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

Establishing a Nationwide Filing System

While the Pilot Rules only applied the filing requirement to EIEs with a capital amount of RMB 500 million or above, the Notice has removed this threshold and subjects all equity investment enterprises to filing.  Existing EIEs are required to file within three months of the promulgation of the Notice (i.e. November 23, 2011) and newly-established EIEs should file within one month of completing their registration with the Administration for Industry and Commerce, unless:

• the EIE has registered as a venture capital enterprise pursuant to the Interim Management Measures on Venture Capital Enterprises; or
• the EIE is funded and established by a single entity or natural person, or by two or more investors that are wholly-owned subsidiaries of the same entity.

The filing authority is divided into two levels depending on the scale of the EIE:

• for capital equal to or more than RMB 500 million or its equivalent in foreign currency (including paid-in capital and committed capital), filing should be made with the NDRC, which takes up to 40 working days; and
• for capital less than RMB 500 million or its equivalent in foreign currency, filing should be made with an authority appointed by the provincial government (we believe that such filing authority will usually be the provincial counterpart of the NDRC), which takes up to 20 working days.

The Notice itself does not impose substantial sanctions for failure to follow the filing requirements (the only sanction provided in the Notice is that the NDRC will publicly announce non-compliant EIEs).  However, we understand that, in practice, negative consequences may include being prohibited from investment by social security funds and possibly underlying pressure and constraints from the government during its operation and for establishment of new funds in the future.  

Regulating the Establishment, Fund Raising, and Investment Operations of EIEs
 
The Notice provides that EIEs may take the form of a limited liability company, a company limited by shares or a partnership by following the PRC Company Law or PRC Partnership Law.  The capital of an EIE may be committed capital to be paid in installments during the operation of an EIE according to its articles of association or partnership agreement. 

Fund raising of EIEs is restricted to private placement to qualified investors capable of risk assessment and tolerance.  Solicitation to unspecific investors via public channels, i.e. through media, seminars, text messages, etc., and promising a fixed return is forbidden.  EIEs investment is limited to equity of non-publicly-traded companies and unused cash should either be deposited in banks or be used to purchase investment products of fixed income such as treasury bonds.  

Improving the Risk Control System

For risk control purposes, the Notice prohibits an EIE from providing a guaranty to companies other than those it invests in and provides that affiliated parties must refrain from voting for an EIE's investment in affiliated enterprises.  The Notice further provides that assets of EIEs should be entrusted to an independent custodian institute, unless all investors agree to a waiver of such entrustment.  Where the entrusted management institute of an EIE is a foreign invested company, assets of such EIEs must be entrusted to a custodian institute with independent legal status in the PRC.

Clarifying Basic Duties of an Entrusted Management Institute

The Notice requires that, where EIEs adopt the form of entrusted management, the entrusted management institute should prepare and implement the investment plan, manage invested enterprises, provide such enterprises with value-added services, disclose to the EIE relevant operational information, and prepare accounting statements and reports to EIEs.  If the entrusted management institute acts against the interests of investors (i.e. using the EIEs' assets for the benefit of a third party), investor may request the entrusted management institute to resign.

Establishing EIEs' Information Disclosure System

The Notice requires EIEs provide investment operation information to investors as well as submit annual business reports and audited finance reports to the filing authority within four months of the end of each accounting year and report to the filing authority any of the following significant events during its operation within 10 working days from its occurrence:

• amendments to the articles of association, partnership agreement or entrusted management agreement of the EIE or entrusted management institute;

• increase or decrease of the capital or external financing of the EIE or entrusted management institute;

• division or merger of the EIE or its entrusted management institute;

• alteration of custodian institutes or entrusted management institutes including senior management changes or other material changes; or

• dissolution or bankruptcy of the EIE, or the EIE's assets having entered into receivership.

(Written By Jiang Qian)

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.

The previous Department of Price Supervision of the NDRC was renamed and restructured in August as the Price Supervision and Anti-monopoly Bureau.  According to Mr. Zhou, before the restructuring, the Price Supervision and Anti-monopoly Bureau had only 20 officials in 7 divisions with the Anti-price Monopoly Division being the only division handling anti-price monopoly cases.  After the restructuring, the Anti-price Monopoly Division was expanded to three divisions: (1) the First Division of Anti-price-related Monopoly Investigation (反价格垄断调查一处); (2) the Second Division of Anti-price-related Monopoly Investigation (反价格垄断调查二处); and (3) the Division of Competition Policy and International Cooperation (竞争政策与国际合作处). The total number of officials in the Price Supervision and Anti-monopoly Bureau will be increased to 46.

According to Mr. Zhou, the First Division mainly handles cases in the service industries, the Second Division mainly handles cases in the manufacturing industries and the Office of Competition Policy and International Cooperation is the window for international cooperation.

Local price authorities are also intensifying antitrust enforcement efforts¹.   As part of the capacity building scheme, according to Mr. Zhou, 150 additional officials will be recruited by 8 provincial level Price Bureaus.  The Price Bureaus of Beijing and Shanghai will each add 30 officials.  The Price Bureaus of Liao Ning, Jiangsu, Hubei, Guangdong, Chongqing and Guangxi will each add 15 officials. It is reasonable to believe that the NDRC and the provincial level price bureaus will handle more anti-price monopoly cases in the near future. 

¹The NDRC has authorized the Price Bureau of the People's Governments of the provinces, autonomous regions and centrally-administered municipalities to enforce the anti-price monopoly laws and regulations. Thus, both the NDRC and the provincial level Price Bureau have the authority to investigate and sanction price-related monopoly acts.

Refusal to Deal in a Disguised Form

Article 17(3) of the AML prohibits business operators holding dominant market positions from refusing to transact with trading counterparts without a valid reason. The NDRC believes that two pharmaceutical companies' act constitutes refusal to deal in a disguised form based on the below reasoning:

- Weifang Shuntong Pharmaceutical Co. Ltd. (Shuntong) and Weifang Huaxin Pharmaceutical Trading Co. Ltd. (Huaxin) controlled the entire supply of promethazine hydrochloride by entering into exclusive sales agreements with the only two manufacturers of promethazine hydrochloride. Moreover, the two pharmaceutical companies had cross shareholding relationships. The reserpine manufacturers' inability to obtain adequate supplies of promethazine hydrochloride is partly attributable to the lack of competition between the two pharmaceutical companies.

- There was sufficient production of promethazine hydrochloride and the reserpine manufacturers are willing to purchase promethazine hydrochloride under the usual trade terms.

- With the sales price of promethazine hydrochloride increased from less than RMB200/kg to RMB300-1350/kg, reserpine manufacturers were unable to carry on business as a result of not being able to obtain adequate supplies of promethazine hydrochloride on usual trade terms.  The two pharmaceutical companies effectively refused to deal with reserpine manufacturers.

Determination of the Fine

According to Article 47 of the AML, penalties associated with abusing market dominance include confiscation of illegal income and fines of 1-10% of the sales amount of the previous year.  It is, however, unclear under the AML how the sales amount of the preceding year should be calculated.  There have been speculations on whether the sales amount should be confined to that generated in the relevant market involved in the investigation or extended to the entire sales amount of the penalized company.
 
According to Mr. Zhou, the two pharmaceutical companies did not sell promethazine hydrochloride in 2010 and therefore the sales amount related to promethazine hydrochloride of the preceding year is zero.  Taking this into account, the NDRC calculated the fine on the basis of the entire sales amount of the penalized company in 2010.  We note that Weifang Shuntong was fined less than 5% of its sales amount in 2010 and Weifang Huaxin was fined little above 1% of its sales amount in 2010.

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.

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.

The former Guangdong Price Bureau was under the direct supervision of the Guangdong provincial government. The recent reform was made pursuant to the reallocation of administrative authorities within the Guangdong provincial government in accordance with the requirements of the National Development and Reform Commission (NDRC). It is expected that the recent reform would strengthen Guangdong PAB's administrative capacity in connection with enforcement against price-fixing or other price-related monopoly conducts.

The NDRC expects the above reform in Guangdong province to serve as a pilot program, the experience of which could be further implemented to other regions within the country. Consequently, it is also expected that local antitrust authorities will be established in more provinces and cities following Guangdong province and that price-related antitrust law enforcement will be strengthened and further developed.
 

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.

According to press reports, Mr. Peng Seng, the Vice Chairman of NDRC, stressed during the conference that, price cartels are extremely harmful to competition.  Mr Peng also indicated that on of the NDRC's enforcement priorities would be to investigate all alleged price cartels and to stop these cartels from operating in China.

Comments

It is significant to note that the antitrust authorities in China (including the NDRC) regularly co-host conferences such as the one above, with overseas antitrust authorities.  Regular contact between the Chinese antitrust authorities and overseas antitrust authorities ensure that the authorities are up to speed in terms of recent antitrust or competition law developments in each other's jurisdictions. 

Cooperation between antitrust authorities is also a crucial element in terms of "busting" large, multijurisdictional cartels.  To date, it would appear that there is only one formal cooperative arrangement between the Chinese antitrust authorities and overseas antitrust authorities.  In January 2011, the NDRC signed a Memorandum of Understanding with the United Kingdom's Office of Fair Trading.  The objective of the MOU is to enhance cooperation between the NDRC and the OFT in the area of the enforcement of competition policy.  There is no doubt that we can expect more of these formal cooperative arrangements in due course.

According to Mr. Wangjun Zhou, Deputy Director of the Price Department of NDRC, the main purpose of the conference was to "prevent potential illegal acts aimed at inflating the prices of commodities".  According to Zhou, while the government respects the right of the businesses to set prices for the products they sell, businesses should not collude to raise prices, or make advance price increase announcements to "disrupt" the normal market order.  After this conference, various industry associations have announced that they have requested their member enterprises to commit not to fabricate and spreading price increase information, increase the prices of commodities excessively, collude to raise prices or abuse their market powers to manipulate prices, etc. 

The NDRC is the primary agency in charge of administering the Price Law (PL) as well as price-related breaches of the Anti-Monopoly Law (AML).  The objective of the PL is (amongst other things) to maintain a socialist economy as well as to protect consumer interests.  To ensure these objectives are met, the PL prohibits colluding to manipulate market prices, fabricating and spreading news of price increases to drive up prices, seeking exorbitant profits in violation of laws and regulations, etc.  The objective of the AML is to maintain competition for the benefit of consumers.  To ensure these objectives are met, the AML prohibits different types of conduct including cartel arrangements and abuse of dominance. 

Since 2007, the NDRC has the statutory authority, pursuant to the Measures on Price Supervision and Administration by means of Reminder and Warning (Measures), to take various actions allowed under the Measures to either remind or warn the relevant stakeholders when it sees that the market price hikes or is going to hike or that the market fluctuates severely in terms of the prices of commodities.   In addition to holding such talks, the NDRC and other pricing authorities may also, pursuant to the Measures, issue warning or reminders, in relation to price hikes or severe market fluctuations.

It is note-worthy that NDRC has been very active recently in terms of exercising its authority to enforce both the PL and the price-related aspects of the AML.  We will continue to monitor its moves to see what action it will take next in these respects.

Article 14 of the AML prohibits business operators from fixing the prices (including minimum resale prices) of distributors.  The objective of Article 14 is to prohibit suppliers from imposing vertical restraints on distributors, to the detriment of competition in the relevant market. [For more on the operation of Article 14 of the AML, please see our article Rules Governing Resale Price Maintenance in China  Conduct is exempted from Article 14 of the AML, only if these fall into one of the exemption categories pursuant to Article 15 of the AML.  Article 15 of the AML lists out categories of conduct which are exempt from Article 14, including efficiency or other public benefit type considerations.

We note that certain vertical co-operative arrangements between entities in the automobiles sector (and in fact in most high-capital intensive sectors) may be justified – in order to keep suppliers and distributors efficient and competitive.  Specifically, certain types of vertical cooperative arrangements improve economic efficiency by facilitating better coordination between the participating entities (in particular these may lead to a reduction in transaction and distribution costs and/or an optimization of their sales and investment levels).

It is for the above reasons that the European Commission has, in place, a block exemption in relation to certain categories of vertical agreements and concerted practices in the motor vehicle industry (See Commission Regulation 461/2010 on the application of Article 101(3) of the Treaty on the Functioning of the European Union to categories of vertical agreements and concerted practices in the motor vehicle sector).  The following are some salient points which characterize the EC block exemption on motor vehicles:  

• this block exemption focuses on very specific types of vertical restraints, including the purchase, sale or resale of spare   parts; restraints to do with the repair and maintenance services for motor vehicles and concerted practices relating to the   conditions under which businesses may purchase, sell or resell new motor vehicles;
   
• the block exemption does not cover hard core restraints such as minimum resale price maintenance; and
   
• the block exemption exempts conduct from the prohibition against anticompetitive agreements but does not exempt conduct in    relation to an abuse of dominance.

In China, we do not have a block exemption regime.  However, at an AML conference recently, an official from the National Development and Reform Commission (NDRC) (the antitrust authority in charge of enforcing price-related breaches of the AML) said that the NDRC was currently looking into the possibility on granting exemptions in respect of certain sectors, including the automobile industry.  However the NDRC official did not go into detail into whether individual exemptions or block exemptions are being contemplated or the breadth or scope of these exemptions.  The NDRC official also did not disclose a timeline in which the NDRC anticipated setting up such an exemption regime.

It will be interesting to monitor developments on the CADA complaint front.
 

The proposed price increase of container instant noodle, along with the proposed price hikes in relation to household and daily care products have caught the attention of both the National Development Reform Commission (NDRC) as well as local pricing authorities such as the Provincial Administration for Commodity Prices of Jiangsu (Jiangsu PACP).  The NDRC is the authority in charge of governing and administering laws in relation to pricing of certain commodities as well as price-related breaches of the Anti-Monopoly Law (AML).

According to press reports, officials from the Jiangsu PACP have commented that the public announcement by the instant noodle manufacturer risks being construed as "coercing other enterprises to follow suit "(i.e. to increase prices of container instant noodle products), as the instant noodle manufacturer is considered an industry leader.  There is also some indication that Jiangsu PACP officials have referred to this conduct as being a breach of the Price Law 1997 (PL).  However, Jiangsu PACP did not mention expressly which PL provision the instant noodle manufacturer may be in breach of. 

We think this is likely to be Article 14(3) of the PL.  Article 14(3) of the PL prohibits business operators from engaging in "unfair price acts" by "fabricating and spreading news in relation to price hikes, bidding up prices, causing commodity prices to increase excessively." The broad objective of the PL is to stabilize the overall market price level in order to protect competition, consumer interests and to maintain the well-being of the socialist economic regime in China. 

It is not clear in the text of Article 14(3) of the PL itself what constitutes "excessive" increase of prices.  It is also unclear as to whether a mere "fabrication" or "spreading" of news in relation to price hikes would amount to a breach of Article 14(3); or whether this has to result in a price hike, or the business operator had intended to cause a price hike – in order for a breach to be established.  In practice, such uncertainty gives the administration authorities a lot of leeway to exercise their own discretions.

The penalties in relation to the PL are set out in the Provisions on Administrative Punishment for Illegal Pricing Acts (effective from 1 February 2011).  Specifically, a breach of Article 14(3) of the PL could result in the following penalties: corrective orders; confiscation of illegal income, imposition of a fine of less than 5 times the illegal income; if there is no illegal income – then a fine of up to RMB3 million (in case of a serious violation); and revocation of business license (in case of a serious violation) (see Article 6 of the regulation). 

As outlined above, the Jiangsu PACP officials have expressed concerns that the instant noodle manufacturer's conduct of increasing the price of container instant noodles products may be a ploy to "coerce" other entities in the industry to follow suit.  We note that there are no express provisions in the PL which prohibits "coercing" other entities to increase prices – even though arguably, Article 14(3) of the PL could potentially "catch" this behaviour, depending on how broad one's interpretation of Article 14(3) of the PL is.

Further, we note there are overseas precedents whereby conduct amounting to an "invitation to collude" has been considered to have breached antitrust or competition laws. But these are not straightforward cases.  For instance, in the US, we understand that the US antitrust authority (the Federal Trade Commission (FTC)) brought proceedings against U-Haul (a large consumer rental truck company) for inviting its competitors to collude on rental prices (In the Matter of U-Haul International Inc and Amerco, Docket C-4294) (2010).  Notably, U-Haul's top executive made public announcements which were articulated in such a way whereby competitors were invited to collude or raise prices.  It is interesting to note that in the final Decision and Order issued by FTC, although U-Haul is prohibited from communicating with its primary competitors regarding its prices or rates, this prohibition does not apply to "transfer or dissemination of information through Web sites or other widely accessible methods of advertising, such as newspapers, televisions, or signage".  It appears that FTC considered that something more than mere dissemination of information through mass media must be established, in order for a conduct to amount to an "invitation to collude".  We note also that an invitation to collude is also not expressly prohibited by US antitrust laws; rather, in recent years, the FTC has made use of Section 5 of the Federal Trade Commission Act (which prohibits "unfair methods of competition" and "unfair or deceptive acts or practices" to catch such conduct.

According to press reports, NDRC has showed great concerns over these price increase attempts and has communicated with the relevant companies.  The instant noodle manufacturer has declared suspension of its price increase plan "due to the stabilized raw material costs" and so as to be "in alignment with the State's policy for maintaining the stability of commodity prices".  Some manufacturers of household and daily care products have also announced suspension of their price increase plan.  It has also been reported that the NDRC has not found evidence of collusion in its investigation of these incidents.

Going forward, businesses should be cautious if they wish to announce or disclose competitively sensitive information, such as future prices or an intention to raise prices as this may be construed as being a breach of provisions of the PL, including Article 14(3), or even the AML, which prohibits a number of behaviors, including price fixing and excessive pricing (as a form of an abuse of dominance).  Generally, competition concerns for such disclosures are more likely to arise in a highly concentrated market, or if the company intending to release such information has considerable market power. 
 

Because the price increases by the manufacturers above were undertaken at the same time, there has been some discussion in the press in relation to whether this "collective price increase" would amount to collusion between competitors (in breach of the Anti-Monopoly Law). 

When competitors increase prices of specific goods and services at the same time; this does not automatically or necessarily amount to collusion.  It is possible that "unconscious parallelism" has taken place; that is that competitors have raised their prices independently as a result of common perceptions of industry developments.  For instance, in relation to the above matter, we understand that some of the manufacturers have explained that the price hikes in washing agents is due to the increase in cost in raw materials used to manufacture these products (including petroleum).  Other examples of where unconscious parallelism may take place include when a new product is introduced and demand for an outdated product shrinks – this would generally propel manufacturers of the outdated product to lower prices in relation to this product – in order to stimulate sales.

Pursuant to Article 13 of the Anti-Monopoly Law (AML), in order for an antitrust authority or a plaintiff to establish that a monopoly agreement exists, there must first be the existence of "an agreement, decision or [a] concerted practice" between competitors. 

Pursuant to Article 6 of the Anti-Pricing Monopoly Regulation promulgated by the National Development and Reform Commission (NDRC)¹ in establishing whether there has been a "concerted practice", the NDRC will consider a number of factors including: whether the business operators' "pricing behaviors are consistent" and whether the business operators "have engaged in communication of intentions".  Other factors such as market structure and any recent changes to this market structure will also be taken into consideration.  Pursuant to Article 3 of the Regulation on Prohibition of Monopoly Agreements promulgated by the State Administration for Industry and Commerce (SAIC)² , in order to establish a "concerted practice", the SAIC would also consider whether the business operators can justify this "consistent" business behavior with other reasons (other than collusion or coordination).

We are of the view that mere parallel conduct in itself would not constitute a breach of the AML (or its accompanying regulations); rather, there must be some evidence of collusion or coordination between competitors, in order to establish a breach of Article 13 of the AML.  This is the position also, pursuant to United States antitrust laws and jurisprudence. 

We will continue to monitor developments in relation to the above proposed price hikes – it will be interesting to see how this matter unfolds. 
 

¹The NDRC is the antitrust authority that governs price-related breaches of the AML.
²The SAIC is the antitrust authority that governs non-price related breaches of the AML.

On 17 March 2011, the NDRC¹; issued a notice which instructed local price authorities to conduct investigations into the increase in the retail price of table salt²; On 18 March 2011, the NDRC announced that 10 retailers of table salt  were in breach of Article 14(3) of the Price Law 1997.  Article 14(3) of the Price Law1997 prohibits the concoction and spreading of price-hike information, "jacking up" prices in relation to commodities to excessively high level, as this conduct amounts to an "unfair price act".  It would appear that these 10 retailers are of the small to medium enterprise (SME) variety.  Each of the 10 retailers received fines in relation to their conduct of raising retail salt prices - amongst them, the heaviest fine was imposed on Xiaofang Aquatic Product and Non-staple Food Store (Xiaofang).  The Xi'an Municipal Price Bureau confiscated RMB25,000 (in illegal gains) from  Xiaofang and fined Xiaofang RMB50,000.  The other retailers generally received fines between RMB1000 to RMB3000. [Note: Pursuant to Article 6 of the 2010 Provisions on the Administrative Punishment of Illegal Price Conduct, business operators in breach of the Price Law 1997 will be subject to a confiscation of illegal gains and a fine not exceeding 5 times this illegal gain.  In relation to "severe" breaches of the Price Law 1997, these 2010 Provisions state that business operators will be subject to orders to suspend their business or will have their business licenses revoked.]

Comments
The NDRC possesses a lot of discretion in relation to what constitutes excessive pricing pursuant to Article 14(3) of the Price Law 1997.  In this regard, it makes sense to "catch" such price hikes pursuant to the Price Law 1997; rather than using provisions pursuant to the Anti-Monopoly Law (AML)³.  Pursuant to the latter, excessive pricing is considered illegal provided the entity possesses dominance or market power (see Article 17, AML).  In relation to this matter, we note that the entities in question appear to be mainly SMEs.

.   .   .   .   .
 

¹ The NDRC is the authority in charge of administering the Price Law 1997.

² These are: (a) Xiaofang Aquatic Product and Non-staple Food Store located at No. 13 Qinling Haoshaobei Vegetable Market of Xi'an; (b) Songjiang Township Maoxing Food Wholesale Store located in Huide City, Jilin Province; (c) Gongxiao Convenience Store of Jiande City, Zhejiang Province; (d) Xincheng Trans-Era Food Store located in Shahe City, Xintai, Hebei Province; (e) Gaoleitangjiu Convenience Store located at Jiancaoping District of Taiyuan City, Shanxi Province; (f) Xiaoqing Shanghai Hualian Franchise Store in Yuhuatai District of Nanjing City, Jiangsu Province; (g) Meilanaheng Breakfast Store located in Haikou City, Hainan Province; (h) Laochai Store in Wusu City, Tacheng, Xinjiang; (i) Huafeng Store located at Hatubu Town, Wusu City, Tacheng, Xinjiang and (j) Guangjin Store located at Hatubu Town, Wusu City, Tacheng, Xinjiang.

³ There are overlaps between the Price Law 1997 and the AML. Both laws aim to regulate anti-competitive conduct and protect the interests of consumers. The focus of the Price Law 1997, however, is aimed at regulating the prices of certain commodities and services in order to promote and maintain the well-being of China’s socialist market economy.

The flagship policy recently announced is the Planning on Restructuring and Revitalization of Auto Industry which was issued by the State Council on March 20 (the “Auto Industry Planning”). Following the Auto Industry Planning, MOFCOM, the Ministry of Industry and Information, Ministry of Public Security, Ministry of Finance, State Tax Administration, State Administration for Industry and Commerce, CBRC and CIRC jointly issued the Opinion on Promoting Auto Consumption (the “Opinion”) on March 30, 2009. The Auto Industry Planning and Opinion clearly state their goals to be (i) kick-start domestic automobile demand, (ii) encourage the consolidation led by domestic auto giants, (iii) develop high-tech and environmentally friendly cars and (iv) again stressing the economic imperative, boosting auto consumption by a variety of means.

Highlights of the Auto Industry Planning on Restructuring and Revitalization of Auto Industry

The Auto Industry Planning covers a period of three years from 2009 to 2011. It reinforces that the auto industry is the key composition in Chinese economy and the Auto Industry Planning is issued to ensure the sustainable, healthy, stable and comprehensive development of the auto industry.

The Auto Industry Planning sets the following objectives for the next three years:

1. Promote the consumption of autos

The Auto Industry Planning sets a sales volume target for 2009 which exceeds 10 million units and an average rate of increase in the following three years of at least 10 percent. The Auto Industry Planning sets out Beijing’s toolbox it intends to use to achieve these ambitious goals, including: (i) building up a comprehensive legal system to promote the purchase of cars, (ii) adopt a reasonable taxation system, (iii) eliminate rules which impede the development of small engine vehicles (e.g. 1.6 litre or below), and (iv) further develop the support systems for auto consumption, including the auto financing and the second-hand auto sales.

2. Consolidation and Restructuring of Auto Manufacturers

The Auto Industry Planning wishes to steer consumption patterns and also strongly encourages the consolidation of auto manufacturers.

From a market structure perspective it foresees that in the commercial vehicle sector heavy duty trucks will account for 25% or more of truck sales, while in the passenger vehicle sector, vehicles with 1.5 litre engines or smaller will account for 40% or more of sales with 15% being passenger vehicles with less than 1.0 litre.

In respect of consolidation the Auto Industry Planning plans a mix of national champion manufacturers. In particular the Auto Industry Planning foresees the establishment of 2 to 3 auto super national champions which will have an annual production volume of more than 2 million vehicles. In addition to these giants there will likely be a further 4 or 5 auto giants with an annual production volume of more than 1 million vehicles.

The Auto Industry Planning clearly states that this result will be achieved through consolidation and restructuring. If everything goes to plan the PRC auto market will be more concentrated with less than 10 manufacturers controlling 90% of the market shares (currently the 90% of the PRC market share is spread among 14 auto manufacturers). The PRC authorities are not reticent about naming names and to this end the Auto Industry Planning explicitly encourages FAW, Dong Feng, Shanghai Automotive and Changan Automotive to merge and acquire smaller rivals across the country, whereas BAIC, Guangzhou Automobile, Chery and CNHTC are encouraged to conduct M&A activities on a regional basis. The Auto Industry Planning further requires that establishing new manufacturing entities or setting up new branches in places other than the registered address will need to be on the basis of merging in already established manufacturers.

3. Development of R&D Activities of Auto Manufacturers

The Auto Industry Planning continues the trend of encouraging PRC auto manufacturers to build up their own R&D capability. In particular, energy saving and environmentally friendly technologies are stressed. As mentioned above there are clear indications that China believes a major part of its automotive manufacturing future lies with electric battery operated cars. This is underscored by a number of policy decisions including subsidies to taxi fleets and local government agencies for purchasing hybrid or all-electric vehicles as well as directions to state electricity grids to establish electric car charging stations in Beijing, Shanghai and Tianjin.

Although electric cars may be the future, the present intention of the regulations is clearly to stimulate the economy. In this regard the Auto Industry Planning sets very specific measures to boost demand, including exempting tax for purchases of small engine vehicles from January 20, 2009 to December 31, 3009, 5 billion RMB worth of subsidies for farmers to purchase 1.3 litre or smaller minivans¬, cancelling limits on auto consumption (e.g. limitation on license plate numbers, models, administration fees, etc.). We understand that NDRC is drafting more detailed implementation rules which are expected to be issued in the near future.

Following the promulgation of the Auto Industry Planning, several ministry level bodies jointly issued the Opinion on Promoting Auto Consumption which focuses on the auto consumption. As with the Auto Industry Planning, the Opinion provides general objectives and principles aimed at stimulating auto consumption. The measures foreseen include improving the auto sales market environment, developing second-hand automobile market and strengthening the auto financing system.

In addition to these general principles the Opinion does include a specific, and potentially important, change in respect of Branded Auto Sales Rules.

The Opinion, clearly states that the Branded Auto Sales Rules will need to be modified in the near future. At present auto sales are made through the manufacturer (or general distributor) or brand dealers who are restricted to single brands. There had been concerns that this model gave far too much power to manufacturers and general distributors and was likely to fall foul of the PRC Anti-monopoly Law. The likely revisions will include encouraging various sales models, balancing the overwhelming market power of the auto suppliers (manufactures and general distributors) so as to establish a more level playing field in the auto sales market, particularly for the brand dealers who are now in a weak position when dealing with auto suppliers, etc.

Summary
These new regulations are a mix of government short term and longer term policy. Short term the clear intent is to boost sales and thereby stimulate the economy in these difficult economic times. However, longer term the PRC authorities seem to clearly have greater ambitions and these are to consolidate a fragmented industry and focus efforts on becoming a world leader in manufacturing hi-tech, electric powered cars. Whether China will succeed in these short and longer term goals will largely depend upon the actual implementation of these generally worded policies and the detailed regulations awaited from NDRC and other bodies. Given the importance of stimulating the economy these rules are expected to be issued in the near future.