Creating an Effective Strategy for Offshoring to China

China’s business landscape offers enormous opportunity for both traditional foreign direct investments and newly hot foreign private equity (PE) and venture capital (VC) investments. The country’s economy has grown at an annual rate of nearly 9% for 25 consecutive years, and its growth is forecast to continue at an annual rate of 8% despite the current global economic crisis. Foreign investment in billions of dollars are continuing to flow into China. But the country’s explosive market growth also presents tremendous challenges. International companies must navigate a unique culture as well as an evolving legal and regulatory environment. Before capitalizing on the Chinese economy, foreign investors must give careful consideration to business structures and strategies, the regulatory landscape, and asset protection.

Business and regulatory differences should not be a barrier between China and the West. ()

Developing a Product and Business Strategy

Regulatory Framework: Before a foreign interest invests in China, careful analysis of the related product and technology is warranted. It is important to note that investments in China’s product or technology sectors require special consideration of Chinese laws regarding foreign investment and import/export. The government has classified all products and technologies in terms of how foreign investments in those products and technologies must be structured. For example, the Foreign Investment Industry Guidance Catalogue in China divides industries into four categories:

The industry catalog has been amended several times and is still evolving. Its most recent version became effective on 1 December 2007. Under the new rules, most areas in the pharmaceutical industry are open to foreign investors; however, some limitations apply. For example, manufacture of multivitamin tablets falls within the restricted industry category.

Similarly, the transfer of technology to China is subject to the country’s regulations on administration of technology import and export. Under these regulations, technologies are similarly divided into prohibited, restricted, and encouraged categories. If a technology falls within the prohibited category, it cannot be transferred to China. If a technology falls under the restricted category, approval by the government is necessary before it can be transferred to China.

So to fully understand their rights and responsibilities, foreign businesses must have an understanding of how those categories might be applied to their technology and products. Certain approvals and registrations may be required before such products or materials can cross the Chinese border. Furthermore, as with many regulations in China, these rules are evolving. The guidance of experienced counsel is advised.

Practical Considerations: Foreign investors should be familiar with practical considerations in China before making an investment. One factor to be considered when developing a strategy for doing business in China and seeking a partner candidate for such investments is the geographic and cultural significance of such business. The impacts of such investment, as well as the size of an investment, predict the potential national impact of an investment and therefore determine the level of government interest and involvement in it.

It is worth noting that the Chinese government remains the largest shareholder in most state-owned enterprises. Some level of governmental involvement should almost always be expected in any business or investment deal involving state-owned enterprises. If agendas are aligned, the Chinese government can be relatively easy to work with. It has been known to make investment or business deals “on a handshake” or by verbal agreement, and such deals are followed through. As always, the regulatory climate is actively advancing, so experienced counsel is recommended.

Choosing the Right Investment Vehicle

Traditionally, for most foreign companies investing in China, investments take one of the three primary forms: a contractual relationship, a joint venture entity, or a wholly foreign-owned enterprise (WFOE).

It is relatively easy to establish a contractual relationship with a Chinese partner. Generally, an agreement between a foreign company and a Chinese company regarding selling or buying products in China does not require governmental approval, except for when a separate technology license agreement is involved. The cost of setting up such arrangements is low, significant parts of which take the form of due diligence on, and monitoring of, the Chinese business partner. The downside of having a contract manufacturing arrangement is that the foreign company has only limited control over the Chinese partner and relies on it for supply chain management and quality control.

A joint venture may work for some businesses; however, the different business objectives, management styles, and work ethics between partners can frequently create conflicts. As a result, many foreign businesses prefer to establish a WFOE if doing so is practical and allowed under Chinese law (notably the 2007 industry catalog described above).

To a large extent, your business goal and strategy determine which investment vehicle to use. Factors affecting such a determination include, among others, the size of the deal, market and consumer targets (e.g., Chinese or global), the complexity of operations and interactions between the parties involved, anticipated duration of the business relationship, and the need for a liability shield. Tax considerations, exit strategies, and management structure (e.g., whether a venture will have a separate management team) also come into play.

Recently, for PE and VC funds, common investment structures have included direct acquisition of equity interest in expansion or late-stage Chinese companies and indirect acquisition of equity interest in start-ups and early stage Chinese companies through off-shore special purpose vehicles (SPVs). The nature of investment by PE and VC funds — whether direct or indirect — typically reflects the level of commitment that such funds are willing to dedicate to the endeavor. A direct investment may require more time on the ground and may be subject to more stringent government regulations, but it may provide greater opportunity for continued investment. An indirect investment offers easier repatriation and exit routes as well as flexible equity arrangements. It also offers better transparency through SPVs. Whereas corporate structures in China can be sometimes murky, the structure of a Cayman Islands SPV, for example, is well understood.

Whereas traditional manufacturing companies used to focus more on state-owned enterprises as their joint-venture partners, PE and VC funds typically focus on three more primary investment candidates (in addition to state-owned enterprises): foreign-invested enterprises (FIEs), private start-ups by Chinese nationals returning to China from overseas after studying or working in foreign countries (so-called “sea turtles”), and private start-ups by domestic Chinese nationals with little or no overseas education or experience.

State-owned enterprises and private start-ups by domestic Chinese nationals offer the greatest potential for return on investment because they have the strongest direct ties to the Chinese market. However, investments in FIEs or “sea-turtle” start-ups might be more appealing for foreign PE and VC funds because sea turtles have had more experience with international investors in addition to their personal connections in China.

Dealing with Obstacles and Pitfalls

Despite the booming opportunities in China, foreign companies should be aware of potential pitfalls and obstacles and be able to develop and implement effective protective strategies against them. For example, investors might find a relative lack of reliable financial data on a given target company. Indeed, although progress has been made, China needs greater legal protections for businesses and investors (e.g., stronger enforcement of intellectual property rights, increased corporate governance, and greater clarity and stability on investment regulations and enforcement). Convertibility of the Chinese renminbi (RMB) currency might also be an issue for businesses that seek return of their capital gains in US dollars. In the wake of those and other potential obstacles, investors should approach potential deals with a careful and evaluative strategy that thoroughly analyzes areas of potential conflict prior to investment.

Protecting and Retaining Control of Intellectual Property (IP): The integrity and value of a company’s IP assets depends on an understanding of potential risks and possible recourses. The importance of IP protection differs by industry, but a general understanding of IP protection and enforcement is always paramount. In China and globally, IP is becoming an increasingly powerful business tool, and China’s aggressive market demands thorough consideration of proactive strategies to manage risks for the protection of both your technology and your business.

Although China has made significant progress in enacting laws to recognize and protect IP rights, meaningful enforcement of such rights is still lacking. Before starting to buy or sell in China, a foreign company should conduct a thorough inventory of its own IP portfolio and identify what should or should not be transferred to China. Additional measures should be taken to protect the IP that will be transferred.

China uses a first-to-file system, so it is important to obtain registered protection (such as patents and trademarks, which should generally include an English name, a Chinese name, and a domain registration) before entering the Chinese market. Also, it is important to have people on the ground in China to monitor potential infringement of a company’s IP rights and react quickly to violations.

Controlling the Manufacturing Process: When sourcing products from China, a foreign company should control the ownership of tooling so it can be repossessed if unauthorized use is detected. In addition, hiring different contract manufacturers to produce different parts of a product (e.g., bulk formulations and final products) may make sense — so no single company has access to the complete process. However, such an approach should be balanced with the potential for increasing production costs because of transportation and warehousing.

Bridging Gaps in Corporate Culture and Values: A recognition and appreciation of the differences between foreign and Chinese culture can be key to a business deal’s success. The importance of an “on-the-ground” partner or counsel becomes especially clear here. As with any investment, comfort and trust between the investment partners is essential.

It is also important to understand how Chinese nationalism might influence attitudes toward foreign investment. A foreign investment may be evaluated by Chinese people and their government in terms of its potential impact on the country at large. For example, how significant is the capital investment? What is the potential demographic impact? Some industries are considered more valuable to China and its national security than others are, and those may be more tightly regulated. In general, an understanding of Chinese legal, business, and cultural principles (and bridging the associated gaps) will help investors navigate and overcome potential challenges.

Keeping Up with an Evolving Regulatory Framework

China’s challenging regulatory environment should not be taken as reason to avoid investments there; rather, uncertainty should be mitigated by careful due diligence and competent counseling from legal and accounting and other experts. The current Chinese regulatory framework is an evolving set of regulations that vary with industry as well as the size of foreign investments. In addition to the 2007 Industry Catalogue, several major laws and regulations have been promulgated recently and are significantly affecting foreign investments in China, including:

Amended Mergers and Acquisitions Regulations on Foreign Investors Acquiring Domestic Enterprises (“M&A Regulations”): Significant changes (effective in September 2006) introduced by the M&A regulations include

Unified Enterprise Income Tax Law: Through the enactment of Enterprise Income Tax Law (effective 1 January 2008), China unified tax laws applicable to Chinese companies and foreign-invested enterprises. Under the new law, all companies operating in China will generally be subject to a 25% corporate tax and be entitled to a uniform set of deduction rules. In addition, the new tax code ends many of a previous law’s favorable tax policies that were available only to manufacturing companies with foreign investment. Under the new law, the most notable tax incentive is one available to high-and new-technology enterprises (“HNTE”). Companies qualifying as HNTEs may enjoy a reduced tax rate and special deductions.

Labor Contract Law: The new Labor Contract Law (effective 1 January 2008) significantly changes employment relationships in China. Among other things, all employers in China are required to enter into written contracts with all full-time employees within 30 days after each employee’s start date. It will be more difficult for employers to terminate employees. An employer will be required to pay severance pay under many circumstances, including upon the termination of a fixed-term contract that the employer chooses not to renew, unless an employee refuses to renew the contract under the same or better conditions. This law also confirms the enforceability of noncompete covenants provided certain conditions are met: e.g., the obligation should apply only to certain specified senior employees, the term cannot exceed two years, and an employer must pay compensation to its former employees who are bound by monthly noncompete agreements.

Anti-Monopoly Law: The Anti-Monopoly Law (effective 1 August 2008) addresses three main areas of competition law: prohibition of anticompetitive agreements, prohibition of the abuse of a dominant market position, and merger control.

Planning for Success

Although the Chinese market promises opportunities, it also may present serious hazards to the unprepared. Foreign companies must conduct careful due diligence before establishing or expanding business relationships in China, so they are advised to retain counsel to keep up with evolving legal requirements. When conducting business in China, it is also critical to understand the culture, values, and management strategy of a China-based business partner. Recognition, appreciation, and bridging of differences is imperative. With careful strategizing and structuring and adopting protective measures, success in China is very possible.