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Friday, October 3, 2008

Jerome Cohen on Sanlu: Foreign investors, beware!

A shorter version of the article below by Jerry Cohen appeared in yesterday's South China Morning Post. I'm posting this here with his permission.

FOREIGN INVESTORS, BEWARE! IMPLICATIONS OF CHINA'S FOOD CRISIS

By Jerome A. Cohen

        China's contaminated milk powder scandal, like its previous food safety problems, contains many lessons for foreign investors as well as others. Those lessons also apply to foreign investment in other Chinese industries and in other countries too.  New Zealand's well-known Fonterra Corporation, the world's largest trader in dairy products, has undoubtedly learned much from its 43% ownership of a China venture with the Sanlu Group that became China's biggest producer of baby milk formula. But the tuition has been very expensive. Its Sanlu venture's sale of melamine-tainted products, over many months, has led to horrific human suffering, financial disaster for the partners and further damage to China's reputation.

        This latest food tragedy may make some foreign investors conclude that the risks of manufacturing in China outweigh the potential rewards. Yet such is the allure of the China market that most multinational companies will understandably want to maintain their interest. The challenge is how to do it better.

        Fonterra's fiasco should stimulate foreign joint venturers in China to consider following the example of the many multinationals that have established wholly foreign-owned enterprises there instead of some form of joint venture. Or, in situations where the Chinese government does not permit a so-called WFOE, the foreign firm may seek to negotiate a dominant ownership interest and other arrangements that will allow it to control the joint venture's management.

        If government policy or business considerations preclude it from controlling the venture, the foreign investor must review the adequacy of its participation in the day to day management. In the absence of new legislation requiring adequate participation, the foreign investor should try to obtain new contractual guaranties from its partner.  At a minimum, it must improve its knowledge of how its local partner is running the operation. My experience advising foreign firms in China for over twenty years convinced me that board of directors meetings, written reports and frequent visits are not sufficient to assure an accurate picture. Even posting qualified executives and technicians to work on site can prove inadequate if they lack the Chinese language and human relations skills to penetrate and be accepted by the local partner's business culture.

        The ideal candidates for posting to a China venture are Chinese who have been educated in both their own country and the foreigner's, have already worked at the foreign firm for several years and have proved themselves to be not only professionally competent but also trustworthy and loyal to the firm. Foreign employees in China ventures, especially those of Chinese descent, if they do discover sensitive and perhaps illegal activities, can be subjected to enormous pressures from their local colleagues not to report unpalatable facts to their home office.  Moreover, the foreign company must independently monitor Chinese media and Internet discussions to keep abreast of developments.

        As the Fonterra case illustrates, learning the truth is only half the battle. What then should the foreign investor do? Obviously it must immediately raise any matter that threatens public health with relevant local officials as well as its partner. But how long should it rely on unconvincing assurances that the matter will be properly handled? In China local business people and officials often conspire to conceal information from the central government. At what point should the foreign firm take the initiative to cure the situation and what should it do?

        Should it "blow the whistle" to its own government? To China's central authorities? Should it assure Chinese government action by "going public" via the media? And what will be the foreigner's future in China if it averts the kind of tragedy and economic disaster wrought by Sanlu but alienates its partner and Chinese officials?

        Fonterra's loss, said to be almost three-quarters of its investment in Sanlu, may turn out to be considerably more. Its China business may not survive the scandal. Moreover, the victims' claims for the deaths, hospitalizations and other harm suffered have yet to be reckoned with. Fonterra's chairman reportedly insists that his company did the right thing by "working within the system" for many weeks after belatedly discovering that the products of its China venture were being poisoned. China's legal system, or even New Zealand's, may reach a different conclusion, not only regarding liability of the Sanlu venture itself but also that of its investors.

       Whether the Communist Party's central "Political-Legal Committee", which controls the nation's courts, will allow them to deal with these issues of liability and compensation is still unclear. There are indications that it will not. Certainly public interest lawyers who have volunteered their services to the victims have been forced to desist by local officials, as has often happened in other sensitive "mass cases", such as those spawned by AIDs, the Sichuan earthquake, environmental pollution and family planning abuses.

        Yet, if the victims will not have access to the courts, a Party/government obsessed with "harmony" and "social stability" will have to resort to some other institution for processing their claims. The Ministry of Health has promised to pay for all the victims' hospital expenses, although disputes and doubts have already arisen about the scope and reliability of its pledge. But will the Ministry or some other agency provide compensation for other losses, such as death, and the pain and suffering of the victims and their families, as permitted by previous court decisions? And will the government seek reimbursement for its expenditures from the offending milk companies?

        So Sanlu and Fonterra, and other similarly-situated Chinese and foreign investors in China's milk industry, are likely to be called to account, indirectly or directly, perhaps even beyond the bounds of the usual understanding of corporate limited liability. Foreign Investors, Beware.
_________________________________________
Jerome A. Cohen is Co-Director of NYU's U.S.-Asia Law Institute and Adjunct Senior Fellow at the Council on Foreign Relations in New York.

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