Throughout 2007 and 2008, I served as Counsel for Asia for a US public company. During that period, we negotiated contracts with both private and government joint venture partners, as well as established our own operations and subsidiaries in China. This article attempts to set out very basic ‘lessons learned’ from our experiences. Some of the observations are based on our specific business and the special challenges we faced within the confines inherent to a foreign company setting up operations in our industry in China. Even given these specifics, however, our experiences and resultant actions translate to any foreign company starting out in China. Hopefully, the insights provided here will ease the way for other foreign companies new to China.
Picking Your Partner
The importance of vetting your partners and conducting basic due diligence has been discussed in numerous recent articles. Suffice to say here that it is a mandatory and relatively easy process for companies doing business in China. Rather than repeat basic advice covered in more detail elsewhere, I would like to specifically address circumstances we faced surrounding picking a partner for political relations or picking a government agency itself.
There are two broad situations where foreign companies may find themselves facing the challenges that come with this decision. In the first instance, many industries in China remain heavily regulated by the government. This control necessitates that many foreign companies coming into China partner with a government agency or with a private company with strong government relations. In the second situation, a foreign company, although not directly regulated, may believe that the growth and success of its business depends on establishing strong government connections.
In both instances, a foreign company is well served to prepare itself for potential difficulties that come along with the benefits of such a partner. Foreign companies often choose their partner based upon people that the foreign company is familiar with in the government agency or private company. A current constant in Chinese governmental agencies is that people at the top are subject to rather arbitrary and immediate removal or transfer. As well, top personnel are often rotated at regular periods of eighteen to twenty-four months. A change in top personnel can directly impact the foreign company’s status. Although contracts are now generally widely used in China, they are best thought of as setting forth a foundation for the relationship and not necessarily as representing the fully negotiated partnership. In this reality, a change in leadership is often seized upon as an opportunity to reevaluate the commercial deal. A foreign company with ongoing operations at the time of such a change may be forced to agree to new, detrimental demands by its partner. A foreign company in the middle of negotiating a contract can face significant delays in the completion of its contract, or a complete restart of discussions, regardless of the length of time already spent by either party.
Foreign companies must also appreciate an additional risk arising from the fluidity of top government. As in all governments, not every civil servant has the same allegiances. Even while a foreign company is conducting negotiations, or has already signed and sealed a contract, its competitors are most likely continuing to hold their own discussions with other members of the same government agency. If personnel from these other ‘factions’ are placed into decision making positions, the foreign company can find itself out of a deal completely. An individual government official can exercise significant power.
The above considerations arise even with ‘private’ companies in China with strong governmental ties. These types of companies are usually not fully ‘private’ companies. They are often owned at some level and in some proportion by an actual government agency, or staffed with government personnel. This fact not only requires the foreign company (particularly, if a public company) to conduct a level of due diligence of the ‘private’ partner commensurate to that it would conduct if considering a government partner, but also to be cognizant of consequences attendant to a change in top government personnel. Previously established or long standing commercial partners and relations may be abruptly terminated or altered by such a change. As well, the current interconnection of private and governmentally held companies in China may limit a foreign company in its ability to make independent choices in its suppliers, customers, or other business relations.
Finally, while many government agencies in China have reached a certain level of commercial sophistication, not all have experience in conducting business with foreign companies. Where a foreign company has a choice, it benefits itself to evaluate the experience or inexperience of a governmental or private company in working with foreign companies. An inexperienced partner can cause headaches to the foreign company ranging from relatively minor – daily interference and questioning of business decisions – to extremely major – unethical and corrupt behavior that can put the foreign company at substantial risk in its own jurisdiction.
Establishing Your Operations
Picking the right partner is not enough, of course. At the same time a foreign company is conducting its diligence and discussions with potential partners, it must also be considering the establishment and structure of the future joint venture or subsidiary. In the United States, the technicalities of establishing a company are relatively straightforward. In China, even Chinese use agents whose sole job is to interact with the government agencies charged with approving and registering a company. (As an aside, foreign law firms are not authorized themselves to make these applications on behalf of their clients, and must use Chinese agents.) The Chinese government exercises broad control over the establishment of foreign invested enterprises or partnerships. This control extends not only to larger matters such as the amount of capital required and timing of capital injection, but also to what might be considered minutia by companies unfamiliar with the Chinese regulatory environment, such as the name of your company. There are also several different government bureaus that a foreign company must deal with to establish its partnership or subsidiary, and these bureaus may reach different conclusions and impose different requirements. It is common for one bureau to approve a name application or scope of business, for instance, only to have it rejected by the higher level and the process sent back to step one.
To oversimplify, a foreign company looking to establish operations in China must at least consider three fundamentals: (1) scope of business; (2) optimal investment; and (3) most beneficial tax structure. Unfortunately, each of these factors may in fact be subject to regulations imposed by the government which curtail the foreign company’s flexibility.
A company’s scope of business determines its permissible commercial activities. This is not to be taken lightly, as it is subject to government approval and can be closely monitored. Specific wording can be quite crucial. And, again, this is an area which will require at least two levels of approval by different government bureaus. Finally, future changes in business scope will require new rounds of application and approval.
The scope of business often determines the amount of required investment. Capital investment in China is broken into two categories: registered capital and total investment. The amount of registered capital is dependent on the total investment and each amount must be made according to timing mandates. As well, Chinese law imposes restrictions on the ability of a company to extract previously invested capital. Faced with these rules, foreign companies sometimes make the choice to capitalize their Chinese companies at the lowest level possible. This can be a mistake. A company desiring to make an increase in its total investment is required to reapply and this process is at best lengthy and at worst results in a rejection. These somewhat conflicting considerations create a dilemma for foreign companies in trying to determine the true level of capital required for operations, without unnecessarily typing up capital. Again, this is an area where advance detailed and realistic planning will help the foreign company avoid future headaches.
The regulated schedule for the injection of capital requires a foreign company to proceed simultaneously on several fronts. For a foreign company, opening a bank account is not a simple process. A foreign company must commence the banking procedures at the earliest possible time, although it will be hampered by the attainment of prerequisite government approvals. All investments must be verified by an authorized accounting firm and engaging this firm is also a process that must proceed hand in hand with the applications for the company’s establishment. Finally, the timing of all internal processes and required transfers from external banks must be considered; and, depending on the final corporate structure of the investment into China, this may require injections at several corporate levels which may add significant time.
The length and complexity of the application and approval process involved in a foreign company establishing operations in China makes upfront tax planning crucial. It is important to get the tax structure right from the outset to avoid further rounds of new applications or hostage capital. In some instances, the most beneficial structure may involve establishing several layers of related companies in various jurisdictions.
A not insignificant last consideration is the scope of the paperwork that must be submitted in a foreign company’s application. Corporate documents from the parent company, and/or from various related companies depending on the structure of the foreign company, must be submitted to the Chinese government. These documents generally must be notarized by a Chinese consulate in the jurisdiction of the company and this can take weeks. A complicated corporate structure in the foreign company may also cause delays, additional paperwork, and discussions and explanations to the Chinese approval authorities.
So far, this article has discussed several basic considerations surrounding the technicalities of initiating operations in China. Based on my experiences, I would also like to make several additional observations which I expect are common to companies starting to conduct operations in China.
As mentioned, establishing a company in China involves lengthy government applications and approvals. A foreign company’s Chinese partner may want to ‘assist’ in the necessary paperwork to ease the approval. It is imperative that the foreign company remain actively involved in the preparation and filing of this paperwork, even to the extent of ensuring that a company representative attends the actual filing. This is necessary no matter how trustworthy a partner may be or how long-standing the relationship. Foreign companies, unfortunately, have been victims in situations where a signed contract was not the contract actually filed with the authorities or where changes were unknowingly made to previously filed documents. Active participation and communication between the foreign company and its Chinese partner must continue throughout the life of the relationship to avoid these types of discrepancies between what was apparently agreed to and what appears in the government file. Officially registered documents are extremely difficult to revise, even if the Chinese partner is amenable to so doing. A foreign company must always remember that the official company documents will be those that have been filed with the authorities and no company exists until all of the approval procedures and filings have been completed. This is true no matter how many contracts have been signed between the foreign company and its partner.
The structure of corporate governance is crucial in a foreign invested partnership or company in China. Of course foreign companies will adopt different processes to protect themselves, but there are basic areas which any joint venture corporate structure must handle.
The ‘legal representative’ of a Chinese company, foreign invested or not, is the person who carries legal authority to bind the company. The preferred position for a foreign company is to possess the right to appoint its own representative to fill this position. Practically, a Chinese partner will be highly reluctant to acquiesce to this request, and, in some cases, applicable industry regulations require that the position be held by a Chinese national. If the legal representative position is not held by the foreign company’s representative, an alternative protection is ensuring that the financial officer be appointed by the foreign company. In many situations, for foreign invested companies to withdraw or pay money, both the signature of the legal representative and the financial officer are required. While this will not protect the foreign company from contracts entered into without authority by the legal representative, it will offer some protection from unauthorized expenditures.
In a similar vein, a company’s seal or stamp is extremely important in China. Although more recent practice requires both a signature and a seal, contracts and agreements can be made with only a stamp. These stamped contracts can bind a company even if such agreements were not authorized through internal corporate approval procedures. Unfortunately, control of the stamp often rests in the hand of the legal representative and many foreign companies will have no success in negotiating to retain control of the stamp. If so, the foreign company must ensure that it carefully and constantly monitors use of the stamp and the actions of the person maintaining possession.
These practicalities aside, a foreign company cannot afford to neglect contractual corporate governance and decision-making procedures. Basic ways include the right to appoint a majority of the directors; or requiring supermajority decision making. Don’t be fooled by a Chinese partner claiming that only a ‘form’ contract (the Chinese form) will be accepted by the government approval authorities. Acquiescing to resistance from a Chinese partner, or abandoning common sense corporate formalities, for the sake of signing a deal may be disastrous for the foreign company in the future. Sometimes it is necessary to walk away if no control is granted by the Chinese partner.
During contract negotiations and commercial discussions a foreign company must keep in mind the hierarchy of the Chinese government and private company system. Titles in China can be misleading and levels of authority and company structures may be non-transparent. This can cause an unprepared foreign company to believe they are negotiating with a final decision maker, when, in fact, the person with the true authority has never been introduced.
Expect unanticipated, and potentially substantial, costs. Of course, as in any well-planned international transaction, legal and tax fees may be high. However, in China, additional expenses must be incurred that might not be necessary in other countries. Even among ‘sophisticated’ private companies or high level government agencies, English is not widely spoken, whether in reality or as a negotiating tactic. This necessitates frequent use of translators and translations; the official language of almost every contract in China is Chinese. Transportation in country can be expensive; private cars and drivers are often required, particularly, if larger groups of people are traveling or extended periods of time are required. Visas can be difficult to obtain, and generally an outside service must be used for efficiency and ease.
To repeat the cliché, China is a diverse country – not only geographically and culturally, but also in basic ways, such as infrastructure and telecommunications, which can substantially affect a company’s operations. A foreign company will save itself significant start up time, expense and hassle if it invests in upfront evaluation and investigation to understand the peculiarities of the areas in which it intends to conduct operations. Differences from region to region may mean negotiations of commercial terms and contracts on a one-by-one basis, with very different results (even within the same ‘national’ company).
Professional consultation and careful initial planning will also save a foreign company in the area of staffing its operations. As many know, China has recently changed its labor laws, and, in theory, at least, employees enjoy greater employment protections. In particular, once an employee has passed the probation period – the length of which is mandated by law – it is difficult to terminate the employee and, even if termination can be accomplished, a severance payment will most likely be required. These employment laws are similar to those existing in Europe, although in some areas can be less restrictive. It is useful to establish a staffing plan and employment policies, including levels of compensation and benefits at a very early stage. Employment in China can be more ‘equalitarian’ than in other parts of the world. Giving early hires higher than market salaries or benefits may create morale difficulties with later hires, or may restrict a company’s ability to set future rates and benefits. Foreign companies should be prepared to extend benefits that are not now widely provided outside of China, including, for instance, car or transportation allowances, housing allowances, food allowances, and education contributions for employees’ children. Many companies in China offer company transportation as well; and the company may need to budget for a company van or bus. Finally, foreign companies should now be aware that compensation and benefit levels in China for highly qualified and upper level management are on par with those outside of China. A foreign company may be surprised at what it must pay to attract top level candidates.
One last consideration is to be aware of challenges that may be faced by those foreign company personnel ‘on the ground’ in China and those back in the home countries. Management in the home countries and parent companies may find the extremes of Chinese regulation and rules to be beyond the pale and may dispute the advice of even their professional counselors simply because they cannot fathom the extent of the regulatory processes. Communication and emphasis on advance planning in areas such as those discussed in this article can avoid delays which might result from such confusion. The notion that ‘China is different’ still remains quite prevalent, not only within government agencies and private companies closely associated with the government, but even among newer and more entrepreneurial companies.
This article presents a high level summary of certain challenges facing a foreign company looking to move into China. At many levels, it has oversimplified the laws, rules, regulations and approval processes involved, as well as the practical realities. My previous company struggled through each one of the above discussed areas from the negotiation phase through start-up operations. While foreign investment in China has certainly become more streamlined and widespread, and is not to be feared (our operations resulted in US$30million of weekly sales), it still brings with it significant challenges even for multinational companies. Upfront internal planning and consultation with experienced advisors is necessary for a company’s success. But even the most carefully prepared company must brace itself for several harsh reality checks along the way.