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

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.

2. Pursuant to the Notice, MOFCOM will adopt a filing system for the establishment of new branches by FIEs. The Notice clarifies that establishment of a branch by a FIE does not require MOFCOM or local counterpart approval unless specific regulations state otherwise. This clarifies a previously unresolved issue in that MOFCOM local counterparts had varying practices in such regard from region to region (some local MOFCOM counterparts required approval for FIEs to set up a branch engaged trading). The Notice implies that if the FIE’s business scope relevant to a restricted area has been approved, then no additional approval from MOFCOM is required to set up a branch for the approved business. Furthermore, the Notice regulates that if a FIE intends to set up a branch abroad, then this should be approved by the provincial MOFCOM with the consent of the Chinese embassy’s commercial department in the country where such branch is to be located.

B. Ease of Approving Holding Companies

On March 6th 2009, MOFCOM also issued the Notice on Delegating the Approval Authority for Foreign Invested Holding Companies to streamline the establishment of foreign investment holding companies.

This notice provides:

1. Proposed holding companies with a registered capital of USD 100,000,000 or less will be examined and approved by the competent MOFCOM counterparts at the provincial or vice-provincial city level. Previously, the establishment of a holding company required MOFCOM level approval regardless of scale.

2. Any amendments to established holding companies (i.e. such as name change, revisions to business scope, normal changes to capital structure) can be approved by lower level MOFCOM counterparts except for cases where a single capital injection increases its value by over USD 100,000,000.

3. Despite the positive developments, MOFCOM also reinforces in the Notice that holding companies cannot invest in areas that are restricted or forbidden to foreign investment. Further, if required by relevant industry rules, investments by holding companies will still need approval from the industry authorities even if approved at the local MOFCOM level.

Summary
The devolution of approval competency for most projects will simplify and speed up the approval process for foreign investors as well as lower the work burden of MOFCOM. In addition, the new policy will make the operations of existing FIEs easier in that many will be able to now bypass central MOFCOM approval for operational actions such as capital increases.
Although, there is no apparent negative impact upon foreign investors in such notices it should be also noted that MOFCOM and other approvals still remain in place under specific circumstances. Foreign investors will need to carefully check which approvals at which level will be required in order to have a valid establishment.

[1] Vice-provincial cities, as an administrative division in China, are not treated as a province from an administrative perspective, but are distinct from a financial perspective.
[2] According to a notice issued by National Planning Commission (the predecessor of National Development and Reform Commission), central government reliant projects include the FIEs using state subsidies, FIEs investing in infrastructure, etc. But this notice was issued in 1999 based on the old Industry Category for Foreign Investment in 1997 which has been revised largely afterwards, thus may be out of date.