MERGERS & ACQUISITIONS
Legal Compliance: Structuring Cross-Border Mergers in China
August 1, 2006
Deborah Levenson

To enter a sector that allows full foreign ownership, Grace Fremlin of Steptoe & Johnson LLP suggests a WFOE structure unless one is buying a well-positioned Chinese company that provides immediate market share. ARTICLE TOOLS Print Version Reprints RECENT ARTICLES Different cities, same customers China is the region's top stop for exporting Improving wire transfers Quantifying your banks' performance

A complex legal system, layers of regulations, and subtle differences in local customs and dialects make mergers and acquisitions exercises in fortitude for companies effecting business combinations in China, say attorneys who specialize in the country.

Before China's WTO membership, myriad restrictions on the types of businesses non-Chinese could own easily made joint ventures (JVs) the only option for foreign companies seeking to operate there. In practice, they would typically find a Chinese JV partner and together form a new company. The Chinese company generally contributed land use rights and physical facilities, while the foreign company brought technology and cash to the deal. Most of these JVs have been unprofitable, however, says Grace Fremlin, partner in the Washington office of Steptoe & Johnson LLP, largely because partners have had different goals.

Since joining the WTO, China has allowed foreigners up to 100% ownership in several business sectors —such as manufacturing-and many foreigners now choose to "go it alone" by setting up wholly foreign owned enterprises (WFOEs), a business structure most attorneys interviewed for this story favor.

But if a non-Chinese company wants to get into business in a sector the Chinese government considers strategic, a Chinese partner is required. Such businesses include banking, insurance, auto assembly, and call centers, which Amy Sommers of the Beijing office of Squire, Sanders & Dempsey L.L.P. told ChinaForum are now a "big thing."

Joint Ventures or Wholly Foreign Owned Enterprises

To enter a sector that allows full foreign ownership, Fremlin suggests a "WFOE unless you're buying a really well-positioned Chinese company" that will give immediate market share, domestic customers, lower costs, broader distribution, and elimination of key competitors, or if property rights are not a major concern.

One big reason is that WFOEs offer foreign investors the greatest control over management. The structure avoids dealing with divided allegiances of Chinese managers, who tend to be more loyal to the Chinese partners they have the most contact with. "There's none of that with a WFOE. You hire them (managers) and they know who is boss," Fremlin said.

Experts also point to "wrinkles" in Chinese JV law which give Chinese partners management rights disproportionate to their investments. For example, Chinese law says that the Chinese company must appoint the president of a JV regardless of its investment, said Michael Burke, associate in the international section of Williams Mullen, a law firm in Washington, D.C.

If a U.S. partner does need or chooses to enter into a JV, Burke suggests that the agreement include deadlock resolution provisions. Without them, a U.S. company looking to leave would have to enter the uncertain and time-consuming Chinese court system. Unwinding the venture could also require approval of the local Ministry of Commerce office, he added.

It is difficult to change an existing business structure, according to Owen Nee, senior corporate counsel in the New York and Hong Kong offices of Orrick, Herrington & Sutcliffe LLP. If the deal does not become successful, "You can't do much except buy out the partner. They will make it difficult," Nee said.

It is possible to enter a sector requiring partial Chinese ownership without a JV, according to Sommers. The foreign and Chinese partners can form an entity in another country —such as the Cayman Islands— and have that entity then set up a WFOE in China. This approach works best when the Chinese party has been collecting capital outside of China. Moving it there can be a challenge, Sommers said.

Not everyone prefers a WFOE, however.

No one business form best suits investments in China, said Ann Marie Plubell, founder and CEO of The Plubell Firm in Washington, D.C., and vice chair of the American Bar Association's International Law Section, China. She puts stock in the experience of an in-country JV partner and prefers it for companies experienced in China and "trying something new." But a successful JV requires extremely careful due diligence research on that Chinese partner to make sure its connections exist and are good ones.

A suitor isn't necessarily limited to a JV, according to Plubell. U.S. companies can structure deals initially so that the Chinese partner steadily transfers an increasing percentage of its interest so the foreign party ends up owning a WFOE for all intents and purposes, she said.

However, transferring interest usually requires long waits for Chinese regulators' approval, according to Sommers.

Conducting Due Diligence Reviews: The Prudent Executive Test

When asked about the pitfalls of setting up mergers and acquisitions in China, attorneys identified several due diligence issues. Some identified a separate problem-the tendency of some U.S. executives to slack off on due diligence.

That's because Chinese partners often emphasize guanxi, or trust and relationships, in business. "Don't ignore what any prudent executive would do in the U.S.," Fremlin said, adding, "It takes more time and effort there."

While due diligence is crucial in any deal, it is especially so in China. "When you do due diligence, you will find liabilities you hadn't expected. When you know them, you can walk or plan for the level of risk you are undertaking," Fremlin said. She notes that Chinese business people "usually have a higher risk tolerance than Americans do."

Problems commonly uncovered by careful due diligence on target companies and deals in China include:

• Multiple sets of books. Although WTO requires China to have a single accounting standard, companies typically have different sets of books for themselves, the government, and foreign investors, attorneys said. It may be difficult to determine "if what you're buying is worth the asking price and if the company has the cash and debt it's representing to you," Sommers said.

• Nonpayment of social benefits taxes. Nee says companies run by domestic or and sometimes foreign owners figure out ways to avoid these payments. "It's possible that after the sale, China's labor bureau will impose back payments and fines," he warns. In this situation, "you could find yourself with no recourse against the seller," Sommers said.

• Bribery. Acquisitions by U.S. companies internationally must comply with a federal law that prohibits bribing officials. Although legally prohibited in China, bribery is rampant there, attorneys said. The U.S. Foreign Corrupt Practices Act (FCPA) defines as "officials" managers and other employees in Chinese state-owned enterprise, and possibly communist party members, Burke said. Giving extravagant banquets or perks for family of JV partners visiting the U.S.-such as first-class flights and expensive accommodations-could trigger violations and fines, he said.

• Land use rights and real estate issues. Owners of buildings in China do not possess the dirt they sit on. National, provincial, and local governments and the military permit companies to use it for specific purposes, attorneys said. Determining whether the land has been granted or allocated, and for what use is confusing, even to the Chinese, and often requires extensive research, Plubell said. "If the government wants to rattle foreign investors, this issue can crop up at odd times," Burke said.

• Intellectual property (IP), trademark, copyright and patent protection. Decide how aggressive your company wants to be about various types of infringements, Burke said. Usha Haley, a University of New Haven China expert, says national Chinese patent laws are among the best in the world, but enforcement is very lax because provincial governments see violations as means to maintain jobs and revenue. Foreigners face uphill battles and, too often, losses in court. At least with trademarks, the tide may be turning with the first-ever successful defense of an American company's logo. A Chinese court recently ruled a that Shanghai XingBaKe Coffee Shop Ltd.'s use of the transliteration of "Starbucks" in Chinese characters and a logo very similar to Starbuck's infringed on the U.S. company's trademark rights.

Choosing In-Country Counsel Wisely

Most of the attorneys interviewed for this article recommended hiring a U.S. or global law firm with offices in China and a relationship with a domestic Chinese firm.

Only Chinese firms can file registrations, appear in court, and represent clients in front of a government entity, Burke explained.

Nee said he uniformly recommends that U.S. companies involved in mergers and acquisitions have a well-known U.S. firm with offices and personnel in China set up its business structure and handle operations for "first year or so."

After that, he recommends the company hire in-house counsel and when necessary give projects to a domestic Chinese firm.

But nationality shouldn't be companies' first consideration when hiring legal counsel, Sommers said. Instead, determine if an attorney's style fits with your team, and whether he or she will be effective in negotiations and at looking after your interests without tainting relationships, she said.

"Some companies want their lawyer to be the bad guy," she said. Others, such as companies with less experience in China, may be better off with an attorney who can build relationships.

Most attorneys said Chinese firms' fees are comparable to those of U.S. firms and that their lawyers usually don't understand U.S. tax laws, corporate governance matters, and FCPA. But Chinese law firms are increasingly hiring lawyers with U.S. legal educations and work experience, according to Nee.

He added that in China, accounting firms, not law offices, do tax work. "Be careful that you don't get stuck in a situation with bad tax consequences in either country," he said.

Most lawyers trained in China will not give the type of advice to which U.S. financial professionals are accustomed, Sommers said. That's because their training emphasizes the specifics of Chinese law, not legal analysis. "They (Chinese lawyers) tend to tell you why you can't do something without offering alternatives," Sommers explained.

With 128 different languages and dialects in the country, language itself may become a factor the choice of a Chinese firm, depending on where you do business regionally, Plubell says.

Also, although Chinese firms' rates are comparable to international and American ones, Plubell noted that U.S. corproations are sometimes unaware that Chinese firms give their fellow citizens lower rates. "If you have a JV partner with whom you share an interest in profitability and success, you know he will negotiate a good price. You don't get that with a WFOE."

Specific business activity also determines attorney choice. Attorney Eric Newman, executive vice president and general counsel of the North Carolina-based restaurant franchise Bojangles, hired a Dallas firm specializing in international franchise law, with experience in the restaurant industry. Together with that firm, Bojangles used a local Chinese firm whose founding partner is American and has lived in China before its entry into capitalism, Newman said.

When disputes arise, it is best to avoid Chinese courts, most of the attorneys said. While growing in independence, they are still subject to regulation by the Ministry of Justice and influence of high ranking Communist Party members. Courts often shy away from controversial cases and will be reluctant to make decisions other than to settle cases, according to Nee. He adds that it is not uncommon for local parties to bribe judges.

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