China Law Insight : China Business and Intellectual Property Lawyers & Attorneys : King & Wood Law Firm : IP, Arbitration, Litigation, Securities, Foreign Investment

Translators

“Mr. Zhang, you are a crook. You have misappropriated Joint Venture funds. I demand that you return the funds immediately.” — Irate China Investor

“尊敬的张先生，我们的外商对中国的财会操作不甚了解。他发现贵公司和合资企业之间存在着某种企业间的借贷关系。若贵公司能尽早把上述款项归还给合资企业，我们的外商将会十分感激。” — Translation by China interpreter (Translation as follows: Esteemed Mr. Zhang: Our foreign guest is unclear of Chinese accounting practices. He understands that there may have been certain inter-company loans between your esteemed company and the Joint Venture. Our foreign guest would appreciate if your esteemed company would at its earliest convenience return such funds to the Joint Venture.)

Many business primers in China lay great emphasis upon the use of independent translators. However, many others continue to believe it is not necessary. They are wrong.

With very few exceptions, the Chinese side will indeed need a translator even if the person with whom you are talking can speak English (or if you assume he speaks English).

I am reminded in such regard of the Belgian businessman who had conducted a number of meetings with a Chinese customer. The Chinese customer spoke some English himself and had his daughter acted as a translator as she had studied English at high school. The Belgian businessman was delighted about how quickly the Chinese customer had understood everything and his intense concentration. The Belgian would often speak for 20 minutes without interruption. At the end, the Chinese customer would simply agree. Curiously, most questions raised were on very simple issues or words. This was in fact not surprising as the Chinese customer probably understood virtually nothing, and his daughter may have only understood some of the opening statements.

There are no if's or but's — it is crucial to have your own translator in China.

However, that is not the end of it. As illustrated in the opening quote of this section, the translator wields enormous influence over the negotiations with the Chinese counterpart. Some foreign investors like the idea of a sherpa-like interpreter. This is someone who will take your words and then turn them into “acceptable polite Chinese wording”. For most investors, this is a poor solution. Most Chinese business people with whom you will meet can take it straight. I suggest only to use an interpreter if you believe the person: (1) is a better negotiator than you; (2) is clearer about your objectives than you are; and (3) has a better understanding of your company than you do. If not, it is better to use a translator. And if your direct manner does get you in trouble with the Chinese counterpart, well, it is likely that you are not destined to do business with one another.

It is also worth emphasising the word “independent”. If you are in a joint venture, it is probably important to have an independent translator at meetings with the Chinese partner.

In many cases, the foreign partner relies upon his Chinese manager to fulfil this role. In my experience, this will often lead to extremely negative results. Firstly, the Chinese manager is typically very keen to see a transaction occur. For this reason, the Chinese manager will often soften wording or provide explanations to a potential Chinese partner who you may deem unnecessary, or worse still, wrong. This does not mean that such behaviour is an act of bad faith, but he can often believe that his behaviour is in the best interests of the project. In very few cases does the China manager see a project dying as being in the company's best interests. However, experience has shown time and again that it would have been best to put a project to sleep rather than embark on an enterprise in which the partners have been misled to the overall strategy. Further, if a project does go ahead, it is often important for the shareholders to be able to have a direct discussion without the presence of local management. Direct confrontation is avoided in China even more than in the West. Therefore, having a person translating who may be part of the problem will at the very least affect the way in which the Chinese partner may wish to raise problems. (In some circumstances, the translation might twist the meaning of the original message. For example, when one tries to translate to his boss that the other side says “the General Manager is an incompetent fool”, he might have to translate it as: “They think the General Manager needs more support to improve the overall condition of the company”)

 Accountants
“Can't live with them, can't live without them.” — China project manager on accountants

Accountants are involved in almost every FIE project. Their scope of work in China will often surprise many. They are often involved in the selection of investment location, advising on tax rates, negotiation of tax subsidies, audit, financial due diligence, and ongoing advice on issues such as transfer pricing, customs duties and VAT planning, foreign exchange issues, tax incentives, and China and overseas tax returns, etc.

The Big Four accounting firms are all very well represented in China with offices in the major cities. In addition to the Big Four, there are also a number of smaller foreign accounting firms and local Chinese accounting firms.

Accounting firms normally provide services such as:
• audit and assurance;
• investment strategies;
• forensic services;
• risk management solutions;
• HR services;
• IPO services;
• mergers and acquisitions support;
• tax services; and
• transaction services.

Although it will be difficult to avoid accountants, it is important to find talented ones. It can be a mistake to leave them entirely to their own devices. Often, junior personnel will be assigned to work on the project, or in some cases, the accountants will only view documents to the exclusion of physical evidence or even common sense. This can be illustrated by the case of the USD 100,000 Ford Escort.

Case study: The USD 100,000 15-year-old Ford Escort
The client had purchased the entire business and assets of a Chinese target. At closing it was necessary to complete the stock take. During the stock take, it became clear that a vehicle which was in the books for USD 100,000 was not a large, expensive, new Mercedes truck but rather a small, old Ford Escort.

The client had not conducted a physical stock take of the assets but had rather relied on the accountant's financial due diligence, which in turn relied upon the books of the company. Accordingly, no one had looked at the physical assets. The Ford Escort had entered the books
as a payment for a debt of USD 100,000, ie the target's customer did not pay and the company took his car.

The business development manager of the foreign company was now in a dilemma. It was a multi-million dollar deal, and in the scheme of things, the USD 100,000 was a relatively small amount. However, headquarters (as headquarters are prone to be) would love to unravel
a whole transaction based on a minor asset. The headquarters would be unlikely to know whether a plant in China is worth USD 1 million or 10 million, however, anyone would know that a 15-year-old Ford Escort is not worth USD 100,000. To add insult to injury, when the client notified the accountant of the problem, the accountant advised that it could indeed be a problem and recommended that they conduct a second financial due diligence on this issue — seemingly oblivious to the fact that they had done a first due diligence and that the case was at the stage of closing.

 Lawyers
“Lawyers are like rhinoceroses: thick skinned, short-sighted, and always ready to charge.” — David Mellor

Corporate lawyers are basically consultants. However, it is wise to never refer to a corporate lawyer as a consultant unless you wish to irritate him. If a consultant tells the corporate lawyer that he is a consultant “just like you”, it is likely that the corporate lawyer's face will contort into a pained look similar to that of a policeman being told by a prison guard that they are both in “law enforcement”.

In many cases the services of lawyers can overlap with those of consultants and accountants.

The services lawyers typically provide in China M&A deals include:

• conduct legal due diligence of the target company and/or assets;
• structuring the transaction;
• drafting contracts;
• assisting in negotiations of the transaction documentation (joint venture contract, assets transfer agreement, articles of association, etc);
• accompanying the project’s approval process; and
• providing ongoing support.

It is important for the business teams to properly manage lawyers within a deal. Many lawyers wish to restrict themselves to providing narrow, pure legal advice. In China transactions much of the lawyer's value should be experience gained in other transactions. In addition to legal advice it is important for the lawyer to provide the client with an independent assessment of the transactions risks and the context of such risks.

Summary

China projects do not run themselves. The assembling of a transaction team is a key factor in completing a successful project. Experience has shown that if the in-house team has high level support from within their company then they will have a far better chance of success and the project will be able to proceed much more quickly.

The in-house team will in most cases need external support. Selecting and managing the external consultants is extremely important for the project's success. Ideally the external team should provide practical insights as to how best to overcome issues and minimize risk in the project.

The unsuspecting foreign investor will be surprised to find how helpful everyone is in China. Indeed, it often seems that China's biggest sector after manufacturing is consulting service in relation to China. A Google search of “China consultants” resulted in over 20 million results.  Googling “ethical consultants in China” resulted in two million results — more than expected!).

One of the reasons that multinationals do relatively well in China is the depth of their management. Medium-sized companies will often need external support for their China projects, and there are so many consultants to choose from in a myriad variety of types and sizes. The usual suspects (ie types of consultants) are listed below.

The China Consultant — Jack of all Trades
“Russia is a riddle wrapped in a mystery inside an enigma.” — Winston Churchill
“China is much more complicated than that!” — China consultant

The China Consultant can be a blessing to an inexperienced China investor. However, it is extremely important to choose one that understands you and what you wish to do. Further, it is important to ensure that the investor remains deeply involved in the project — responsibility cannot be outsourced. If it is your investment project and it fails, it will not help to blame the hired hands, ie the consultants.

The generalist China consultant — the “zhongguo tong” or old China hand can play an important role.

In many cases, these consultants have little knowledge (many people believe the sentence could end at this point) far less than the client of the industry in which the client is operating. They rely to a great degree on their “China knowledge” and “guanxi”.

China is clearly different in many ways from Europe or the US. However, it is not the unfathomable enigma made out by many China consultants. Naturally unscrupulous consultants wish to make China more mysterious than it actually is in order to maintain their role in a project. If a consultant states to you that he is a crucial part of the project (as opposed to becoming crucial by doing a good job), well then, it is probably time to find a different consultant.

However, it would be unfair to dismiss the China consultants out of hand. Consultants can and do play important roles. It is important for foreign investors to select a consultant with whom they feel comfortable and who can cover manpower or expertise shortcomings within their own organization.

Crucial criteria for selecting a consultant include:

The consultant has your interests at heart - For many consultants, it is not the success or failure of the project that matters, rather, it is whether the project proceeds that is important. In many cases, unscrupulous consultants prepare feasibility studies which have best case scenarios based on the assumption that “if every Chinese added one inch to his shirt tail”, and worst case scenarios which are only slightly less pessimistic, such as “if every Chinese added two-thirds of one inch to his shirt tail”.

Case study: The Intermediary
In the Harvard Business Review on Doing Business with China (Graham, John L. and Lam, N. Mark, “The Chinese Negotiation”, in Harvard Business Review on Doing Business in China (Boston MA: Harvard Business School Press, 2004).), an article entitled “Chinese Negotiation” by John L. Graham and N. Mark Lam lays great importance on the role of the “intermediary” (zhongjian ren) (In Chinese: 中间人). Basically the intermediary is a person who can bridge the two sides and intercede when there is conflict. The authors advise that the intermediary plays an indispensable” role in such discussions:

“Only a native Chinese speaker can read and explain the moods, intonations, facial expressions, and body language Chinese negotiators exhibit during a formal negotiation session. Frequently only the zhongjian ren can determine what’s going on. … the zhongjian ren can step in because he is an interpreter not so much of words as of cultures.” (Graham, John L. and Lam, N. Mark, “The Chinese Negotiation”, in Harvard Business Review on Doing Business in China, p 41)

Experience, at least mine, has shown that if in order to communicate with the Chinese partner on the other side you need someone to analyse his “moods, intonations, facial expressions, and body language”, well, it is probably time to look for another Chinese partner who is less difficult to deal with. One should also bear in mind that the mission is not accomplished with the signing of a contract — it is the establishment of a successful project. At the time of project implementation, the zhongjian ren will no doubt be off brokering deals elsewhere while you will be sitting with Chairman Liu, trying to work out what he means when he crosses his arms and speaks with a slightly higher than normal lilt.

However, I may be wrong as John L. Graham and N. Mark Lam even helpfully provide an example of intermediary “magic”:

“Indeed, we have seen more than one zhongjian ren successfully deal with divisive disagreements. The following is one such case.

A vice president of a New York-based software company went to Beijing to negotiate a distribution contract with a Chinese research institute. Having attended meetings arranged by the intermediary — a former senior executive with the institute — the VP was pleased with the progress during the first two days. But on the third day, the two sides became embroiled in a fruitless debate over intellectual property rights. Feeling they were losing face, the Chinese ended the meeting. That night, the VP and the China country manager met with the intermediary. The following day, the intermediary called the head of the institute and worked his magic. In the end, both sides agreed that the intellectual property rights were to be jointly owned, and the contract was signed.” (Graham, John L. and Lam, N. Mark, “The Chinese Negotiation”, in Harvard Business Review on Doing Business in China, p 42)

And that indeed sums up the problems with using intermediaries in China.

Intermediaries normally convince the unsuspecting foreigner to agree to what the Chinese counterpart wants. The above passage even admits that the intermediary was “a former senior executive with the institute". It is unlikely that he would switch allegiance to the US company based on some nice dinners (according to the authors, “Expensive meals in nice places are key”). In my experience, the intermediary (especially one with links to the Chinese partner) grants the Chinese partner an enormous advantage in negotiations. The intermediary will allow the Chinese side to know what the foreign side is thinking and will normally push for the easiest way to an agreement. This is normally to convince the foreign partner that “this is China” and to agree to the proposal on the table.

The “magic” solution outlined above was that the New York software company agreed to joint ownership of the intellectual property rights of its software with a Chinese distributor. Leaving aside the fact that it would seem strange to grant a distributor intellectual property rights, the even greater question is: what was the “magic”? Did the Chinese distributor want sole ownership of the software? I do not think I would grant a distributor ownership of software.

The consultant is realistic about China and himself - Many China consultants have a vested interest in making China a mysterious, unfathomable, and almost dangerous place. Only with their guidance and even more importantly, their highly placed contacts, could your medium-sized company hope to navigate the behemoth which is China. This is obviously over the top. Some things are different in China, but most things that make sense overseas also make sense here. Contacts do help as is the case everywhere, but they are not the only factor.

In addition, one should be wary of consultants who claim “they have unrivalled contacts in China”, “my father was a foreign minister in post-liberation China” (indeed the writer has met three consultants who have made this claim — but they well have been telling the truth as they all proved to be crooks and may have been related) etc.

The consultant should not care too much - Naturally it is important for your consultant to care but it is also important that he does not care too much.

This can be best illustrated by the following case:

Case study: There is no place like Home

A company from Austria was interested in manufacturing cane chairs in China. Basically, the design was made in Austria. Cane would need to be sourced in China and some assembly work was required. The production would then be exported. All in all, a small project.

As the company was small and had little overseas experience, it came across an Austrian entrepreneur living in China. This Austrian entrepreneur had a factory located in Xiaoshi, a small village in Liaoning province in the Northeast of China. The Austrian entrepreneur had convinced the Austrian company that he was an extremely successful businessman in China and was running a number of factories very successfully. That this successful businessman was willing to take time out of his hectic schedule to assist in locating an ideal place to assemble some cane chairs did not seem to raise any alarm bells.

In any event, consult he did. The conservative Austrian company requested a feasibility study on the location of the facility. The Austrian consultant went off and conducted his investigation. Now, a layman may think that the obvious location for a small assembly plant for export would be near a port, a railway connection or some other form of transport. Alternatively, it would make sense to have the facility located near the raw materials.

You would be wrong. The feasibility report concluded that the perfect location for the assembly would be Xiaoshi — despite being located far from rail, sea or port; despite being four hours from the nearest airport; despite being possibly one of the only places in China where bamboo refuses to grow.

However, if the consultant surprised with the general location of the proposed facility, he was able to exceed all expectations in relation to the level of specification. The consultant had been able to pinpoint a factory on a street near his current factory. Further good news abounded in the feasibility study. In addition to finding an optimal assembly location, the consultant had been able to drum up support with the local party secretary. The report proudly stated that “Xiaoshi’s party secretary supports the establishment of a cane chair production facility”. In addition, he would give his support to the Austrian company to use the state-owned factory provided the Austrian company was able to meet certain investment and tax requirements. The consultant was also willing to take a share in the new venture to “smoothen things”.

The Austrian company decided to set up a simple assembly plant in Suzhou and has been successfully assembling and exporting chairs for several years without high-level political support.

Having an export manager deal with a China project on a part-time basis will mean that the project may have a lower priority than it deserves. Having a middle manager deal with a China project on a full-time basis and having his destiny interwoven with the China project (i.e. no China project = no job) may mean the deal will proceed regardless of whether it makes sense or not.

In the author's experience the most successful China project teams are indeed teams rather than individuals. Suitable team members will typically consist of an in-house team consisting of an executive-level member, a business development manager, an in-house lawyer and a technician; and normally external support including lawyers, accountants and consultants.

In-House Team

(1) Executive
Often in China, it is difficult to close a deal without the assistance of an executive-level negotiator from the head office. It can often be a mistake to bring such persons too early into the game as this demystifies them. Better to bring the high-level negotiator to close the last remaining open points rather than waste him on small wording issues.

(2) Business Development Manager/Project Manager
Projects without a dedicated project manager or business development manager tend to proceed slowly. Ideally, this person will not be the person to actually implement the project if it is a joint venture. This may appear at first glance to be counter-intuitive. However, experience shows that although a dedicated project manager is good, one that is too dedicated can be very bad.

Project managers who end up implementing the project (i.e. as General Manager) will tend to adopt a position of compromising too easily on important issues to the company and digging in the heels for items that, although less critical from a corporate view, may impact upon the General Manager. If the candidate for the General Manager is already clear, then it is useful to have him or her involved but not leading the discussions.

Case study: Our Friend François
An example of such an issue was with a French chief representative who was negotiating a joint venture for his company. François saw his very career being entwined with the formation of the joint venture as he would be the General Manager. The project was to be a 50/50 joint venture due to legal restrictions.

In the initial letter of intent, the parties had agreed that the French side would nominate the General Manager. However, as one may expect, during the actual negotiations of the detailed joint venture documentation the Chinese side wished to have a “veto” over the actual appointment. Sacré bleu! The Chinese side was sensitive to François’ obvious discomfort with the proposal which appeared to him to be a thinly veiled attack.

In order to smoothen our Gallic friend François’ ruffled feathers, the Chinese explained that it was not that they were against François as General Manager. No, François was their friend. No, François was a competent man. No, the problem was that the Joint Venture was to last for 20 years and their concern was whether François’ successor would be equally competent. François’ response (unfortunately heartfelt) was that they should not worry. It was clear that after his term as General Manager, he would return to France and have a board position in the headquarters and be responsible for Asia. Accordingly, the Chinese partner could rest assured that François would still be involved. It was a little difficult, but I felt it necessary to take François to one side and explain to him: “1. The Chinese partner is interested in doing the project with the company, not with you; and 2. they were only being polite — they do not really think you are competent.”

(3) In-house lawyer
A much maligned breed. For many project teams, the in-house lawyer represents the worst nightmare — the lawyer you cannot fire.

However, in-house legal counsels will often play an important role in a China project.

Their main advantages are: (1) they have a good understanding of the foreign company doing the project (i.e. what is feasible and what is not); (2) they can play an important role in ensuring that the proper headquarters’ resources are brought to bear as required; and (3) an often underrated advantage is that they are able to ensure that outside counsel remain focused on the project.

When the legal counsels are good, they can be very good for a project. However, occasionally one comes across in-house counsels that seem to block everything. As the Chinese saying goes: “A man who cannot say yes is useless, a man who cannot say no cannot be trusted” (不能说“是”的人没有用；不能说“不”的人信不过。). Some in-house lawyers from headquarters fall within the “cannot say yes” category.

There is one tried and true solution to such a dilemma — invite the in-house lawyer to attend negotiations in China. Most China project negotiations do not occur in metropolitan Shanghai or Beijing but in relatively remote areas. One trip will normally be enough to change the in-house lawyer's attitude from “No way, this is a crucial issue” to “OK, well if you cannot negotiate that point, I understand it is difficult to second guess negotiations when you are thousands of miles away (please God, do not make me go back to that hell hole)”.

(4) Technician
Almost all China projects have a technical or technological element. The technology is normally an integral part of the potential risk as well as being crucial to the project's success. Despite this almost all joint venture projects are negotiated without the participation of technicians. Input from technical staff is crucial in determining how to protect technology, assess what technology should flow into China, and also crucially, how to transfer technology to China.
 

For many companies approaching a transaction, due diligence is a tool to confirm
compliance or to seek confirmation that their project is not excessively risky. In the
context of an acquisition in China, this is the wrong approach. Chinese companies are
used to informal arrangements; as a result, non-compliance issues may arise in the
fields of employment and social contributions, tax, licensing and intellectual property,
among others. However, if a Chinese company raises no compliance issues, it is
almost certainly not a viable option for a project - the target does not need the acquirer
and the acquirer is unlikely to be able to afford the target. When properly performed, due
diligence should uncover problems and compliance issues, but should go further and
provide a plan - including price reductions, corrective measures and other steps - that
allows for successful implementation.

A foreign company's ultimate decision maker may see little immediate opportunity in
China, being reluctant to move hastily in a risky market and making full compliance a
prerequisite for a deal. However, a visit to China can turn the most cautious chief
executive officers into the most over-zealous converts. Due diligence plays its part in
contextualizing a particular opportunity in the most practical terms.

Types of due diligence

A foreign investor normally starts conducting due diligence as soon as a letter of intent
has been signed. This work is conducted in various ways:

• Legal due diligence is carried out by law firms, which check the legal status of the Chinese target, including its ownership structure, assets, operations and staff.
• Financial due diligence is carried out by accountancy firms to check compliance with accounting and financial requirements, and may overlap with a law firm's work.
• Investigatory due diligence is conducted by private investigation firms to check the good-faith basis of key management or business operations. This is normally necessary only in sensitive cases or to address serious concerns that are brought to light by financial or legal due diligence.

Environmental due diligence is increasingly common. A law firm's research usually
determines whether the target has the necessary environmental permits and
operational licences, but it is based on documentation and interviews. In some
cases a foreign investor also requires a technical assessment of a factory or other
asset in order to assess its level of compliance. For example, soil sampling can
determine whether the land involved in the deal is contaminated.

Procedure

The due diligence process follows an initial discussion with the client to gain an
understanding of its industry, project and intended goal.

Strategy paper

• A strategy paper should give a basic legal opinion on:
• the restrictions on the intended business (eg, whether a wholly owned foreign enterprise can be used and which operational licences are required);
• the potential advantages of incorporating a new company, including any preferential treatment available to a foreign investor on this basis; and
• operational requirements.
   

Preparation for fieldwork

Preparation for fieldwork should involve:

• liaising with other due diligence teams to minimize disruption to the target's organization and business;
• providing a list of documents for the target to prepare in advance; and
• making clear to the potential partner that cooperation with the due diligence process is a precondition of the deal.

Fieldwork

In the case of a Chinese target, due diligence that is confined to data rooms and document review is highly unlikely to result in useful findings for the acquirer, whereas direct research can be remarkably revealing. Ideally, fieldwork should involve:

• collecting documentation;
• interviewing members of the target's management, who may be surprisingly frank
• about the basis of its operations;
• cross-checking documents and visiting the relevant authorities, including the Real
• Estate Bureau, the State Administration for Industry and Commerce, the
• Commission of Foreign Trade and Economic Cooperation and the courts; and
• meeting stakeholders, including banks, customers and employees.
   

Picturing the target - an acquirer's checklist

In order to make a balanced decision about a transaction, an acquirer should have an
overview of:

the target's structure, including:

• parties' agreements or board resolutions on amendments to the target's articles
• of association;
• amendments to the shareholder agreement, if any;
• business licences; and
• an itemization of the parties' investment in the increased registered capital;

the basis of the target's operations, potentially including:

• approval from the State Administration of Foreign Exchange;
• production or product licences;
• environmental protection agency approvals;
• pharmaceutical licences;
• certification of tax registration;
• land use rights and building certificates; and
• documents relating to equipment and machinery;

the target's contractual obligations, including:

• agreements between the target and its shareholders;
• loan agreements;
• major supply and sales contracts; and
• documentation on product distribution, technology, employees and accounts
• receivable; and

 the target's claims and potential liabilities, including:

• pending outstanding debts;
• claims or awards pending with courts or arbitration bodies;
• discrepancies in audited accounts; and
• ongoing investigations by government authorities.
   

Potential problems

A would-be acquirer must be prepared for difficulties in areas that might be taken for granted in a transaction outside China, and an examination of potential problem should start with the basics - it seems unlikely that a foreign investor would buy a nonexistent company, but this has happened. Beyond disaster avoidance, an investor must consider whether the problems are irreparable or whether realistic solutions can be found.

Land use rights and buildings

Many Chinese companies operate on the basis of an informal arrangement with local
authorities. An apparent owner may see no problem with pursuing a deal even if it has
only a short-term, unenforceable buy-back agreement with the local municipal
government, which remains the target's actual owner. Land or buildings may be
mortgaged and the company may operate on the basis of allocated rather than
commercial land use rights.

Assets

In addition to the issue of actual ownership, an assessment of assets must consider
customs supervision, production know-how and third party rights (eg, mortgage or retention of title).

Operational issues

Acquirers should be aware that state-owned enterprises can obtain licences for
commercial activities that are not open to foreign-invested enterprises; thus, the
involvement of a foreign entity may result in licences being withheld or not renewed.
Most companies do not apply Western standards of environmental performance and
different standards apply to different enterprises.

IP rights

Although the approach to intellectual property in China has been changing fast in recent
years, many Chinese targets value IP rights far less than a typical foreign acquirer
would do, and may not even price them into the transaction. However, this approach
demonstrates a less than rigorous approach to IP issues and often spells trouble. It is
not unknown for a Chinese target to seek to sell technology in which it has no
proprietary rights, and trademark and patent registrations must be cross-checked with
official records.

Employment

Few Chinese companies can accurately claim to comply perfectly with labour
obligations. In one transaction the due diligence report found that 220 of a target's 350
workers were classified as disabled, which enabled the company to take advantage of
the value added tax exemption for certain enterprises employing disabled people as
more than 50% of their staff. However, none of the employees actually performed work
for the company; rather, the company's workers were found to be employed by a third
party.

Comment

Although one purpose of due diligence may be to act as a corrective to 'deal destiny', a
review of the potential pitfalls for M&A projects in China might be enough to dissuade
some potential overseas investors entirely. Not all problems are surmountable and not
all projects should proceed. Some risks may be legally remote but difficult to repair, and
if a target is seriously flawed, the acquirer must be prepared to look elsewhere.

However, many projects fail - or stall for long enough to allow a rival to swoop - because
due diligence results are not read in context or because it is easier to list noncompliance
issues than to remedy them. Firm but fair dealing with the target in the due
diligence process and a clear message about the need for cooperation ensures that
the process and results can be used properly: to reduce risk and optimize the legal
structure of a deal. In this market in particular, it pays to be prepared.

1 Foreign Investment More Welcomed in Certain Sectors

According to China's economic development needs and planning goals, foreign investment in high-end manufacturing, high-tech, modern services, new energy, energy efficiency, outsourcing, and environmental protection industries will be welcomed while polluting or energy-gorging projects and industries running at overcapacity will not be as welcome. Based on the above guidelines, the Foreign Investment Industrial Guidelines Catalogue issued in 2007 will be revised.

In addition, foreign-funded projects in the “encouraged” category of China's foreign investment catalogue will benefit from lower land prices which will be discounted 30%. These policies are intended to facilitate China's continued economic growth by targeting foreign investment in industries higher up in the economic value chain and permit environmentally sustainability.

2 New Policies With Geographic Focus

Foreign enterprises are encouraged to increase investment in China's central and western regions with a particular focus on environmentally sound and labor-intensive businesses. This will be accomplished through tax incentives, policy support and in the development of streamlined procedures for foreign companies that relocate operations from the coastal regions to the center. Incentives will include potential matching funds, technical support, improved administration and other favorable policies. Based on revisions to the Foreign Investment Industrial Guidelines Catalogue, the Foreign Investment Dominant Industrial Catalogue in Central and Western Regions will be further revised.

3 More Open Domestic Capital Markets

Foreign investors are encouraged to participate and acquire domestic enterprises through restructuring or M&A. In particular foreign strategic investors are invited to participate in domestically listed companies, which used to be restricted for foreign investors. Foreign companies will also enjoy standardized and streamlined rules for investment in domestic securities and in corporate M&A moves. M&A transactions between foreign parties should become more streamlined, but a national security examination mechanism will also be established to review foreign M&A operations in China. Qualified foreign invested companies will also soon be allowed to list and issue corporate bonds or medium term notes in China.

4 Improved and Streamlined Operational Incentives

Multi-national companies will be encouraged to establish regional headquarters, R&D centers, financial management centers, and other critical management and operational centers in China. Imports for scientific and technological development from qualified R&D centers will be exempt from tariffs, import VAT and goods and services tax by the end of 2010 under the guidelines.

The approval procedures for foreign investment will be streamlined and the scope of approval and authorization will be reduced. Examination and approval competency for foreign investment will also continue to devolve to lower governmental levels whereby encouraged investment below $300 million for encouraged and permitted projects will be examined by local authorities rather than national ones. The devolution of approval competency for most projects will simplify and speed up the approval process for foreign investors.

In addition, the procedures on settlement of foreign exchange capital funds for foreign investment companies will be simplified. With respect to foreign investment companies operating legally but unable to meet their capital contributions requirements as a result of a tight budget, their deadlines for capital contributions may be extended.

Through these new guidelines, China reiterates its support for foreign investment and could be a response to some complaints that China was reversing its foreign investment policies in the wake of several high-profile matters involving Google and Rio Tinto. These guidelines widen market access to foreign investors and better direct the inflow of foreign capital while also improving China's global competitiveness and promoting more efficient foreign investment into economically vital areas. Naturally detailed rules to implement these initiatives are still to come out.
 

Please note that this entry is provided for general information only and may not be used as a substitute for legal consultation.
 

Without the Measures, the existing Partnership Enterprise Law itself does not allow foreign investors to directly invest in partnerships due to a provision which says such circumstances will be subject to administrative measures to be issued by State Council. Though with such restrictions, international PE/VC firms still appear to prefer using limited partnership as the form of RMB fund, and try the approach of setting up a foreign invested company acting as the general partner and raising fund from domestic investors, which proves practicable in some areas of China. Nonetheless, due to the foreign exchange control in China, a limited partnership cannot receive substantial funding from foreign investors even in such an indirect way.

The Measures generally allow a foreign investor to act as a general partner or limited partner of a limited partnership, but it is still too early for PE/VC firms to celebrate the opening of door. The Measures indicates that for foreign enterprises or individuals setting up partnerships in China with the main business of investment, special laws or regulations in this regard could apply. According to the answers of the Legal Affairs Office of State Council explaining the Measures to journalists, the authorities has not figured out a clear position on partnerships with the main business of investment, such as venture capital enterprises and private equity funds etc., and thus the relevant wording in the Measures is flexible. As a general practice in China, the implementation of the Measures will require detailed rules, which may address this issue further.

The Ministry of Commerce and its local counterparts (“MOC”) has been the main approval authority for foreign invested enterprises for decades, but the Measures take a different approach for foreign invested partnerships (“FIP”). An Application for the establishment of an FIP shall be submitted to the local administration of industry and commerce as authorized by the Sate Administration of Industry and Commerce (“AIC”). MOC will only be notified of the registration information upon the establishment of an FIP. An FIP is still subject to foreign investment industrial policies, including the Foreign Investment Industry Catalogue, and the AIC will review an explanation on compliance with foreign investment industrial policies as part of the application process. We would like to put a question mark on the consistency between AIC and MOC in applying industrial policies to FIPs and other foreign invested enterprises respectively, and speculate that this could trigger the involvement of MOC in approving FIPs.

I. Franchising Trends in China

A. Trend 1: Franchising of Services Derived from Product Trademarks

Generally, franchising is a complete and compact business model that focuses in one particular limited industry area. For example, "Ten Fu' s Tea," is a tea shop where people may taste tea before they buy, but it is not a tea house with tea tasting “services". In franchising, very few companies mix product trademarks with service marks. Mostly, companies prefer to distinguish between the two, for example, IBM was mainly a computing brand, but its after-sale service brand is "Blue Express."

However, franchising in China recently saw the development of a new trend which extends the product trademark to the service sector. In other words, franchising may extend from the manufacturing industry to the service industry. For example, Shanghai Jahwa's mark "HERBORIST" is a trademark for high-end cosmetics that can only be bought in company-owned stores. This limitation on the brand is a clear message to consumers that only company-owned shops sell that product line, and any other channel where the product line is available is not officially authorized. By doing so, the company greatly reduces the possibility of its products being counterfeited and crosses from the manufacturing phase to the retail phase. Moreover, it ensures the quality of the product line, and that the brand will always be connected with "high-end" products. Once this brand acquired market recognition, Shanghai Jahwa opened the "HERBORIST SPA" salons through franchising, which extends the brand from a product brand to a service brand as well.

B. Trend 2: Franchisees dissatisfaction with dependency

In order to maintain quality, franchisors often intervene into operations of the franchisees and take strict control of the franchisees' management. The franchisors often set various restrictive provisions in their franchising agreement and franchisees are often controlled or restricted by the franchise agreements with respect to branding activities, management models, supplies and so on, and must give up control in strategic decisions. For example, franchisees do not have flexibility to adjust its operational model to suit local customers' needs. As a result, although a franchisee is legally an independent owner, it is in fact a subordinate of the franchisor. As the franchisee improves over time, it becomes obvious that the franchisees will feel uncomfortable with their obligations on payment of royalties, advertising fees, and training fees to the franchisor.

During the current economic downturn, when a company wishes to expand, the first and foremost issue is looking for capital. Many multinational companies have since decided to expand into the Chinese market. Under such circumstances, multinational corporations often try to work with strong local Chinese companies under franchising arrangements. However, a franchisee who only obtained territorial authorization is often dissatisfied with its subordinate position. This is particularly apparent if the franchisor has to rely on a franchisee' s financial support and distribution networks. The franchisee will then desire a stronger position which may lead to future conflict.

This situation is more likely during the current financial crisis as more franchisors need to rely on the franchisees' financial support. This new imbalance may cause a franchisee to gradually deviate from the franchisor's control, the unified management standards, and quality requirements. The faster a franchisor expands his franchising businesses, the bigger a franchising territory is, the harder for the franchisor to control franchisees. Any deviation from the spirit of franchising will ultimately damage the franchised brand, and result in losing its market completely.

As this series continues, we will examine how franchisees exert influence on franchisors and provide suggestions for franchisors to maintain control.
 

Before the issuance of such a Circular, the above-mentioned question has for a very long time confused not only foreign investors, its lawyers, and other consultants, but also some local officials of SAFE partly due to the reason that SAFE did not clarify this question by issuing an official and universally-applicable rule. As a result the answer to this question has to depend, to large extent, on the local regulatory practice. Not surprisingly, in practice, some local offices of SAFE held a view that a FIE should not be allowed to exchange the foreign currency from its capital account into RMB for purposes of re-investing in China on the grounds that the foreign currency deposited in such account had been specially approved to satisfy the defined project as described in the business scope. In the meantime, some others officials held different views and allowed the FIE to settle the foreign exchange into RMB to satisfy the needs of re-investing in China. This is particularly the case where a local government is thirsty for foreign investment and it may be driven to take a more flexible policy.

Now, with the promulgation of the Circular, the door to direct re-investment by FIE(s) using the RMB settled from its foreign exchange capital account in China is closed. If a FIE happens to come upon a good investment opportunity, it will have to use its accumulated RMB profits or income or borrow RMB from domestic banks.

As is known in recent years, international “hot” money has unnerved the Chinese government which has thus taken a series of measures to cope with the issue. Without doubt the new rule is intended to strengthen the administration of foreign exchange flow and curb the inflow of hot money. However while it may contribute to the strengthening of its foreign exchange administration and the stability of its economic growth, it may also add the cost of making re-investment by foreign investors through their FIE(s) in some cases more difficult from a commercial perspective.
 

Conditions to be Considered - the regulations introduce factors for the authorities considerations such as whether an import will unfavorably influence the PRC domestic industry’s development, adverse affect upon public morality or environment.

Validity Period - the amended Article 9 states that the validity period for the Proposal for Technology Import License will be set within the range of one to three years. As the previous law did not set limits it is not clear what this restriction will mean in practice.

Procedural Changes – the new regulations require on-line registration with a MOFCOM website before an applicant can collect a Technology Import License. More importantly, contracts which include royalty payments require the technology importer/exporter to make a recordal within 30 days after the base figure for the royalty has been determined. This requirement appears to be an on-going requirement for subsequent years.

Requirements in respect of free technology transfers have been relaxed. Under current law the technology importer or exporter should re-register any amendment to a free technology import or export contract. The June 2008 amendments simplify this by requiring the technology importer or exporter to comply with an amendment recordal procedure rather than re-registering. However, the current practice of the vast majority of companies in China – i.e. doing nothing – is simpler still. However, a failure to follow up properly will make taking legal action against a breaching importer more difficult still.

By Mark Schaub, Partner