Rationalizing Risk: Phantom Gray Areas in Chinese Law

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Get ready, I’m going to be sanctimonious in this post. If you like that sort of thing, strap in and enjoy.

I’ve been talking about risk management and China foreign investment over the past few weeks, what with Yahoo quarreling with its Chinese partner Alibaba and Chinese listed firms overseas tanking because of fraud or other irregularities.

For background on this, see:

Alipay Fallout: Foreign Investors and China Risk Assessment
Expropriation Risk in China: How Much Should We Worry About the Alipay Transfer?

One context we can use to understand the carnage is to talk about how difficult it is for the foreign investor over here. The legal system is not transparent, enforcement is uneven, and even if you do your due diligence, you may not be able to find the answers you need.

Fair enough. All those things are true.

But is it really fair to chalk up the investment problems of companies like Yahoo to gray areas in Chinese law? It sounds comforting, but I think it’s a rationalization employed by those responsible for making risky moves in the first place. When the Board of Directors is staring you down and asking “How the f#@% did this happen?” you tend to shift the blame elsewhere.

Bloomberg ran an article on the Yahoo/Alibaba case, written by Debra Mao in Hong Kong, in which the dispute was explained away, for the most part, as the result of uncertainty due to legal gray areas. (The title of the piece was “Yahoo’s Alibaba Spinoff Losses Show Dangers of China’s Legal Gray Areas.”)

Excellent article, with some fabulous quotes from folks here in China who understand foreign investment law. My favorite was from Pillsbury Winthrop’s Tom Shoesmith:

“Western businesses come into China and they want to know what the rules are,” Shoesmith said. “There’s the technically correct answer, there’s the practical answer, and then the third one is, ‘Who cares anyway?’ Sometimes the answer is ‘Who cares anyway?’ until you get busted.”

This is a wonderful statement, and not only because it’s refreshingly honest from someone at a big firm. To my understanding, Shoesmith is saying that his clients sometimes flaunt risk entirely, hoping that they won’t get caught. This isn’t about whether the system here is transparent, or unclear, or if gray areas exist. This is about understanding risk and plowing ahead anyway.

The rest of the Bloomberg piece is about gray areas in Chinese law and how difficult it is for foreign investors to deal with the uncertainties. This is fine and dandy, but it does not explain Yahoo/Alibaba, and it doesn’t mesh with what Shoesmith was saying.

Remember the fundamental problem with the so-called “Sina Structure” or “VIE” that I’ve talked so much about recently? If you recall, the government restricts foreign companies from investing in certain industries, yet some of those sectors are so attractive that foreign investors will pretty much do anything to get in anyway.

So what happens? An elaborate structure is cobbled together that includes offshore holding companies, onshore subsidiaries, and a series of exclusive commercial agreements. This is done to approximate, as much as possible, a direct investment.

For more on this, see:

GigaMedia: the Answer to the ‘What If?’ VIE Question
Buddha Steel, VIEs and Legal Ethics: Part I, the Internet Years
Buddha Steel, VIEs and Legal Ethics: Part II, Man Discovers the WFOE

Here’s the crux of the matter. Is this kind of structure an example of a legal gray area under Chinese law? News Flash: this isn’t a gray area at all; it’s obviously improper, designed to circumvent Chinese foreign investment law.

Yeah, I really said that. It’s rather obvious. All those folks out there, including many of the top Internet firms in China that received foreign money, who set things up to skirt legal restrictions, are violating the spirit of the law.

To be clear, I’m not suggesting that legal uncertainty doesn’t exist. Indeed, when I counsel these guys, the discussion is not “Hey, you know you’re violating the spirit of the law?” They already know that. What they really want to know is the likelihood that: a) their structures will be enforceable, and b) will the government swoop down on them at some point and force them to restructure (e.g. Yahoo/Alibaba).

So yes, there is uncertainty here with respect to enforcement of these structures and their related commercial agreements. Moreover, the authorities here are aware of these “spirit of the law” violations and generally allow them to exist (at least until they decide otherwise).

That’s a far cry, however, from suggesting that the structures themselves occupy a gray area under Chinese law. They don’t. That’s wishful thinking and a rationalization.

But I understand what’s going on here, at least psychologically. If there is a gray area, then the investor and his lawyer are off the hook, at least to a certain extent. Instead of telling the Board of Directors “I knew it was illegal, but since everyone is doing it, we decided to go for it and hope for the best,” a more respectable “The legality of the structure is unclear, so we moved forward as carefully as possible” can be used instead.

The second one sounds better, doesn’t it? Too bad it isn’t really accurate.

UPDATE: Fredrik, of China Finance Blog fame, suggests the following filing language for firms that want to be above board about their China investment structure. This is hilarious:

Although our corporate structure is intended to circumvent Chinese laws and regulations, and is thus illegal, enforcement of these rules in China is subject to substantial uncertainty. We do not believe that the PRC authorities will enforce these laws in our case, but we cannot assure you that the PRC authorities will take the same view.

5 responses on “Rationalizing Risk: Phantom Gray Areas in Chinese Law

  1. Fredrik

    Nice post!

    I think we can rightly divide this debate up in two sections what you can get away with saying, and what the actual reality is.

    You can clearly say that you don’t know for certain how the laws will be interpreted, only a court decision can help with that. This being said it’s not like there aren’t clues as to what will happen, such as the outright ban for using the structure by GAPP and the scaled down ban in the MIIT circular.

    While it’s technically correct that we do not know how the ruling will go, the question in my mind is which side has the burden of proof.

    1. Stan Post author

      Yes of course, but . . .

      When we talk about a ruling with respect to VIE structure, though, we are really talking about enforcement of some, or all, of that structure. How MIIT or SAFE or whoever will react to a particular filing or challenge all goes to the details, or implementation, not the big picture. If we’re honest, we really do have to admit that the fundamental purpose of most VIEs is to circumvent foreign investment restrictions. To that extent, we already know what the legal answer is with respect to the transaction as a whole.

      I’m not being naive here, just cutting through the BS.

      1. Fredrik

        Yes I see your point, maybe they could push through a change in the risk section wording:

        “Although our corporate structure is intended to circumvent Chinese laws and regulations, and is thus illegal, enforcement of these rules in China are subject to substantial uncertainty. We do not believe that the PRC authorities will enforce these laws in our case, but we cannot assure you that the PRC authorities will take the same view.”

        What do you think?

        1. Stan Post author

          Awesome! I think I might need to hold on to that quote. I suspect I will want to use it someday.

          Now if only the world really worked that way, it would be a much better place. The honesty!