Gray Areas in China Law: A Vote For Legal Realism

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Professor Don Clarke, of George Washington University Law School and the Chinese Law Prof Blog, has some excellent comments on last week’s post “Phantom Gray Areas in Chinese Law.”

If you recall, the post was about foreign investors who pull the trigger on China deals with full knowledge that what they are doing violates one or more China laws and then, when the government enforces that law, complain that this is unfair.

My basic point was not that foreign investors should not assume risk, but that knowing the risk and moving ahead with the deal anyway, it’s ridiculous to play the innocent later on and claim that this was all somehow unforeseen. To be blunt, I have seen this happen with clients, and it pisses me off.

As an example, I used the corporate structures known as VIEs (variable interest equities), which have been in the news a lot recently.

So I had two comments on that post: one by Dan Harris at China Law Blog (in agreement) and Don Clarke (in partial disagreement).

In a sense, Don’s issue relates to what we lawyers mean when we say something is “legal.” This is actually a very interesting area of study that means a great deal not only to academics, but has real world consequences to practitioners.

If I read it correctly, this is the crux of the problem for Don:

What I want to point out here is that there’s an implicit, and contestable, theory of law in this statement: the theory that there’s a distinction between what a legal system actually does and the legal system itself. I don’t say this is a wrong or useless conception of a legal system; I do say it’s a contestable and non-self-evident conception. Under a purely formalist definition of a legal system that takes no account of reality, Stan is right. Under a purely legal-realist definition of a legal system that takes account only of reality, he’s wrong.

The distinction here is what the black letter of the law says, and what the legal system allows. This is formalism versus legal realism, and Don is correct when he points out that my original discussion was based on a formalist position. That was the area I was staking out in my post. (I’ll explain why below.)

Here’s another summary point Don made that needs clarification:

As I understand Stan and Dan, they are basically saying that if foreign investors get involved in these formally illegal structures, they have nobody but themselves to blame if things go wrong; they shouldn’t blame any alleged uncertainty or changing government policy.

Sort of, but it depends on the circumstances. I think a better way to state my position is that although foreign investors certainly have the right to blame selective enforcement or changing government policy, they are often insincere when they feign lack of knowledge. This is the big sin in my book as a practitioner (probably with Dan as well), because you know that their outside counsel told them “Yeah, that’s technically illegal, but we know a way around those legal restrictions.”

That’s where I have to start when giving legal advice. The black letter law answer, assuming one is available, always comes first. If the answer is negative, then we go on to explore alternatives, all the time not forgetting what the risks are.

Why do I have so little sympathy for the guys who feign ignorance after the fact? Because these guys are not making an argument based on legal realism, they are simply trying to cover their asses. And you know what happens when they make excuses like that to the Board? The outside counsel gets blamed for not properly explaining the risks of that deal.

I do want to make an important distinction here. My conservatism runs towards the kind of advice given and an investor’s ability to manage, and tolerate, risk. In many cases, after a company is told about these risks, they decide to move forward anyway. And if something goes wrong, something that was foreseen, it is chalked up to doing business in a country whose legal system has pitfalls and uncertainties.

I have no problem with that, and indeed deal with investors all the time who are forced to act because of what the competition is doing. As Don says, in some cases it would almost be a breach of fiduciary duty not to do the deal. That’s the real world, and as long as everyone understands the situation, then fine.

I think what this comes down to is that Dan Harris and I are looking at this as practitioners. If a client wants to do a deal in a restricted area by setting up a structure that has never been shut down by the government in 25 years, I still can’t tell that client that this is a “gray area.” I just can’t do it as a lawyer, for basic liability reasons.

What I can say is that it is technically illegal, and then explain the history of enforcement (or lack thereof). If the client then wants to proceed, then (in some cases), I will stay on board and help facilitate the transaction (in some cases, I will beg off).

Putting on my academic hat, though, I guess I would agree with Don. If that legal structure is obviously condoned by the government, should we really be calling it “illegal”? Perhaps not, although if I say that in the classroom, I don’t need to worry about a client suing me!

4 responses on “Gray Areas in China Law: A Vote For Legal Realism

  1. Mike Cormack

    I find it interesting that such grey areas are allowed to exist – plenty of “wiggle room” for the Chinese government to strike as and when it sees fit. Is such ambiguity common in developing nations or is it a Chinese thing?

  2. Tim

    Excellent post and something that consultants run into as well.

    An example would be tax incentives provided at local-level zones that are not technically allowed since the revisions to the tax code in 2008. Most foreign investors still believe these are legally available, after all why would the local governments be offering them? There has not been any crackdown on tax subsidies since 2009 that I am aware of and they are given out like candy to large FDI projects.

    It is a struggle explaining this risk, as there is no proof that the State-level will ever retaliate against these questionable incentives.

  3. Liam Casey

    I think what Chris Devonshire-Ellis had to say yesterday on the subject of China incorporation structures being more finance based than legal based also made a lot of sense. His partial argument that investors concentrate too much on the legal admin and less on the art of sorting out your finance rings true, at least for this hardened old timer, albeit written for the CEO rather than legal counsel:’s-get-real-they-are-a-tax-based-not-legal-structure.html Legal wranglings aside, it’s always about the money, not law, and I think he hit it on the head with that one. There are oft lawyers who get in the way too much when it comes to commercial viability. It’s money that makes China businesses work, not the law.

  4. Mistral

    @Liam – agree sometimes lawyers get in the way and make complications. Not to say they’re not useful but often they overstep their actual importance in getting China business structures right.