Director General of the Price Supervision and Anti-monopoly Bureau of the NDRC, NDRC has been investigating China Telecom and China Unicom for their alleged abuse of dominance in the broadband access and inter-network settlement sector.

According to Ms. Li, the followings have already been found through investigations:
 

• China Telecom and China Unicom together account for more than 2/3 shares in the internet    access market, indicating the companies have dominant market positions;
   
• Both companies charged their competitors much higher prices than non-competitors, which   could constitute "price discrimination" (one of the prohibited abusive conducts) under the AML.

Ms. Li further stated that if the abuse is established, fines of 1% to 10% of the companies' sales of the preceding year could be imposed in accordance with the AML. She also mentioned that the turnover of China Telecom and China Unicom in relation to their internet access business is approximately RMB 50 billion and RMB 30 billion respectively.  It is therefore speculated that the potential antitrust fines can be as much as billions of RMB.

This news report verified an earlier report claiming that China Telecom has been under antitrust investigation by certain "relevant authorities". Furthermore, it suggests that the investigation has extended to another telecommunication giant—China Unicom. As mentioned in our previous article, the two companies almost duopolize China's broadband access market.

The news led to a plunge in the two companies' share prices. Later on the same day, both China Telecom and China Unicom, in conformity with their disclosure obligations under the Hong Kong Stock Exchange rules, made announcements in response to the news. China Telecom claimed that it would fully cooperate with the authorities on the investigation.¹  China Unicom declared that it was in the process of providing the NDRC with pricing, volume, turnovers and other relevant information of its involved business.²  

Comments

NDRC's confirmation of its antitrust investigations against the two giant State-owned telecommunication operators can be seen as a clear indication that Chinese competition authorities are ready to show their teeth to all violators of the AML regardless of their identity.  In this sense, it is an improvement for AML enforcement, and clears doubts as to whether state-owned enterprises will be treated differently under the AML.

From a technical perspective, as mentioned in our previous article, assuming the alleged abusive conducts existed, the companies are likely to be caught by Article 17 (1) or Article 17 (6) of the AML.  According to Ms. Li, the companies potentially violate Article 17(6) of the AML for conducting "price discrimination".

 What is "price discrimination"?

Pursuant to Article 17(6) of the AML, a dominant operator shall not abuse its dominance by "adopting differentiated terms of transactions, such as transaction price, with trading counterparts of same conditions without a valid reason".  We have said before that one of the key points in establishing price discrimination is whether the companies' competitors and other internet bandwidth renters (such as Internet Content Providers) can be regarded as "trading counterparts of same conditions" thereby deserving equal trading terms.  Furthermore, the companies can also defend their differentiated pricing policies by claiming they have "valid reasons" for doing so.

 What are possible "valid reasons" as defense?

There is no hint in the NDRC's Rules on Anti-Price Monopoly about what could constitute a "valid reason" for a dominant company to exercise price discrimination. However, we may find some clue in the State Administration for Industry and Commerce ("SAIC")'s Rules on Prohibition of Abuse of Dominance ("SAIC Rules") that governs non-price-related abuse of dominance.  The SAIC Rules provide that when determining valid reasons, SAIC may consider: (1) whether the conduct is based on normal operations and for normal benefits of the company; and (2) the impact of the conduct on economic efficiency, public interest and economic growth.  Although the SAIC Rules are not binding on the NDRC, it is reasonable to make reference to these provisions since the SAIC and NDRC are both antitrust authorities having close relationships.

 What is the finable turnover?

Another interesting issue we noticed in the news report is that the turnover of the companies the NDRC official referred to only relates to the companies' internet access business, which is the subject of this investigation.

Article 46 of the AML provides that an operator in violation of the AML could be imposed a fine of 1% to 10% of its turnover of the preceding year. The AML and the relevant rules provide no further guidance as to whether the turnover here, as the basis for calculating penalties, refers to a company's total turnover or it only relates to a company's business segment where violation is found.  Neither is there clarification as to whether the turnover here is on worldwide or China–wide basis. The NDRC's statement shed some light on this unsettled issue: it appears that at least for now, only the turnover of the relevant business is taken into account.

Although the NDRC has yet to make a definitive finding on its investigation of China Telecom and China Unicom, its fierceness on this event is ground-breaking and reflects the growing emphasis and attention on AML enforcement in China. Whatever the result is, this investigation will become a milestone of AML enforcement in China.   

As one of the most powerful state agencies, the NDRC had been challenged for not taking significant actions to enforce the AML. Apparently, the NDRC is trying to change the landscape and it is reasonable to expect that it would become more active in the future in combating price-related anti-competitive conducts.

¹Available at http://www.chinatelecom-h.com/eng/announcements/announcements/a111109.pdf.

² Available at http://www.chinaunicom.com.hk/tc/investor/ir_annouce.html. As a dual listed company, China Unicom also made a similar announcement with Shanghai Stock Exchange.

Parties. The acquirer, Alpha V is a private equity fund, whose investments mainly relate to non-ferrous metal recycling, supply of household textile, and production and supply of textile machinery.  Specifically, Alpha V holds 27.9% shares of Uster Technologies Ltd (Uster),the global leader in textile testing and quality control machines. 

The target, Savio, is a manufacturer of textile machinery, and its main products include automatic cone winders, yarn clearers, rotor spinning machines, and double twisters. 

Relevant market. MOFCOM found that Uster and Leopfe (a wholly-owned subsidiary of Savio) are the only two suppliers of yarn clearers in the world. Since there are no other machines that are substitutable, MOFCOM considers that yarn clearer is the relevant product market here. In the yarn clearer market, Uster has 52.3% market share of the global market while Leopfe has the remaining market share. Their performance in China largely resembles their performance in the global market. 

MOFCOM did not specify the relevant geographic market but indeed looked into both the global market and the China market.

Competition concerns. MOFCOM paid a lot of attention on whether Alpha V may influence Uster's operations and management.  For this purpose, MOFCOM reviewed, among other things, Uster's shareholding structure, voting mechanism of the shareholders' meetings, meeting minutes of the shareholders meetings, composition and the voting mechanism of the board of directors.  After the review, MOFCOM decides that it can not rule out the possibility that Alpha V may influence Uster's operations.

In light of the above, MOFCOM considers that after the transaction, it is likely that Uster and Leopfe can coordinate with each other through Alpha V to restrict and/or eliminate the competition in yarn clearer market; on the other hand, it is also likely that Alpha V can restrict and/or eliminate competition through its control and/or influence over Uster and Leopfe. 

Barriers to entry. In order to fully assess the potential anti-competitive effects of the transaction, MOFCOM also carried out a detailed study of the barriers to entry in the yarn clearer market. The result shows that there are significant entry barriers to new entrants due to the existing IP rights, importance of the economies of scale, and customer recognition.  MOFCOM specifically notes that there has been no successful new entrant for the past three years. 

Remedies. In light of the above, MOFCOM was of the view that the transaction is likely to restrict or exclude competition in the yarn clearer market. In order to counter these anticipated anti-competitive effects, MOFCOM imposed the following four conditions on Alpha V:

(1) Alpha V shall divest its shares in Uster to an independent party within 6 months upon MOFCOM's approval of the transaction;

(2) Alpha V shall notify MOFCOM of the transferee of the shares of Uster, the transaction amount, and the estimated closing date of the transaction, to make sure such transfer would not raise any new competition concerns;

(3) Alpha V shall not participate in or influence Uster's operations and management before completion of the divesture process; and

(4) Alpha V shall entrust a monitoring trustee to supervise the divestiture.

Comments

This is the first conditional clearance decision MOFCOM issued after the promulgation of the Interim Rules on the Assessment of the Impact of Concentrations on Competition (see our article entitled MOFCOM's New Antitrust Rules Shed Light on Its Competitive Assessment Process).  In line with the Interim Rules, in its competitive assessment process, MOFCOM considered, in particular, market shares, market structure, market entry, and examined both the unilateral effects and coordinated effects that may arise from the transaction.

The most notable issue in this case is MOFCOM's reading of Alpha V's potential influence in Uster's operations through its minority interest. It appears to be the major reason underlying MOFCOM's concern over this Transaction and MOFCOM appears to consider that this concern can only be properly addressed by divestiture of Alpha V's entire interest in Uster.  The fact that the relevant market is a highly concentrated oligopoly market may partly explain MOFCOM's approach. The takeaway for funds with portfolio companies is that even if they believe they do not have control over portfolio companies in which they only hold a minority interest, MOFCOM may think otherwise.    

It is also interesting to note that MOFCOM did not specify whether the geographic market in this case is worldwide or China-wide. In practice, MOFCOM would look into both the global market and China market, and would require the parties to provide the market data of both.

 
According to the announcement, during the review process, MOFCOM sought opinions from the following third parties: government agencies, trade associations, competitors, downstream undertakings and industry experts.

For a more detailed analysis of MOFCOM's decision, please see our article entitled MOFCOM's 8th Conditional Clearance – Alpha V/Savio Deal.
 

¹A copy of MOFCOM's Announcement [2011] No. 73 could be found here (in Chinese):  http://fldj.mofcom.gov.cn/aarticle/zcfb/201111/20111107809156.html.

Facts

SCTG is a Taiyuan company active in many transportation related services.  It has been running the railway ticket agent business since 1987, and currently owns 15 railway ticket agent stores in Taiyuan city.  Ever since 2007, SCTG has been applying for establishing new railway ticket agent stores with the Taiyuan Bureau of Railways for 4 years, but has never received any responses.

According to the current regulations in China, local bureaus of railways, like Taiyuan Bureau of Railways, are in charge of granting authorization to railway ticket agents.  The local bureaus of railways are also the authority in charge of the operation of railways.  Since 2006, the Taiyuan Bureau of Railways has authorized 74 new railway ticket agents, all of which are controlled by affiliates of Taiyuan Bureau of Railways.
 
SCTG alleged that Taiyuan Bureau of Railways had abused their dominance in the railway ticket agent market, unfairly deprived other non-related applicant like SCTG the right to engage in the railway ticket agent service; and that this was in breach of the AML.

It is not exactly clear what SCTG's petitions are from public information . 

Comments

China's railway authorities faced lots of blames for its monopolistic management and operation of the railway and railway related industries.  The SCTG Case represents the pressing demand of the public for an open market and fair competition in these industries. 
The interesting issue of the SCTG Case is that the case is an administrative litigation rather than a civil litigation, although SCTG accused Taiyuan Bureau of Railways for abuse of dominance, rather than abuse of administrative power to eliminate and restrict competition. 
The AML only provides that civil litigation can be initiated against business operators' monopolistic conducts (i.e. Article 50), and does not expressly provide administrative litigation as the dispute resolution mechanism for alleged abuse of administrative powers.  If the government agencies abuse its administrative power to eliminate and restrict competition, according to Article 51 of the AML, its superior authority shall order it to correct such action. 

It remains to be seen how the SCTG Case would proceed after the acceptance.
 

Facts

•  About Tmall

Launched in April 2008, Tmall (www.tmall.com) is an online B2C retail platform wholly owned by Alibaba Group¹ .  In June 2011, it was separated from Alibaba Group's online customer-to-customer (C2C) platform – Taobao Marketplace (www.taobao.com) and became an independent business.  According to information on Alibaba Group's website, Tmall contributes to 48.5% of China's B2C online retail market as of 2011 Q2 and is also the most visited B2C online retail website in China².   Tmall currently features more than 70,000 major multinational and Chinese brands from more than 50,000 merchants.
 

• Triggering event – Tmall's new rules

On October 10th, Tmall announced its new merchant rules which, among other things, are set to charge significantly higher annual technical support fee and security deposit to vendors on Tmall.   Under the new Tmall rules, the annual technical support fee of 2012 would hike 5-10 folds, from RMB6,000 in 2011 to RMB30,000 to RMB 60,000 (varied by the size of the B2C stores) in 2012; the security deposit of 2012 would hike 5-15 folds from RMB10,000 of 2011 to RMB50,000 to 150,000 (also varied by the size of the B2C stores) in 2012.  Both fees are fully or partially refundable depending on a store's sales. 

The new rules also include terms on a seven-day return period for all purchases, stricter rules on shipping time upon order confirmation, and stricter policies against selling of fake products.  According to Tmall, the new rules are purely for motivating vendors on Tmall to provide quality goods and better services to customers. 
 

•         Small vendors'fight against Tmall

The new rules immediately angered smaller vendors, which would be under huge cash flow pressure and might find it hard to survive.  At the night of October 11, several large vendors on Tmall were attacked by some 4000 well-organized attackers, most of which are smaller vendors on Tmall.  These smaller vendors placed massive orders with the large vendors and then immediately returned the products demanding refunds, while giving the large vendors poor ratings simultaneously.  The online protest escalated later with more large vendors affected and the number of attackers growing to over 40,000.  The online attacks were said to bring losses of up to CNY 10 million to some of the large Tmall vendors.


•         Government intervention

On October 15, the Department of Electronic Commerce and Information of the Ministry of Commerce (MOFCOM) started to intervene and ordered mediation.  Tmall then changed its uncompromising attitude and started to open online discussions with the attackers, who immediately suspended online attacks.  On October 17, Tmall announced that it would delay implementation of the new rates, and commit to invest RMB1.8 billion to help small Tmall vendors.  The Tmall incident appeared to have temporarily settled.

Analysis

After its occurrence, the Tmall incident instantly hit the newspaper headline in China. It also ignites heated discussions of whether Tmall's new rules might itself constitute an abuse of dominance that is in breach of the AML. 
 

•         Does Tmall have a dominant market position?

For all abuse of dominance cases, the threshold issue would be to define a relevant market and then to explore whether the business operator at issue has a dominant position in the relevant market.

There is no easy answer here as to whether the relevant market shall be defined as the B2C market, B2C and C2C markets as a whole, or even all retail channels including both online platforms and  brick-and-mortar stores.

Even if the relevant market is defined as the relatively narrow B2C market, the abovementioned market share data (48.5%) is not able to support a presumption of dominance under Article 19 of the AML.  Under Article 19, only if a single company holds more than 50% share of a relevant market could a (rebuttable) presumption of dominance be established.   
 

•        Does Tmall's conduct constitute an abusive act?

Each of the abusive conducts listed under Article 17 of the AML requires a "reasonableness" test.  In other words, a conduct will become abusive only if it is implemented by a dominant company without a valid reason.  Since the charged fees are refundable, it will be reasonable for Tmall to argue that the new rules are designed for valid reasons, namely, to improve the overall quality of Tmall vendors and to combat selling of fake goods on Tmall for the ultimate benefits of consumers.

Comments

This is yet another incident where a giant internet company in China is accused of abusing its market power.  In order to avoid becoming the antitrust target, it is crucial for big companies to watch out for antitrust risks before making any potentially controversial business decisions. 

Moreover, prompted by the incident, MOFCOM announced that it would promulgate new rules regulating the online retail market, to delineate the rights and responsibilities of each of the market players.  We will keep a close watch on any legislative development in this regard. 

¹Alibaba Group is a China-based company group running Internet-based businesses, including online retail, wholesale and payment platforms, a shopping search engine, and data-centric cloud computing services.  Alibaba.com is said to be the world's largest online business-to-business trading platform for small businesses.
 

²Please refer to http://news.alibaba.com/specials/aboutalibaba/aligroup/index.html.

Fact

From the news and other public available sources, we understand that the antitrust investigation may focus on whether China Telecom abused its dominance in broadband backbone network market by charging other broadband access network operators a price for using its backbone network that is much higher than the price China Telecom charge the other internet operators, for the purpose of squeezing out the other access network operators.
 

• China Telecom's position in the market of broadband backbone network services and broadband access network services

The broadband backbone network is the principal data routes that connect different networks among cities, countries or even continents. In China, there are only two nationwide duopolists running backbone networks, i.e. China Telecom and China Unicom. In fact, rather than competing with each other, China Telecom monopolizes the backbone network service market in South China, while China Network monopolizes  the market in North China.
 

Broadband access networks are built to approach the broadband end-users such as families and enterprises. China Telecom and China Unicom also are big players in providing access network services, whereas other operators such as Great Wall Broadband, China Railcom and China Mobile are active as well. Since all of these broadband access network operators have to connect to the broadband backbone network, they are heavily dependant on broadband backbone network operators, i.e. China Telecom in South China, and China Unicom in North China. In particular, under  the Measures for Inter-network Settlement at Internet Exchange Center (hereinafter referred to as "Settlement Measures") promulgated by the Ministry of Industry and Information Technology (MIIT), these operators are required to pay backbone network access fees (access fees) to China Telecom and China Unicom.  Moreover, the cap of the access fees is also provided in the Settlement Measures.
 

• China Telecom's alleged abusive conducts
  

As alleged in news reports, China Telecom may have charged competing access network operators an access fee that is three times or even a dozen times higher than other types of users such as internet content providers (ICPs). By forcing its rivals to pay much higher access fees, China telecom may thus be in a better position to expand its own business in providing broadband access network services. 

In practice, to avoid the hefty access costs, the other access network operators usually buy bandwidth from third parties (such as the ICPs), as the cost could be much lower. 

• Reported antitrust investigation
  

The investigation is said to be triggered by an August 2010 internal circular of China Telecom, under which China Telecom required its provincial branches to cut down connection to the backbone network if the access is achieved through buying the bandwidth from a third party.  The crackdown measures are reported to have adversely affected a wide range of broadband access network operators including many state-owned operators, and as a result affected thousands of internet end-customers.

It is reported that the antitrust investigation by "a relevant antitrust authority" started in the first half of 2011 and it has already carried out many rounds of inquiries and evidence collections with China Telecom. A number of access operators, research institutions and experts were also approached for verification. It is also reported that the authority has drawn a preliminary conclusion that the conducts of China Telecom as mentioned above can be found as constituting abuse of dominance. So far, there is no official response from any government authorities in this respect.

Comments

Since large state-owned enterprises in telecommunications, a traditionally highly concentrated industry, are involved, the news attracted lots of attention in spite that the sources and accuracy of the information still need to be verified.  Observers are pondering whether this is a sign that the Chinese competition authorities are ready and eager to show their teeth to large state-owned enterprises.
 

• Whether an abuse of dominance can be found?

Assuming China Telecom's accused conducts truly existed, we consider that such behaviors are likely to be caught by Article 17(1) or Article 17 (6) of the AML. Article 17(1) of the AML provides that a dominant operator shall not abuse its dominance by charging unfairly high or low prices. Article 17(6) of the AML provides that a dominant operator shall not abuse its dominance by "implementing differential treatment for terms of transaction such as transaction price for similar trading counterparts without a valid reason".

As is the case for all abuse of dominance cases, the threshold issue would be to identify a relevant market and then to determine whether there is a dominant position in the relevant market. In addition, in relation to Article 17(1) of the AML, the key issue would be whether the access fee is unfairly high, which could be drawn by a comparison with China Telecom's relevant costs. In relation to Article 17 (6), it is still left to be argued whether the access network operators and other types of users are "similar trading counterparts" that deserve to be charged at the same price level.

To defend itself from both accounts, China Telecom may argue that the highest access fee it charges its rivals is still below the price cap set in the Settlement Measures by MIIT.  In other word, the price charged by China Telecom to other access network operators is still in compliance with the guidance price set by the government. 

We understand that this case is similar to the famous Deutsche Telekom case, in which Deutsche Telekom charged a higher access fee at wholesale level than at the retail level to force its competitors to charge their end-user higher price (so-called "margin squeeze"). This was found to be an abusive conduct by European Commission in 2003 and confirmed by the European Court in 2008 (Case T-271/03),  and the defendant's similar argument was not accepted by the European Court. The Court pointed out that compliance by Deutsche Telekom with the industrial regulation did not absolve it from responsibility under competition law. Besides, we also noticed that, according to the news report, it is China Telecom's crackdown measures (rather than the higher price charged) that triggered the possible investigation.  We consider that the crackdown itself may also be suspicious of violating Article 17 (3) of the AML which prohibits the dominant operators from refusing to transact with trading counterparts without a valid reason. The disputable point in this scenario is whether China Telecom has any valid reasons to prohibit resale of bandwidth if such resale does not violate any laws or regulations.
 

• Who is the investigation authority and what are the possible results?
  

Although no public sources have identified the specific authority, we understand the proper investigation authority should be the National Development and Reform Commission ("NDRC") since the major conducts under the said antitrust investigation (i.e., charging the other access network operators a much higher access fee) are price-related.

According to Article 47 of the AML, once an operator was found guilty for abusing dominance, the anti-monopoly enforcement agency, who in this case is possibly NDRC, shall order the operator to stop the illegal act, confiscate its illegal income and impose a fine of 1% to 10% of the sales amount of the preceding year. If such penalties are to be imposed, it will not only be the first time for a fine to be imposed on a state-own enterprise under the AML but also will likely involve a huge sum of money, given that, according to the mid-term report published by China Telecom, the revenue generated from broadband access services in the first half of 2011 amounts to almost RMB30 billion. Furthermore, if fines were imposed here, it will be interesting to see how the "illegal income" and specific amount of fines would be determined, by considering the nature, extent and duration of the illegal acts according to Article 49 of the AML.
 

• Will the fine be imposed to China Telecom.

Early this June, the European Commission imposed a fine on a Polish telecommunications company for abusing its dominant position on the Polish broadband market. We notice that the Polish case as well as the aforesaid Deutsche Telekom case shares many similarities with the reported China Telecom case although we doubt that the Chinese competition authorities would go that far as the European Commission and European Court.

On the other hand, stakeholders in the industry seem to hold a negative view on the antitrust investigation and the possible fines.  Some of them believe that the issue in the spotlight can only be addressed by revising the Settlement Measures which set a too high price cap for the access fee that is totally outdated. Some even believe that this issue can only be dealt with once and for all by reconstructing the whole broadband industry.  MIIT, who is responsible for updating the Settlement Measures and regulating the industry, may also be expected to adopt some measures to solve the issue. This brings us to the common problem of how the anti-monopoly enforcement agencies and industry regulators will cooperate with each other when antitrust issues come forth.

We will keep an eye on this case and follow up if there is any substantive development.

Noticeably, the Rules have the following major breakthroughs/new features:

1.The Rules outlined the basic methodology MOFCOM applies in assessing competitive effects of a concentration. 

According to Article 4 of the Rules, in its competitive analysis, MOFCOM will first evaluate whether a concentration will create or strengthen the capability, incentive and likelihood for a single operator to unilaterally exclude or restrict competition, or for relevant operators to jointly exclude or restrict competition if there are only a limited number of operators in the relevant market.  Where the operators are not actual or potential competitors in the same relevant market, MOFCOM will focus on whether the concentration is likely to exclude or restrict competition in the upstream/downstream market or adjacent market.

Comment

MOFCOM did not use such terms as "unilateral effects/coordinated effects" (as in the U.S.) or "non-coordinated effects/coordinated effects" (as in the E.U.) in the Rules.  Neither did it explicitly refer to "foreclosure effect" (likely caused by a vertical merger) or "portfolio effect" (likely caused by a conglomerate merger).  However, it appears, both from the Rules and its own practices, that MOFCOM adopts essentially the same methodologies as its counterparts in major foreign antitrust jurisdictions. 

For example, in the Coca Cola/Huiyuan case, the only deal prohibited by MOFCOM thus far, it appears that MOFCOM relied on the "portfolio effect" theory in finding that "Coca Cola is capable of leveraging its dominance in the carbonated soft drinks market to the juice beverage market".² In the Mitsubishi Rayon/Lucite case, MOFCOM appears to have relied on the "foreclosure effect" theory in establishing that since post-merger, Mitsubishi Rayon will achieve dominance in the Methylmethacrylate ("MMA") market, Mitsubishi Rayon "is capable of foreclosing the downstream operators" of the supply of MMA.³

2 .The Rules outlined the elements that are relevant for assessment of whether the merging parties have "market control power".

Article 5 of the Rules explicitly listed 7 factors that are relevant for assessing the merging parties’ market control power, such as merging parties' market shares, substitutability of the their products or services, their ability to control the sales market or the procurement market for raw materials, production capability of non-merging parties, and purchasing power of the merging parties’ downstream customers.

Comment

In determining if the merging parties have market control power, the Rules copied a number of factors from Article 18 of the AML, which are relevant for determining dominant market position of a business operator.  Nevertheless, we understand that it would require a lower threshold to establish "market control power" than "dominant market position".

3 .The Rules confirmed that market concentration level can generally be measured by the Herfindahl-Hirschman Index ("HHI") and the Concentration Ratio Index ("CRn").

Under Article 6 of the Rules, HHI is defined as the sum of the squares of the market shares of individual operators in a relevant market; CRn is defined as the sum of market shares of the leading N operators in a relevant market. 

The Rules further set out the basic rule for assessment of competitive effects by the concentration levels, namely the higher the concentration level of a relevant market and the higher the increase of the concentration level post-merger, the more likely a merger will have anti-competitive effects.

Comment

Both the HHI and CRn are economic concepts that are widely accepted by major antitrust jurisdictions in determining the level of concentration in a relevant market.  MOFCOM itself had applied the HHI in the Pfizer/Wyeth case.  In this case, MOFCOM found that post-merger, the HHI of the relevant market (the PRC market for swine mycoplasma hyopneumoniae vaccines) will reach 2182 with a delta of 336.  On this basis, MOFCOM reached the conclusion that the relevant market is highly concentrated, which contributed to its finding that this particular deal is likely to have anti-competitive effects.⁴

It appears that MOFCOM is willing to rely more on these economic tools in determining the concentration levels in its merger review process.  However, unlike the practice in U.S. and E.U. where the post-merger level of the HHI and the increase in the HHI resulting from a transaction can be a direct indicator of whether a transaction will likely have adverse competitive effect, the Rules did not provide a scale of measurement for any competitive assessment by HHI or CRn. 

The Rules have also explicitly identified (without furnishing any details though) public interests, economic efficiency, bankruptcy defense and countervailing buyer power as additional factors that MOFCOM will weigh in during its review process.

Understandably, although having drawn upon its three years of practice, the Rules are still lacking in details.  Nevertheless, it demonstrates the efforts of MOFCOM to be in line with its more experienced foreign antitrust counterparts and to further improve transparency of its decision-making process.  It will be interesting to see how MOFCOM applies and further develops the Rules in its future practice.

1 Under Article 27 of the AML, factors to be considered when assessing the competitive effects of a concentration include (i) market shares and market control power of the merging parties in the relevant market; (ii) concentration levels of the relevant market; (iii) impact of the concentration on market entry and technological development; (iv) impact of the concentration on consumers and other relevant operators; (v) impact of the concentration on national economic development; and (vi) other factors that should be considered.

2 See MOFCOM’s decision in the Coca Cola/Huiyuan case at http://fldj.mofcom.gov.cn/aarticle/ztxx/200903/20090306108494.html (in Chinese). 

3 See MOFCOM’s decision in the Mitsubishi Rayon/Lucite case at http://fldj.mofcom.gov.cn/aarticle/ztxx/200904/20090406198805.html (in Chinese).

4 See MOFCOM’s decision in the Pfizer/Wyeth case at http://fldj.mofcom.gov.cn/aarticle/ztxx/200909/20090906541443.html (in Chinese).

This change shows that the authority would take a rather strict approach in the enforcement of the NSR regime.  It is fair to say that it would be very hard for foreign companies to try to circumvent the NSR process by designing complex transaction structures, including by means of variable interest entities (VIEs).  It is expected that the NSR Rules will have a far-reaching effect on the landscape for foreign mergers and acquisitions in China.

Furthermore, during the foreign investment approval process, the local commerce departments (local counterparts of MOFCOM) are charged with the responsibility to screen transactions that are subject to the NSR regime yet are not voluntarily filed.  According to the Notice on Establishing National Security Review Mechanism for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors issued by the State Council (NSR Notice), MOFCOM has the sole discretion in determining whether a transaction is subject to the NSR process.  As far as we know, a list of sectors that are subject to the NSR process has been circulated to local commerce departments.  Although the list is not publicly available, the scope of industries included therein is said to be broader than expected.  In practice, we have encountered cases where local commerce departments require the foreign investors to file for national security review if the industry involved in the transaction has some bearing on the listed industries (see our article entitled Local commerce administrative agencies and the national security review process). 

Other than being requested to make a filing by local commerce departments during the foreign investment approval process, relevant ministries of the State Council, nationwide industry associations, enterprises in the same industry (in relation to the proposed transaction) and enterprises in the upstream or downstream industries (in relation to the proposed transaction) can also trigger the NSR process by proposing such to the ministerial joint committee (Joint Committee) through MOFCOM.  It is reasonable to expect that competitors who feel threatened by a transaction where NSR may be applicable may wish to trigger the NSR process if the parties have not done so.  Therefore, it is particularly important for parties involved in high-profile or controversial transactions that potentially fall under the NSR regime to carefully examine the implications of the NSR Rules on their transactions to avoid any future surprises or potential delays.

Once MOFCOM officially accepts an application, the proposed transaction would face a compulsory waiting period of 15 working days, during which MOFCOM will determine whether the transaction falls under the purview of the NSR regime and therefore should be passed onto the Joint Committee.

If the proposed transaction is deemed by MOFCOM to be within the scope for national security review, the investor should expect another 30 to 90 working days (30 working days of general review period plus a possible 60 working days of special review period) to obtain the final decision of the Joint Committee. 

The procedural framework of the NSR process is very close to that of the merger control process under the Anti-monopoly Law (AML).  Based on our experiences in handling AML filings, nowadays a greater portion of the AML filings enter Phase II (equivalent to the special review period in the NSR process).  It is yet to be found out whether it would be the same case in the NSR process. 

Since there is no requirement under China's NSR rules for publication of NSR decisions, it is not entirely clear how many NSR filings MOFCOM has accepted thus far and whether MOFCOM has approved (or disapproved) a transaction under the NSR regime.  As part of the government approval procedures for foreign investment in China, the impact of the NSR process on inbound M&As is hard to be neglected.  Foreign investors should always keep the NSR process in mind, plan ahead, and put in place a well-thought-out strategy.
 

Specifically, the MIIT Opinion prohibits basic telecoms enterprises from:

• entering into exclusive agreements (both oral and written) with school authorities such that other competitors will not be able to enter school campuses;
• disparaging competitors or carrying on any promotion that compares the networks or equipment of competitors;
• including SIM or UIM cards in the enrolment notices mailed to freshmen;
• purchasing cell phones (or batteries), SIM or UIM cards from clients of competitors;
• mandating the use of designated service plans or equipment (such as cell phones).

Basic telecoms enterprises are also required to respect the users' right to know and the right of selection.  They are not allowed to restrict customers from choosing competitors' services.

Unfair competition conducts such as those listed above are common in China's campus telecoms market.  The MIIT Opinion can be seen as an application of anti-unfair competition provisions in the Regulation on Telecommunications (the "Regulation") in the campus telecoms market.  For example, Article 41 of the Regulation prohibits telecoms operators from harming customers' rights by limiting customers to use designated services or buy designated equipment.  Article 42 of the Regulation prohibits unfair competition conducts such as restricting customers from using competitors' services.  According to the Regulation, a violation of Article 41 may be subject to a fine of RMB10,000 to 100,000; a violation of Article 42 may be subject to a fine of RMB100,000 to 1 million.  The MIIT is the competent authority in charge of the telecommunications industry.

Comments

The State Administration for Industry and Commerce ("SAIC"), along with its local counterparts, is the agency in charge of anti-unfair competition issues in China.  Yet, pursuant to Article 3 of the Anti-unfair Competition Law ("AUCL"), agencies other than the SAIC may also undertake a supervisory role when authorized by law or administrative regulations.  The Regulation on Telecommunications (an administrative regulation) authorizes the MIIT, as the industry supervisory authority, to regulate unfair competition acts of telecoms enterprises.  Therefore, MIIT is well placed to regulate unfair competition issues within this industry.

On the other hand, whether MIIT has the authority to enforce the Anti-monopoly Law ("AML") remains unclear and controversial.  Earlier this year, MIIT issued the draft Interim Rules for Supervision and Management of Internet Information Service Market, which touches upon not only competition issues but also antitrust issues in relation to the internet information service industry (see our article entitled MIIT Releases Draft Rules Which Govern Antitrust Issues http://www.chinalawinsight.com/2011/02/articles/corporate/antitrust-competition/miit-releases-draft-rules-which-govern-antitrust-issues/).  Doubts have arisen as to whether MIIT has the authority under the AML to enforce antitrust issues and how MIIT is to work with the other antitrust enforcement agencies, such as SAIC, to perform such tasks.  We note that this draft rule has not yet been enacted.  

¹Basic telecoms operators in China include China Telecommunications, China Mobile and China Unicom.

1 Background

As early as 2003, China issued provisional rules governing acquisition of domestic companies by foreign investors, and on August 8, 2006, these provisional rules were amended into the Rules on the Merger and Acquisition of Domestic Enterprises by Foreign Investors ("M&A Rule") by the Ministry of Commerce ("MOFCOM") and five other agencies. The M&A Rule, for the first time, called for notification and review of a transaction that might have an impact on China's "national economic security". Subsequent to the M&A Rule, the PRC Anti-Monopoly Law ("AML"), effective on August 1, 2008, mandates a broader "national security" review when a foreign investor participates in the concentration of business operators by merging or acquiring a domestic enterprise or by any other means where national security is involved. Following the AML, on April 6, 2010, the PRC State Council issued the Several Opinions on Further Improving the Work of Utilizing Foreign Investment, which directs the government to accelerate the establishment of a national security review mechanism on mergers and acquisitions of domestic companies by foreign investors.

2 Highlight of the Notice

The Notice sets up a ministry-level intra-agency joint meeting as the national security review committee. It also lays out the scope and content of national security review as well as the mechanism and the procedures for the review.

2.1 Scope of Review

National security review covers the following areas:

•  
• national defense security, including foreign investors' acquisition of military enterprises and military supporting enterprises, enterprises adjacent to important and sensitive military facilities and other entities relating to national defense security; and 

• other national security areas, including foreign investors' acquisition of enterprises involving important agricultural products, energy and resources, infrastructure, transport systems, key technology sectors and important equipment manufacturers which may have an impact on national security and foreign investors may acquire de facto control of such enterprises.

Under the Notice, the term "de facto control" refers to the following circumstances:

•  
• a foreign investor and its parent company and subsidiaries hold in the aggregate more than 50% of total shares of a domestic company after acquisition;

• several foreign investors hold more than 50% of total shares of a domestic company after acquisition;

• a foreign investor holds less than 50% of total shares of a domestic company after acquisition, but the voting right of the foreign investor could have significant effect on the resolutions of the shareholder meeting or the resolutions of the board of directors; and

• other circumstances which may lead to a foreign investor's de facto control of a domestic company, including its operational decisions, financing, personnel and technology.

Foreign investors' M&A activities in relation to domestic enterprises include the following circumstances:

•  
• share purchase, including a foreign investor (a) purchasing the shares of a non-foreign-invested enterprise in China or subscribing to its the capital increase to convert it into a foreign-invested enterprise; and (b) purchasing the shares from Chinese shareholders of a foreign invested enterprise or subscribing to its capital increase.

• asset purchase, including a foreign investor (a) establishing a foreign-invested enterprise to purchase assets of a domestic company and operate such assets, or purchasing shares of a domestic company through such foreign-invested enterprise; and (b) purchasing the assets of a domestic company directly to establish a foreign-invested enterprise with such assets.

2.2 Content of Review

The national security review committee will review, approve or block a transaction based on the following aspects:

•  
• influence on national defense security, including influence on domestic manufacturing capabilities, services and related facilities and equipment required by national defense;

• influence on national economic stability;

• influence on basic social order; and

• influence on China's ability to research and develop key technologies for national security.

2.3 Review Procedures

(a) Review Body

The foreign investment security review committee will be guided by the State Council and led by the National Development and Reform Commission and MOFCOM, which will conduct reviews together with other agencies on as needed basis.

(b) Procedures

• Notification

Foreign investors shall make an application to MOFCOM when acquiring domestic companies. If the transaction falls into the scope of national security review, MOFCOM will submit the application to the committee for review within 5 working days. The Notice also permits the agencies of the State Council, national trade associations, competitors, suppliers and upstream and downstream enterprises to apply to MOFCOM for review of a transaction. 

• Review Process

  The review process starts with a "general review", and if a transaction fails to pass the general review, a "special review" will be required. If a transaction is deemed not have an impact on national security, the committee will send its review opinion to MOFCOM. Where a transaction is deemed to affect national security, a "special review" will be initiated by the committee and a security evaluation will be conducted and in the event of major disagreements, the committee will submit the transaction to the State Council for its final decision. After a final decision is made, MOFCOM will notify the applicant about the review result.

  During national security review, the applicant may apply to MOFCOM to amend the transaction plan or cancel the transaction. Where the acquisition of domestic companies by foreign investors has had or may have a material impact on national security, the committee shall require MOFCOM, together with the relevant agencies, to terminate the transaction or transfer relevant equities/assets or take other effective measures to eliminate the transaction’s impact on national security.

3 Comments

As mentioned in the beginning of this article, the requirement for national security review is already stipulated in the AML, however, there were no concrete rules in place until the newly issued Notice. In addition to the requirement for national review in respect of M&A activities, foreign investment in China must comply with the Catalogue for the Guidance of Foreign Investment Industries and, if required, complete anti-trust review in accordance with the AML. However, compared to developed countries, China's new requirement for national security review is not unique. For example, Australia has set up the Foreign Investment Review Board to review foreign investment projects, and the United States also has an intra-agency Committee on Foreign Investment in the United States, which reviews foreign investment in a US company that may result in foreign control or have an impact on national security.

While China's national security review may add additional burden and costs on foreign investors as well as uncertainty for M&A transactions in China, the Notice also provides a timeline for the review process and some level of transparency on the review procedures.

The Notice describes the scope of review in a broad stroke and some of the products or sectors are not sufficiently described or defined and this may give the review committee a lot of discretion. For example, the term "important agricultural products" are not defined and thus it is difficult to ascertain what kinds of products are covered, whether agricultural products include agricultural products processing, etc.

With respect to content of review, the Notice does not specify the criteria for evaluating influence on national economic stability and influence on basic social order. As the national review gets tested in real-life cases, there will likely be questions raised on the review process and procedures. It is possible that further explanations or regulations will be issued by the State Council or relevant agencies to make the national review more workable in the future.

If you have any questions or comments, please do not hesitate to contact us.

King & Wood

Xu Ping

Partner

Tel: 8610 5878 5012

xuping@kingandwood.com

During that workshop, the NDRC also listed some 10 instances of price-related breaches of the AML and / or Price Law 1997 – investigations and enforcement actions against the breaching entities were undertaken by provincial or local price authorities. 

The following table sets out details to do with these 10 breaches (from publicly available information).

Comments

The above list of cases aren't an exhaustive list of public enforcement cases to do with the AML and the Price Law. It is interesting that in the NDRC's press releases, they have listed some of the above price cartel breaches as being both in breach of the AML as well as the Price Law.

As far as we are aware, the NDRC (along with its related provincial authorities) does not keep a systematic "public register" of enforcement cases pursuant to the AML and the Price Law on their website. They are not statutorily obliged to do this. Pursuant to the Price Law, there are no express provisions which deal with the publication of decisions or enforcement actions. Pursuant to the AML, Article 44 states that the authority may release or make its decisions or enforcement actions public.

In light of the above, it is currently challenging to keep track of how many enforcement decisions or cases there have been, pursuant to the Price Law and the AML.

The primary objectives of the Bill are two-prong:

• to prohibit conduct which prevents, restricts or distorts competition in Hong Kong; and
• to prohibit mergers that substantially lessen competition in Hong Kong.
   

Who does what?

The Bill provides for a judicial enforcement model, such as applies in Australia and New Zealand, with a Competition Commission (the Commission) and a Competition Tribunal (the Tribunal) established to enforce the Bill.

The Commission's primary role is to investigate suspected breaches of the CO. The Commission may commence investigations:

• on its own initiative;
• upon receipt of complaints; or
• on referral from the Hong Kong Government (the Government) or a court.

The Commission will be led by a Chairperson and will consist of at least 5 members (including the Chairperson). Commission members are expected to have expertise or experience in industry, commerce, economics, law, small and medium enterprises or public policy.

The Tribunal's primary role is to adjudicate on whether breaches of the CO have occurred. The Tribunal will also hear appeals from the Commission on a limited set of matters where the Commission can make binding determinations such as on exemption or exclusion applications.

The Tribunal may hear cases brought to it either by the Commission or by private parties.
All judges of Hong Kong's Court of First Instance are Tribunal members. The Tribunal will formally be a division of the High Court. The Chief Executive in Council (CE) will appoint a President to lead the Tribunal. Each case will be led by a presiding Tribunal member who will sit with other judicial members. The Tribunal may also appoint one or more assessors or non-judicial persons to assist in the adjudication of cases.

The separation of investigative and adjudicative functions (between the Commission and the Tribunal) provides a good system of checks and balances appropriate in a small jurisdiction.

The following diagram outlines the institutional framework outlined by the Bill.

 What does the Bill prohibit?

The Bill prohibits three categories of conduct:

• the First Conduct Rule prohibits undertakings (a broad term encapsulating any entity engaging in commercial or economic activities(3) ) from engaging in agreements, concerted practices or decisions with the object or effect of preventing, restricting or distorting competition in Hong Kong;
• the Second Conduct Rule prohibits undertakings with a substantial degree of market power from abusing that power by engaging in conduct which has the object or effect of preventing, restricting or distorting competition in Hong Kong; and
• the Merger Rule prohibits undertakings from directly or indirectly carrying out a merger that has, or is likely to have, the effect of substantially lessening competition in Hong Kong. The Merger Rule will apply only to undertakings who are licensees in respect of the telecommunications industry only. This is a continuation of the current merger regime applicable to telecommunications licensees in Hong Kong, although as the Government has said, the Merger Rule has been “modernised”. (4) 

The First Conduct Rule and the Second Conduct Rule are known collectively as the Conduct Rules. The First Conduct Rule, the Second Conduct Rule and the Merger Rule are collectively known as the Competition Rules.

Exclusions and exemptions

Certain conduct or agreements may be excluded from the application of the Conduct Rules, provided these fall into the categories of conduct and agreements set forth in the exemption and exclusion framework in the Bill.

The following table indicates the exemption and exclusion grounds under which conduct or agreements may be exempt, and which of the Conduct Rules these would be exempt or excluded from.

The exclusion grounds in (1) to (3) (in the table) above apply without the need for a Commission determination applying the exclusion to an undertaking. This allows scope for undertakings to undertake self-assessment to determine if their conduct or agreements fall into the exclusion grounds.

In respect of the exemption grounds listed in (4) and (5) above, undertakings would not be able to undertake self-assessment to determine if their conduct or agreements fall under those grounds, until the CE makes an order indicating the sorts of conduct or agreements which may be exempt based on those grounds.

There is only one exclusion ground in relation to the Merger Rule. The Merger Rule does not apply to a merger if the economic efficiencies that arise or that may arise from the merger outweigh the adverse effects caused by any lessening of competition in Hong Kong.

Commission's role in exclusions

There are two avenues by which the Commission can provide for more certainty about the application of exclusions.

First, the Commission has the power to issue Block Exemptions which exclude categories of agreements from the First Conduct Rule, based on the exclusion ground listed in (1) in the previous table.

Second, if undertakings wish for clarification or greater certainty as to whether their agreements or conduct are exempt or excluded, they would be able to seek clarification from the Commission through a decision process. If the Commission makes a decision that conduct or agreements are excluded or exempt from the application of either or each of the Competition Rules, then those conduct or agreements are immune from any action pursuant to the Bill (including both public and private enforcement action). However, the Commission may rescind a favourable decision if there has been a material change of circumstances since the decision was made or if the information in which it has based its decision was incomplete, false or misleading.

Government and statutory bodies

The Competition Rules will not apply to the Government and to statutory bodies in Hong Kong. However, statutory bodies may be brought within the scope of the Competition Rules through regulations. There are some 500 statutory bodies in Hong Kong with very diverse functions. The Government has yet to reveal which statutory bodies could be subject to the Competition Rules.

Enforcement by the Commission

The Commission will be vested with a full range of investigative powers, including the power to require production of documents and information, the power to require persons to attend an interview before the Commission and the power to enter and search premises under a court warrant. The Commission may only conduct an investigation if it has reasonable cause to suspect that a contravention of a Competition Rule has taken place, is taking place or is about to take place. There are criminal penalties for non-compliance with the Commission’s investigative powers.

An innovation in the Bill is the power to issue infringement notices to undertakings alleged to have breached Conduct Rules. The Commission may only issue an infringement notice if it has reasonable cause to believe that a contravention of a Conduct Rule has taken place; and only if it has not yet brought proceedings in the Tribunal in respect of the alleged contravention. The infringement notice would describe the alleged infringing conduct, the evidence on which the Commission has formed its view and the terms in which the Commission would be prepared to settle the matter, including the payment of a specified amount not exceeding HK$10 million (approximately US$1.3 million). Undertakings who receive the infringement notice could choose not to accept the notice without any adverse inferences being drawn, in which case the Commission could proceed to institute proceedings before the Tribunal. It is likely that the Commission would issue infringement notices in respect of “smaller” or “minor” infringements of the Conduct Rules.

In addition:

• the Commission may accept commitments from a person to take any action or refrain from taking any action that the Commission considers appropriate to address its concerns about a possible contravention of a Competition Rule. If the Commission accepts a commitment, it may agree:
  • not to commence an investigation or if it has commenced an investigation, to terminate it; or
  • not to being proceedings in the Tribunal or if it has brought proceedings, to terminate them (5); and
• the Commission may also enter into leniency agreements with individuals and corporations who have breached the Bill, but wish to mitigate their penalties by cooperating with the Commission. The Commission cannot bring proceedings against a party which is the beneficiary of a leniency agreement (which could include employees of a company which has made disclosure to the Commission).

Penalties

The Tribunal is vested with the power to apply a full range of remedies for contraventions of the Competition Rules. These include pecuniary penalties not exceeding 10% of the turnover of the offending undertaking; disgorgement orders; awards of damages to aggrieved parties; interim injunctions during investigations or proceedings; injunctions and disqualification orders against directors. The Tribunal may only impose pecuniary penalties on application by the Commission.
Private rights of action

The Bill provides for private actions to be brought by persons who have suffered loss or damage as a result of a contravention of a Conduct Rule. Such private actions:

• could be brought by a private party, following on from a Tribunal determination (i.e. a “follow-on action”); or
• could be brought independently of a Tribunal determination by a private party (i.e. a “stand-alone action”).

In relation to follow-on actions, private parties do not need to prove that the breach of the Conduct Rule occurred (but merely that they have suffered loss or damage as a result of the contravention of the Conduct Rule). In relation to stand-alone actions, private parties would need to prove that the contravention of the Conduct Rule occurred, before any loss or damage assessment can be undertaken.

Private rights of action

The Bill provides for private actions to be brought by persons who have suffered loss or damage as a result of a contravention of a Conduct Rule. Such private actions:

• could be brought by a private party, following on from a Tribunal determination (i.e. a “follow-on action”); or
• could be brought independently of a Tribunal determination by a private party (i.e. a “stand-alone action”).

In relation to follow-on actions, private parties do not need to prove that the breach of the Conduct Rule occurred (but merely that they have suffered loss or damage as a result of the contravention of the Conduct Rule). In relation to stand-alone actions, private parties would need to prove that the contravention of the Conduct Rule occurred, before any loss or damage assessment can be undertaken.
 

(1) King & Wood and Gilbert + Tobin are Consultants to the Hong Kong Government on the cross-sector competition law, however, the views expressed in this article are those of the two firms’ alone.

(2) Currently, there are competition law rules and regulations in Hong Kong which apply to licensees in the Telecommunications and Broadcasting industries only. There are transition arrangements in the Bill which provide for the smooth transition of these sector-specific competition laws to the cross-sector competition law. For instance, when the Bill is enacted as law, the Broadcasting Authority and the Telecommunications Authority will possess concurrent jurisdiction with the Competition Commission to enforce the prohibitions in the law.

(3) Similar terminology is used in the United Kingdom and Singapore competition laws.

(4) The Government has also announced that there is a possibility that the Merger Rule will apply more broadly in the future.

(5) If a person accepts an infringement notice, this could be done using the commitment framework.

Negative influences on the market due to Coke’s existing dominant position in the carbonated drink market

MOFCOM believed that after the completion of the Transaction, Coca-Cola would have had the ability to leverage its dominant position in the carbonated drink market in the juice drink market.

The ability to leverage is where an operator has a dominant position in a certain market and by taking advantages of its current dominant position, it is also able to obtain a new dominant position in a similar product market through tie-ins or bundle sales, imposing exclusive trading conditions, or other methods.

As Coca-Cola may have a dominant position in the carbonated drink market, MOFCOM believed that after the Transaction, Coca-Cola may (i) tie or bundle in Coca Cola’s juice drinks by utilizing its customers’ preferences in its carbonated drink, or tie its carbonated drink in as a means of promotion when selling juice drink; (ii) by offering discounts or refunds, encourage carbonated drink retailers to purchase a large number of its juice drinks, or limit their purchase and distribution of juice drinks manufactured by other competitors; (iii) increase sales volumes of its juice drink and supplant other juice drink products by taking advantage of its current sales channels, for example, its in-store refrigeration units installed at down-stream retailers.

Dominant market position in a certain market may be leveraged in adjacent or other closely related markets, which has already raised competition concerns by authorities in other jurisdictions. For instance, according to the decision made by the Australia Competition and Consumer Commission (ACCC) of the acquisition of Berri Limited (Berri) by Coco-Cola Amatil Limited’s (CCA) on October 8, 2003, ACCC believed that CCA would have the ability and incentive to leverage its market power in CSD (carbonated soft drinks) to increase distribution of Berri’s FB (chilled and ambient fruit juice and fruit drinks) product to the exclusion of rivals in the non-grocery trade channels.

Coke’s ability to impede market entry by controlling brands

Through review, MOFCOM believed that the brand is a key factor that influences effective competition in the drink market, that is, among other factors which may influence competition, such as capital and technology, the brand is considered one of the most important as opposed to other industries where technology may be more important. New entrants may not successfully gain market share in that it is difficult for them to obtain consumers’ recognition of their brands, even though they own certain technologies, facilities and capital. Coca-Cola may also restrain new market entrants by using its dominant position in the carbonated drink market as well as the leverage effect.

Accordingly, MOFCOM believed that after completion of the Transaction, Coca-Cola would have significantly stronger power to control the juice market by controlling two famous juice brands: “Meizhiyuan” and “Huiyuan”, as well as using its dominant position in the carbonated drink market. Therefore, the Transaction would significantly increase obstacles for potential competitors to enter the juice drink market from the prospective of branding.

The negative influences of the proposed concentration over small and medium operators and for the competition within the industry

MOFCOM believed that the Transaction would reduce survivability of domestic small and medium juice manufacturing enterprises, inhibit the ability of domestic enterprises to compete in the juice drink market, and harm the effective competition structure in the China juice drink market.

MOFCOM may have also believed that in the juice drink market, Coca-Cola and Huiyuan are direct competitors and therefore after the completion of the Transaction, Huiyuan, as an important and competent competitor, will no longer exist, which may lead to an increase of concentration. In addition, after the Transaction, Coca-Cola may soon gain a new dominant position by better utilizing Huiyuan’s current purchasing channels for raw materials, distribution channels of products, manufacturing equipment, market share, brand effects, and other advantages, as well as the leverage effects resulting from its dominant position in the carbonated drink market. Therefore, it could be concluded that the Transaction may negatively impact small and medium operators and may have a bad influence on the competition structure of juice drink industry and its further development.
 

B. Exemptions and exclusions
One of the issues that is gaining the most interest in the consultation phase is the issue of whether and when should there be exclusions or exemptions from the core competition law rules identified above. Under the Hong Kong proposed Competition Ordinance, conduct would be excluded or exempt from the competition law if it passes one of the following three tests:

• the Economic Benefit Test: essentially an efficiency gains test weighing economic benefits against potential anti-competitive harm;

• the Services of General Economic Interest Test: undertakings would first have to show that (a) they have been "entrusted" by the Government to provide the service in question and (b) the conduct must be a service of general economic interest (i.e. the service must be an essential public service); or

• the Public Policy Test: a test which takes into consideration benefits and broader than economic benefits.

Undertakings would be encouraged to make self-assessments to determine if their conduct fulfills any of the three tests set out above. However, if undertakings wish for clarification as to whether their agreements or conduct are exempt or excluded from the competition law, they may seek the Commission's guidance or decision.

The Commission will also possess the power to issue Block Exemptions. Block exemptions would exempt categories of agreements from the First Conduct Rule on the basis of the Economic Benefit Test. The Commission must undertake a public inquiry process before issuing a Block Exemption.

C. Two new Government instrumentalities
A Competition Commission (the "Commission") would be established and would consist of a minimum of seven members appointed by the Executive Council.

Generally speaking, the small and medium enterprise sector around the world is a strong advocate for robust competition laws but this is not so in Hong Kong. In Hong Kong there is apprehension amongst some small businesses that the law may be used by large companies against smaller rivals. If that were the case, it would be quite counterproductive against the achievement of the objective of the law. Nevertheless, one feature of the package has been designed to address that concern.

Although the person selected would not formally represent small business, at least one member of the Commission would be chosen who has experience with small and medium enterprise to ensure that these perspectives are available to the Commission when making decisions.
The functions of the Commission would be to:

• investigate suspected breaches of the law, for which the Commission will have powers to require documents to be produced and parties to answer questions. However, searches of premises will require a magistrate's order;

• issue orders appropriate to bring breaches of the law to an end or take enforcement litigation; and

• consider applications for guidance or decisions on the applicability of the exemptions to the Conduct Rules where the criteria for granting the exemption requires an economic assessment.
 

Where serious penalties are to be imposed by the State, or where there is litigation between private parties, matters would be brought before another new instrumentality, the Competition Tribunal. The Tribunal conduct trials, consider evidence and make judgment decisions. The Tribunal would have at least one judicial member would preside over matters but, reflecting that competition law is a complex economic regulatory regime, the Tribunal would also have members sitting on the bench selected for their economic credentials or business credentials who would not necessarily have any formal legal training. Appeals from the Tribunal would be to the Court of Appeal.
 

D. Private actions by individual plaintiffs and class actions

Persons or entities which have suffered loss or damage arising from breaches of the competition law may litigate to seek an award of damages or a range of other orders. Such actions could be brought after the Commission has taken action and the private plaintiff would not then be required to again prove matters already determined in the Commission. In such "follow-on actions" the private plaintiff would generally only need to prove what damages had flowed from conduct that the Commission or Tribunal had already decided amounted to a breach. However, it would also be possible for the private plaintiff to bring litigation even where the Commission has not taken any action ("stand-alone actions") but, of course, the private litigant would have to prove all the elements of a contravention and damage.

A credible organization acting in the interests of a defined group affected by anti-competitive conduct is authorised to bring an action on behalf of the group. To guard against potential abuse, a body wishing to bring such an action must have permission of the Competition Tribunal (as described below) and such permission is only granted if the Competition Tribunal considers that the body can fairly and adequately represent the interests of the relevant group.

II. Key issues that the draft paper does not currently address
A. Vertical arrangements
Traditionally, competition law regimes have included a general prohibition against vertical agreements (i.e. supply agreements) that have the purpose or effect of substantially lessening competition. However, the proposed legislation for Hong Kong does not prohibit vertical arrangements between suppliers and distributors of goods and services other than in the context of abuse of substantial market power. The recently adopted Singapore Competition Act takes a similar approach to the Hong Kong proposal.

Common vertical arrangements involve suppliers fixing re-seller price or setting minimum re-sale price for goods and services. Exclusive dealing and tying arrangements are other examples of vertical arrangements. The proposal takes the view that unless a supplier has substantial market power, a vertical agreement is simply a way of influencing the way in which its product is distributed and marketed and that a supplier has no incentive to use a distribution or marketing strategy to make its products less attractive to consumers than its competitors' goods and services.

That approach is similar to the approach emerging in the US through case law and in the EU through the block exemption and case law. The idea is that where a manufacturer and its distributor(s) lack a substantial degree of market power or lack dominance, there is vigorous competition between that brand of goods and other brands of goods. This "inter-brand" competition is invariably a more vigorous form of competition than "intra-brand" competition would be because the whole supply chain is competing, not just the final distributor. The theory also goes that any "intra-brand" restrictions (i.e. restrictions by the manufacturer upon the distributors of its brand of goods) would only be applied by a manufacturer or its distributor(s) where the restrictions enhance the sales of that brand of product against others – that is, the superior "inter-brand" form of competition.

Turning to how this might apply in Hong Kong, as set out above, while a supplier's possession of substantial market power is not prohibited, abuse of such power through vertical arrangements is.
Hong Kong has a small economy where more sectors than most economies have only a few sellers. These sectors are neither perfectly competitive nor are the players strong enough to be described as possessing a substantial market power. It remains to be seen whether applying principles developed in very large economies (i.e. a law that relies either on companies being vigorously competitive or have substantial degree of market power) will be sufficient in small economies such as Hong Kong and Singapore (i.e. in which market participants may fall between these extremes).

B. Geographic markets
Hong Kong is a small, open economy. It is also rapidly integrating into the larger Mainland economy, particularly the Pearl River Delta ("PRD").

The Hong Kong economy's openness can make it susceptible to trans-border anti-competitive conduct, such as regional or global cartels. But it also can complicate the task of market definition. There maybe many sectors of the Hong Kong economy where the relevant market definition may be larger than Hong Kong, such as the PRD as a whole.

Traditional approaches to market definition can accommodate trans-border markets. Hong Kong's competition authority may need to work closely with competition authorities in other jurisdictions to address anti-competitive conduct affecting Hong Kong consumers.

C. Intellectual property
At one level competition law and intellectual property law seek the same thing – to enhance economic efficiency. However, the way in which the two bodies of law seek to do so are, to a significant extent, at odds. In particular, intellectual property laws award a short run limited monopoly to encourage innovation and creativity while competition laws seek to prevent monopolies. This has spawned extensive and expensive litigation in established competition law regimes (e.g. the Microsoft cases in which both the US and Europe found Microsoft to have abused its IP rights).

In the US and Europe there are no exceptions or special provisions to the core competition laws provisions for the use of IP rights (although there is extensive informal comfort from the US regulators in non-binding guidelines and the European Commission has issued limited protection through the block exemption process).

Other countries have specific exemptions for IP rights – take for instance Article 55 of China's Anti-monopoly law. It states:

"This law [that is the Anti-monopoly law] shall not apply to the conduct of operators in exercising their intellectual property rights in accordance with the laws and relevant administrative regulations on intellectual property rights; however, this law shall apply to the conduct of operators to eliminate or restrict market competition by abusing their intellectual property rights."
 

There are also special provisions for IP rights in the competition laws of Australia, Canada and Singapore.

The Hong Kong proposal can accommodate both the US approach (that it is possible to argue that a mere use of intellectual property rights would not offend the prohibitions) and also accommodate the European approach which is to provide additional comfort through the Block Exemption process.

D. High level prohibitions or specific guidance
The law would not define key concepts such as what is a ‘market' or ‘abusive behavior'. There are no "bright line" or "per se rules" (such as an absolute prohibition on price fixing). There are only high level definitions of ‘economic efficiency' defense or ‘essential public service'.

In long established competition law regimes, clarity is typically found in years of case law precedents. This has its advantages because the law can change over time as different types of anti-competitive conduct are discovered or conduct is identified that is actually pro-competitive but falls foul of prescriptive prohibitions.

In newer competition laws, it is more common for the legislation itself to articulate detailed prohibitions rather than relying on the interpretation of the law by the Court or Tribunal (see for example China's Anti-monopoly Law which identifies six specific types of abusive conduct and six categories of economic benefit for which exemptions apply).

The course currently mapped out for Hong Kong provides a range of tools to provide certainty to business.

E. Government exemption
The current proposal is to exempt the Government, its instrumentalities and statutory bodies from the application of the law. This is similar (although not identical) to the approach in Singapore.
 

Competition laws tend to exempt mainline or core Government activities, although they use different approaches. At one level, this can be regarded as necessary: if the police shut down smuggling rackets, it necessarily reduces competition for the supply of the goods that otherwise would be smuggled and if the health authorities require food suppliers to adhere to standards or shut those that fail to meet the standards, competition from sub-standard food suppliers is reduced or eliminated. These actions must continue unhindered.

Turning to governments' involvement in activities that are more akin to the operation of businesses competition law may be appropriate to apply. However, properly identifying and delineating the separation between the regulatory and commercial activities of government s a detailed time consuming task. In economies in which the Government has extensive business interests this task is a higher priority than in economies in which the Government's interests are less extensive. In this regard, it is notable that the Hong Kong Government is less involved in business than most other governments (e.g. the Singapore Government).

The approach in other competition laws is not to have a blanket exemption but to assess whether the Government entity is engaged in business or commercial activities, which can be a complex exercise. The Government's proposal is that the Government and statutory bodies will initially be covered by a broad exemption but that there will be a review to determine whether parts of the Government should, in fact, be subject to the law. This approach has the advantage of not swamping the Commission in the start up phase of the Hong Kong law with a long and detailed task that for the reasons set out above is a lower order priority.

F. Criminal Sanctions
There has been a trend to criminalize certain competition law offences, such as cartel behavior. However, the draft framework paper proposes that the laws:

• not impose criminal sanctions for Conduct Rules; but also

• impose substantial fines of up to 10% of the offending firm's revenue. The fines which can be imposed by the Commission are limited to HK$10m and if the Commission seeks higher fines it will need to bring proceedings before the Tribunal.

A key issue with respect to these two points together arises from a recent decision of the Court of Final Appeal in the Koon Wing Yee v Insider Dealing Tribunal and Another [2008] 3 HKLRD 372 (the Koon Case) concerning the insider trading provisions of Hong Kong's Securities Ordinance (as it applied prior to certain amendments). The court found that the Hong Kong's Basic Law required Hong Kong legislation not to infringe certain human rights found in the constitutionally entrenched Bill of Rights. When the law provides that a substantial penalty may be imposed, the party alleged to have breached the law is entitled to the types of safeguards which apply in criminal proceedings, such as the privilege against self incrimination. This does not make the offenses criminal – for example attracting a prison sentence and resulting in a person having a criminal record. The offences remain civil but the human rights protections are more stringent if the penalties are substantial.

In a related case, the Court of Appeal ruled that questioning of individuals during an investigation by the Securities and Futures Commission (Hong Kong's security regulator) does not infringe the individual's right to remain silent or his or her right to a fair trial. A separate question arises as to whether, once collected, the material can be used in a trial where significant penalties may result. If this ruling stands, it will strengthen the Commission's ability to conduct investigations.

III. Final Comments

Numerous stakeholders have commented on the Government's proposed legislation since the Competition Policy Review Committee issued its first public discussion document in November 2006. Taking into consideration the various public comments, the Government intends to introduce a Competition Bill in the 2008-2009 legislative session. The likely content of the proposed law as summarized in this article will give businesses an opportunity to comment on the proposals and also provide some lead time to review their business practices, correct potentially infringing conduct and develop best practice guidelines to ensure compliance once the law comes into effect.
 

B. IPRs and abuse of dominance

Article 55 also subjects the exercise of IPRs to the abuse of dominance conduct rule (Article 17 of the AML). This is similar to the approaches of the competition laws of the US, Singapore, EU and Australia.

The key phrase is “abusing… intellectual property rights”. However, this phrase has not been defined in the AML.

This phrase, is, however used in Article 40 of the World Trade Organisation’s (WTO) Agreement on Trade Related aspects of Intellectual Property Rights (TRIPS). Article 40(2) may shed some light in relation to the AML phrase “abuse of intellectual property rights”:
“…nothing in this Agreement shall prevent Members from specifying in their legislation licensing practices or conditions that may in particular cases constitute an abuse of intellectual property rights having an adverse effect on competition in the relevant market …a Member may [however] adopt, consistently with the other provisions of this Agreement, appropriate measures to prevent or control such practices, which may include for example exclusive grantback conditions, conditions preventing challenges to validity and coercive package licensing, in the light of the relevant laws and regulations of that Member.”

China acceded to the WTO in 2001 and as such has an obligation to comply with all WTO agreements including TRIPS. In paragraph 286 of the Report of the Working Party on the Accession of China, some members of the Working Party expressed some concern as to the compatibility of China's rules on control of anti-competitive licensing practices or conditions with the corresponding obligations under Article 40 of TRIPS. Notably, the representative of China stated in response that China's legislation would comply with these obligations. The representative of China stated that these rules would apply across the board to all intellectual property rights. The Working Party on the Accession of China took note of this commitment. Hence, there is some suggestion that Article 55 of the AML may not stray too far from Article 40(2) of TRIPS.

On October 11, 2007, the European Communities raised the following question with China during a WTO Council for TRIPS meeting: “…[t]he EC welcomes the recently adopted Chinese Anti-Monopoly Law. This new legislation refers to the concept of ‘abuse of intellectual property rights’ in particular in Article 55. Can China clarify what this concept means in practice? Can China confirm that this concept does not go beyond what the TRIPS Agreement considers as abusive practices under Article 31(k) (compulsory licensing) and Article 40 (competition)?” This question may be indicative of concerns from other WTO members as to whether China will ignore Article 40 of the TRIPS Agreement when defining the term “abuse of intellectual property rights”.

Dominant entities exercising IPRs may still have to be concerned about the following provisions: (a) the prohibition against refusal to deal (without justification) ; (b) the prohibition against exclusive dealing (without justification) ; (c) the prohibition against tying ; and (d) the prohibition against applying differential treatment to parties . In a typical IP licence, it is common to find tying and exclusive dealing provisions. It is also common for IPR owners to refuse to deal with certain entities for various reasons.

Given that no guidelines or regulations have been issued in relation to the AML, there is much uncertainty as to how the dominance provisions (or the rest of the other provisions) of the AML will operate.

In relation to Article 55, the following questions arise: Should dominant entities (exercising IPRs) be subject to the same competition scrutiny as dominant entities selling other goods or services? Or would Chinese competition regulators apply a different standard in relation to IP licences and assignments, in recognition of the fact that IP differs from all other forms of property? Does the Chinese government intend for there to be transitional provisions in relation to the AML? Will the AML apply to IP licences and assignments entered into after 1 August 2008 (the date in which the AML will come into effect) or will it apply retrospectively to IP licences and assignments entered into before 1 August 2008?

C. The Article 15 “improving technology, research and new products” exception

If entities are somehow not able to get their IP related agreements exempt from the AML pursuant to Article 55, then there is a possibility that these agreements may be exempt pursuant to Article 15. Specifically, Article 15 of the AML exempts certain categories of agreements from the “monopoly agreements” conduct rule (located in Article 13 and 14). However, it is important to note that Article 15 does not exempt an agreement from the abuse of dominant position conduct rule (located in Article 17).

The most relevant Article 15 exemption in relation to IP related agreements is the “improving technology, research and new products” exception located in Article 15(1). Specifically, Article 15(1) exempts agreements made “for the purpose of improving technology, researching and developing new products” from the monopoly agreements conduct rule.

The EU has a similar exemption in the form of a block exemption entitled “categories of research and development agreements”. However, in order for an agreement to fall under the EU block exemption, there are several conditions which need to be fulfilled, including the condition that, if the agreement only provides for joint research and development but excludes joint exploitation of the results, then each party conducting the research must be free to exploit the results and any necessary pre-existing know-how independently. In addition, agreements exempt under this block exemption are immune from competition law only for a limited period of time (usually 7 years) and the market share of the participant undertakings must not exceed a particular threshold (for non-competing undertakings, the threshold is 25%).

It is unclear whether the Article 15 exemption will apply in a similar way as the EU’s “categories of research and development agreements” block exemption.

There are still many grey areas to iron out in relation to Article 55 and Article 15 of the AML. Hopefully guidelines or regulations, which are able to shed light on some of the issues and questions above, will be issued before the AML comes into effect.

As China is a fairly young competition regime, there are few competition precedent cases regarding the validity of non-compete clauses. Further, we note that there are no guidelines or regulations accompanying the Anti-Monopoly Law (the "AML"). However, an agreement containing a non-compete clause would fall within the scope of a monopoly agreement and so would be subject to the AML.

According to Article 13 of the AML, monopoly agreements are agreements, decisions or some concert of action that eliminates or restricts competition. If an agreement reached between two or more operators containing a non-compete clause has the object or effect of eliminating or restricting competition, then it will be considered a monopoly agreement under the AML.

It is apparent that non-compete clauses protect the interests of parties in different types of agreement. Since these clauses involve the balancing of interests between promoting competition and protecting the interests of suppliers, retailers and investors, their interpretation and application can be quite complex. It will be interesting to see how the interplay between non-compete clauses and the AML unfolds.