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Edward Epstein for the China Group at Clifford Chance outlines legal issues facing foreign investors in Asia's rising star

When China first willingly opened its doors to the foreign investor, almost 20 years ago, there was a joint venture (JV) law but little else. This was not really surprising because even the Chinese recognised that their lives were ruled by people, relationships and party policy not law. In the intervening years, China has embarked on a mammoth legislative programme, partly as a drive to reform its economic system and partly as a response to the West and to participate more fully in the international trading system.

No one can say today that there is no law in China. On the contrary, there is in many fields a maze of legislation but without an adequate legal system to underpin it. The result is that doing business in China is still plagued by legal uncertainty.

There are a number of key legal risks which are common to most deals in China. Most of them arise from the continuing influence of central economic planning on foreign trade and investment. Misleading media reports about China's market reforms have created exaggerated expectations of business opportunities in China. Central economic planning still exerts a powerful influence over foreign trade and investment and foreign investors who ignore this fact risk frustration and failure. Central planning is manifested in a variety of forms.

Restrictive Investment Policy

First, foreign investment is welcome only in defined areas and in one of the two established investment vehicles. Fortunately, these areas can now be found in a Catalogue which was published in 1995 due to external pressures on China to increase the transparency of investment policies. However, many areas which are attractive to foreign investors, such as trading, retail, sales, media and broadcasting, telecoms networks and other utilities are severely restricted or are effectively off-limits. These restrictions usually irritate Chinese and foreign business people alike and, of course, they frequently find a way around them. Even where this is not done illegally, however, exploiting the loopholes in Chinese law often leaves the investors in a kind of legal limbo and thus vulnerable to future swings in government policy.

For example, foreign investors are coming within a hair's breadth of operating telecoms networks in China through complex contractual arrangements which leave nominal control with Chinese operators but give the foreign party effective control. Similarly, foreign investors in China's retail sector, who are subject to national licensing, increasingly push their licences to the very limit or operate without a licence at all. Such situations are frequently made possible because of differences between the economic agenda of central and local government.

Foreign investment vehicles are largely limited to two types of foreign investment enterprises (FIEs): joint ventures (JVs) and wholly foreign-owned enterprises, including holding companies. In recent years, however, foreign investors have also been permitted to buy shares in existing Chinese enterprises. Joint ventures come in two forms: equity JVs and co-operative JVs. Co-operative JVs (also known as contractual JVs) are slightly more flexible because they do not have to be incorporated and the JV partners can fix a profit sharing ratio which is different from their respective holdings of capital to the JV. This allows an accelerated return of investment and is therefore popular in projects where the object is ultimately to transfer the whole project to the Chinese partner. Recently, China has permitted FIEs to be established as joint stock companies, the shares of which will be readily transferable and capable of listing one of China's two stock exchanges.

Investment Approvals

Even when foreign investment is welcome, it must be approved by both China's planning and investment authorities. As a general rule, there is a three tiered approval hierarchy. Investments under US$10 million can be approved locally, investment between $10 million and $30 million can be approved at the provincial level and over $30 million must be approved by the central government. Although there are some general guidelines to the approval process, investments tend to be approved on an individual basis and it can be difficult to generalise about the treatment which can be expected. Recently, the central government reasserted its control over certain projects whatever the size of investment. This includes power plant projects and any project financed on a limited recourse basis.

By law, investments which are not properly approved are liable to have their approval revoked. To date, this has been done where no capital had yet been injected but investors in projects which are at an advanced stage face an uncertain legal limbo which the authorities can later use to their advantage. Lenders will usually require a legal review of compliance with the approval process and early advice on approvals is therefore an important step in any investment in China.

Scope of Business Activity

"Central economic planning exerts a powerful influence over foreign investment. Investors who ignore this fact risk frustration and failure"
Another consequence of central economic planning is that the approved business scope of an enterprise is narrow and does not imply a licence to manufacture or sell another even similar product. For example, a business licence to retail does not imply the capacity to wholesale, and so on. This is often quite a surprise for the foreign investor, who is accustomed to more flexibility. It severely limits the ability of a foreign investment enterprise to restructure its operations to increase efficiency, for example, by contracting out some of its production activities to other enterprises.

By law, any changes in the approved business scope will require further approvals from the original examination and approval authority as well as the issue of an amended business licence. In practice, many established enterprises push their licences to the very limit and beyond. With careful planning, however, this problem can be minimised in the approval process by anticipating the broadest business scope and methods which are in practice acceptable to the examination and approval of the authorities.

Corporate Governance in a Joint Venture

Foreign expectations of how a JV will be managed are usually based on Western pre-conceptions about corporate governance. Control of the board of directors is not necessarily the most effective means for controlling a JV in China. Instead, the control of key management team positions may be more important. Where state-owned assets or a strategic industry are concerned, governance is a political issue as well as an issue of the parties' trust in each other.

The management structure of an equity joint venture is a hybrid of partnership and corporate governance. As there are no shares in a JV company (only the parties' capital contributions), the board performs the functions of the shareholders' general meeting as well as those of a conventional board. By law, the board is the JV's most powerful organ and has the power to make all decisions on important matters, but it is only required to meet at least once a year. Therefore, depending on how its decision-making process is defined, the board may function more like a shareholders' general meeting and less like a board. In such a case, the board becomes more of a formality and real decision-making power ends up in the hands of the management team which is led by the general manager (GM) (who may be but is not necessarily a director) and deputy general manager(s) as well as specialist managers such as financial controller, personnel manager and accountant.

It cannot be assumed, however, that by holding the right to nominate the GM, the foreign party will control management decisions. In fact, the GM must by law consult with the deputy GM in all major decisions. By reserving the right to nominate the deputy GM, the Chinese party effectively holds a check on the GM's functions which can result in acrimony and deadlock. Drafting advice needs to be taken at an early stage to reduce the likelihood of a structural deadlock.

By law, a number of decisions of the board must be unanimous and there is no limit on the number of other decisions which can be added to the JV articles of association. The Chinese party will frequently press for effective veto power over a wide range of decisions as an alternative to (or even in addition to ) control of the management team.

Where foreign management is crucial to production, it is common for the Chinese party to nominate the chairman of the board whilst the foreign party nominates the general manager and other key members of the management team (except the deputy general manager who is then usually nominated by the Chinese party). This is usually predicated on the basis that the management team enjoys a high degree of control over the JV's operations.

Land Use Rights

One of the most important but difficult problems in establishing an FIE is the acquisition of the right to use a site. Land in China is owned either by the state, usually urban land, or by collectives, usually rural and suburban land. The sale or lease of land in China is prohibited by law but since 1988 it has been permissible to assign, lease and mortgage land use rights for a period of between 40 to 70 years.

Most rights in state-owned land have been registered and are administered entirely by the State Land Administration Bureau, which is subdivided and put under local government control. Rights in collectively-owned land, however, are not yet uniformly administered. It can be very difficult to determine who actually enjoys the rights to collectively-owned land because the decollectivisation of agriculture in the post-Mao era has resulted in collectives being poorly defined.

As the Chinese party to a joint venture frequently contributes the site (and buildings) as part of the total investment, it is very important to ascertain the following:

  • the Chinese party has the right to use the site;
  • the Chinese party has authority to contribute the site to the venture;
  • the valuation of the site;
  • what kind of land use rights the Chinese party will contribute;
  • the use and valuation of existing buildings on the site and the relative costs of refitting or demolishing and rebuilding;
  • the Chinese party has complied with environmental law in respect of pollution on the site.

The extent to which land use rights can be legally transferred depends on whether the land has been classified into 'allocated land' or 'granted land'. Traditionally, the state allocates the right to use state-owned land for nominal or no consideration according to an economic plan. As it is thus subsidised, the right to use 'allocated land' may not be transferred or mortgaged but it has been standard practice for allocated land to be contributed to a joint venture as all or part of the Chinese party's investment capital. Generally the land cannot be used as security for a loan (at least until it is effectively converted to granted land by payment of a premium) and does not form part of the FIE's assets in liquidation.

Since 1988, China has been moving away from the system of subsidising land use for productive purposes. The new system for distributing land is to grant land use rights in return for the payment of a substantial land grant premium. The land user must also pay the costs of developing the land as well as the 'peppercorn rent' of usually RMB 1 per square metre per year. In return, the land user receives land use rights which are a capital asset which may be transferred and used as security. Land use rights are purchased by and FIE or contributed to a joint venture by way of assignment to the name of the enterprise, the land can be liquidated as part of the enterprise's assets.

As the purpose of allocating land use rights is quite different from granting them, in many parts of China it is now required practice for Chinese joint venture partners to convert allocated land to granted land before the right to use the land can be contributed to the joint venture. Conversion will normally occur by way of the payment of a premium. However, the actual practice still varies in different localities and it will be some time before these land reforms are implemented uniformly throughout China.

Foreign Exchange

China's currency, the Renminbi (RMB), is at present convertible only for items of current account expenditure - for example, paying for imported raw materials, wages of expatriate staff and remitting dividends. Access to foreign currency is therefore restricted although at the time of writing foreign currency is relatively freely available and the exchange rate is stable. The lack of free convertibility is not a particular problem for FIEs which can generate sufficient amounts of foreign exchange to meet their needs but investments which generate little or no foreign currency must secure a foreign exchange budget by other means. Foreign exchange risk is part of the overall risk in investing in China but can be managed well with adequate planning.

Notwithstanding the current account convertibility, the Chinese side frequently insists on balancing foreign exchange income and expenditure. Therefore, when planning an FIE you must estimate the amount of foreign exchange which will be needed and when it will be needed. The most common foreign exchange expenditures are as follows:

- production parts and materials etc.

- salaries, living expenses and perquisites for foreign personnel

- servicing foreign exchange loans

- royalties for the use of technology and intellectual property rights

- dividends

You must consider the possible sources of foreign exchange income to balance expenditure. The preferred source of foreign exchange income is the export of products produced by the FIE. China's investment policies are export oriented and it will be relatively more difficult to obtain approval for projects which do not have the capacity to generate their own exports unless they are either high-tech, of strategic importance to domestic industry or commerce, or otherwise considered important by the Chinese government, such as, major infrastructure projects.

Technology Transfer

Technology transfer is an integral part of China's modernisation strategy. China requires FIEs to offer some kind of technological advantage and encourages the active transfer of technology rather than Chinese investors being merely passive users of advance technology monopolised by foreign companies. Therefore, China has developed a legal regime to promote technology transfer.

FIEs which involve the production of goods will invariably involve the transfer of technology by the foreign investor. In this context, 'technology' refers to recognised intellectual property rights, such as trade marks, patents and copyright, as well as know-how that relates to technical processes, formulae, product design, quality control, technical services and management which has not been made public and is not always protected under intellectual property laws.

Foreign investors usually think in terms of licensing their technology but Chinese law and practice refers to 'technology import' because where foreign technology is licensed to a Chinese user for a fixed term (usually, five to ten years), thereafter no restriction may be placed on the use of such technology without approval. In other words, any technology transfer to China will usually be viewed as a sale of that technology. In recent years, however, it has been recognised that owners of the latest technology are not prepared to sell it and approval of pure licensing arrangements in China is increasing.

Like the establishment of an FIE, technology transfer contracts must be approved by the Ministry of Foreign Trade and Economic Co-operation (MOFTEC) or its local equivalent before they can take effect. When foreign technology is to be integral to the establishment of a joint venture, the foreign party will have to consider whether the technology should form part of its capital contribution or be sold or licensed to the joint venture. If royalties are to be paid, it is important to decide how they will be calculated and who will pay them.

The Chinese party will be concerned about the quality of the technology as well as the cost. While the Chinese side invariably thinks that the higher quality of the technology the better, it is important to ensure that the technology is compatible with the Chinese party's needs. Usually, the Chinese side will request guarantees that the technology will meet the contract specifications and that improvements to the technology will be transferred.

Recent intellectual property and unfair competition laws have given additional protection against third parties who misuse proprietary technology but assuring the confidentiality of technology, especially unregistered technology, is difficult in China.

Dispute Resolution

China's courts are relatively inexperienced in handling complex commercial disputes, especially those which contain a foreign element. Therefore, arbitration is preferable to litigation. Although there is no such legal requirement, in practice, all contracts for the establishment of a foreign investment enterprise in China will contain an arbitration clause which excludes further appeal to the courts.

In practice, both arbitration and litigation procedures in China also include mediation and there is often strong pressure on the parties to settle their dispute by mediation. Although mediation has no strict procedure it involves the active participation of the mediators who also act as arbitrators or judges. The pressure to mediate can disadvantage the party with the strongest case but a mediated settlement can provide relief from the additional acrimony and expense of enforcing a judgement or arbitral award. In the small percentage of cases where a mediated settlement cannot be reached, the court or arbitral tribunal will give judgement or an award. In China, mediated settlement agreements are put into the form of an enforceable judgement or award.

One important question in negotiating an arbitration clause is whether arbitration will take place in China or a third country and what shall be the composition of the tribunal. Chinese parties favour arbitration by the China International Trade and Economic Arbitration Commission (CIETAC) which is located in Beijing and has sub-commissions in Shenzhen and Shanghai. In 1996, CIETAC received more than 1,000 applications making it the busiest arbitration commission in the world. If CIETAC is chosen, it is important for the arbitration clause to provide the language to be used in the hearing (if not Chinese) and that the Chairman of the panel shall not be a national of the same country as any of the parties.

In the past, Chinese parties have also been amenable to arbitration in Sweden, Switzerland, Paris, London and Hong Kong. The high cost of arbitration in a third country is seen as a strong incentive to settle disputes by negotiation.

China has acceded to the New York Convention on the Recognition and Enforcement of Arbitral Awards. Therefore, CIETAC awards are enforceable in other contracting countries. Similarly, awards made in a third country which is also a party to the New York Convention will be enforceable in China. In practice, however, there have been problems having foreign and domestic arbitral awards enforced by China's local courts but these problems are being addressed at a national level by the Supreme People's Court as the enforcement situation continues to improve.

Notwithstanding China's legal reforms there are still traps for the unwary, especially the newcomer to China. Yet with adequate planning and sound professional advice, these legal risks can frequently be minimised.

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©Kensington Publications 1997