July 7, 2011
Who owns the Chinese internet?
An article recently published in Xuexi Shibao (Study Times), an organ of the Central Party School, has drawn a lot of attention (see here and here). The authors, Jing Linbo and Wang Xuefeng from the Chinese Academy of Social Sciences, assert (a) that foreigners (“foreign capital”) in the article’s terminology) have come to control the Chinese internet, and (b) that this is a bad thing. I’m not going to address the second point here; among other things, if the first point is false, then the second point is irrelevant. It’s important to get the facts straight on this matter, because apparently it has become sensitive. The authors made the same argument in an academic journal in 2009, but it didn’t seem to attract any attention. Now we are seeing it in the pages of a Central Party School publication. Does this mean something?
I’m going to argue here that the article is fundamentally wrong in its understanding of who controls China’s internet companies. First, it is wrong in thinking that the contracts subjecting Chinese internet operators to the control of foreign companies are robust and enforceable in China. Second, even if the contracts were robust and enforceable, the “foreign” companies exercising the control may in fact be controlled by Chinese individuals – sometimes the same Chinese that are on the other side of the contracts.
Actually, the article represents a curious phenomenon that periodically crops up in China’s relations with other countries: Chinese start worrying about a foreign bogeyman at exactly the same time the foreigners are worrying about a Chinese bogeyman. Each side fears that the other has the upper hand – and in the same matter. They can’t both be right.
Chinese internet businesses with foreign interests – and there are a lot of them – are typically structured through what’s called a Variable Interest Entity (explained in detail here and here.) Because foreigners can’t own internet operations directly, an offshore entity is set up (the Baidu that’s listed on the New York Stock Exchange, for example, is a Cayman Islands company). Typically, the offshore company (“Offco”) is the sole owner of a Chinese subsidiary (“Chisub”). Chinese individuals (“Chiparties”) – typically, the entrepreneurs associated with the business – also set up a Chinese company (“Chico”). Because Chico is owned by Chinese, it is able to hold the licenses and operating permits needed to run an internet business. Offco raises money through a listing abroad, and either directly or through Chisub lends the money interest-free to Chiparties. Chiparties then use the money to capitalize Chico. Both Chiparties and Chico sign a series of contracts with Offco and/or Chisub pursuant to which Offco, directly or through Chisub, controls the operations of Chico, reaps the benefits, and suffers the losses. Since control and risk-bearing pretty much define what ownership is about, this structure mimics – or at least attempts to mimic – precisely what is prohibited under Chinese law. These contractual control rights alarm the authors of the article.
At the same time, however, since last March serious concerns have been raised in the foreign business community about whether this contract-based structure is solid. (Here’s a sample blog post.) The contracts exist in order to mimic the features of direct ownership while evading the prohibition, and contracts for the purpose of achieving a prohibited purpose are void in China. Article 52 of the Contract Law spells this out:
In any of the following circumstances, a contract is void: . . . (3) a lawful form is used to conceal an unlawful purpose; . . . (5) there is a violation of mandatory provisions of laws or administrative regulations.
Moreover, the governmental authorities that now allow these structures to go forward could at any time decide to stop allowing them. That is exactly what happened in 1999, when foreign investors in telecommunications ventures using the CCF (“Chinese-Chinese-foreign”) structure were forced to unwind their holdings, sometimes at a loss.
There is evidence that the worries are well founded:
- GigaMedia had a VIE structure for its China operations. But its Chinese manager – the type of person who is described in the article as a passive puppet-like agent sought out by foreign capital to do its bidding – recently decided to cut the strings, and GigaMedia essentially lost all its China business (about 20% of its consolidated revenues) as a result. (See here and here.) It has apparently not been able to enforce the contracts that purported to give it control.
- Buddha Steel’s planned IPO in the United States was cancelled last March. It used a VIE structure to exercise control over a Hebei cold-rolled steel company. Apparently the Hebei provincial authorities advised the onshore operating company that the VIE agreements “contravene current Chinese management policies related to foreign-invested enterprises and are against public policy.” (See also here and here.)
- Finally, it is puzzling that the authors also use the Alipay dispute as an example in support of their point, since in fact it undermines it. Jack Ma has apparently in no way been constrained by any contractual obligations he or the onshore company may have to Alibaba, the offshore listed company. If he is supposed to be an obedient puppet of foreign capital, I think somebody forgot to inform him.
But let’s suppose the contracts are all valid and readily enforceable, so that the offshore entities really can exercise control. That still leaves open the question of who controls the offshore entities. Is it “foreign capital”? Not always. These entities aren’t necessarily the product of foreign capital looking for a Chinese puppet. They can be the product of Chinese individuals and companies looking for foreign capital.
- Take Baidu (the Cayman Islands company listed on the NYSE), for example. 52% of the voting power is owned by Robin Li, either directly or through a BVI company he owns and controls. Another 16% is owned by his wife. Except for a Scottish partnership that holds 2.49%, the rest of the voting power appears to be widely held. In other words, foreign capital is helping out Robin Li, but exercises no control. Robin Li, to the best of my knowledge a patriotic citizen of China, controls the offshore company and the money.
- Dangdang presents another model of control. In this case, the Chinese entrepreneurs – Li Guoqing and Peggy Yu – don’t have absolute, majority control. They do, however, control more than 45% of the company’s voting power and occupy the top management and board positions. This doesn’t look very much like control by foreign capital.
- Sina.com presents a third model. The president and CEO, Charles Chao, is of PRC origin. (I don’t know if he is still a citizen.) He appears to be the largest single shareholder, controlling over 8.66% of voting rights. Only one other shareholder holds more than 5% of the voting rights. In other words, the shareholding is largely dispersed and there is no controlling shareholder. Since Jing and Wang admit in their 2009 article that Sina.com has no controlling shareholder, how then can they claim at the same time (as they do) that the company is “controlled by international capital”? They state that ownership of more than 50% of the shares constitutes absolute control, but this means that some unified will – a single person or a unified group – has to control all those shares. In grammatical terms, the subject of the verb “to own” has to be an entity capable of thinking and expressing a will. “International capital” is not a person with a unified will. The authors appear to believe that in a 10,000,000-share company, if 5,000,001 foreigners each own one share, that is “foreign control” just as much as if one foreigner holds 5,000,001 shares. It is not. One can always identify a group of random and unconnected shareholders in any company whose holdings add up to more than 50%; that does that mean that they control the company. When a company has no controlling shareholder, who does control it? The answer is: management. And in the case of Sina.com, management appears to be predominantly in the hands of Chinese nationals.
Of course, there may be Chinese internet businesses using the VIE structure in which the offshore company really is controlled by foreigners. I have not researched each one; I have just looked at random some prominent examples, including one discussed by the authors themselves, and discovered that the so-called foreign control is an illusion. Moreover, as argued in the first part of this essay, even if the offshore company is genuinely under foreign control, it is still far from clear that its contractual relations with the onshore company and the onshore company’s Chinese investors are solid and enforceable under Chinese law. In short, the Chinese government still retains its power over the Chinese internet and has yielded little or nothing of importance to foreign interests.
 “有下列情形之一的，合同无效：. . .（三）以合法形式掩盖非法目的；. . .（五）违反法律、行政法规的强制性规定。”
 If anyone doubts this, consider the list of banned search terms on Sina.com’s microblog platform that appeared within 24 hours of rumors of Jiang Zemin’s death – i.e., search terms for which the web site returned the result, “According to the relevant laws, regulations and policies, the results of this search cannot be displayed.” There are too many to list here, but they included any references to rivers (the character used in Jiang’s surname), “former leader,” “affairs of state,” “important news,” and even “Song Zuying” and “mother of the state”, both references to Jiang’s alleged mistress. The state’s hand, and SIna.com’s ready cooperation, is obvious. See 新浪微博敏感词最新更新：江泽民（2011年07月07日）, China Digital Times, July 7, 2011, available at http://bit.ly/oz3jb1; Josh Chin, “Following Jiang Death Rumors, China’s Rivers Go Missing,” China RealTime Report, Wall Street Journal, July 6, 2011, available at http://on.wsj.com/nGNOlt.
Further on gray areas in Chinese law
July 4, 2011
Still more on gray areas in Chinese law
Following up on my earlier posts (here and here): It strikes me that a fair challenge to my position would be to say, "So what?" A theory is useless unless it has specific practical consequences that are different from those of a competing theory. In this case, a fair question (although not the only question) would be to ask, "What are the consequences of my theory for disclosure under US securities laws of a VIE structure (or some similar structure that is questionable under formal law)?" Stan Abrams at China Hearsay is clear about what he thinks the disclosure ought to be (he's sort of kidding, but only sort of). Does my theory dictate or allow a substantially different disclosure?
Here's Stan's favored disclosure, borrowed from Fredrik Öqvist of the China Finance blog:
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.
Somehow I feel it ought to be possible to be honest about at least some structures without declaring that they're "illegal." As I noted in an earlier post, the same thing could be said about joint ventures in Zhongguancun set up with an individual Chinese investor (specifically and openly permitted and welcomed by the Beijing municipal government, although pretty clearly illegal under any plausible interpretation of the Law on Legislation), or limited partnerships set up under local rules at a time when the Partnership Law didn't allow them. However, I have to admit I don't have good suggested wording of my own, and so I'm really in no position to make objections. Suggestions?
More on gray areas in Chinese law
I want to take partial issue with two recent posts in the China Law Blog (Dan Harris) and China Hearsay (Stan Abrams) on gray areas in Chinese law. I say “partial” because I agree with a lot of what they say, and even plugged the China Hearsay post here just yesterday. But reading the subsequent China Law Blog post endorsing the China Hearsay post made me realize that I don’t completely agree with what I understand them to be saying, and here’s why.
The substance of the posts is that people (in this case, foreign investors) often complain about gray areas in Chinese law, when in fact the area in question is not gray at all and what they’re really trying to do is to cover their asses for having engaged in an illegal transaction that came back to bite them. I agree this is often true. But the example in both posts, the Variable Interest Entity (VIE) structure used to invest in sectors where foreign investment is prohibited, raises some interesting issues that deserve more discussion.
For those who don’t know what a VIE is, it’s a Chinese entity that carries on a business restricted to Chinese and in which a foreign entity has no equity interest, but which is nevertheless tied to the foreign entity through a series of contracts that in effect give (or purport to give) control and risk to the foreign entity. As a practical matter, control + risk = ownership, so you’ve managed to get what the law tried to prevent you from getting. You can see a more detailed explanation here and here.
Paul Gillis at the terrific China Accounting Blog has pointed out a number of problems with the VIE structure, both from a Chinese law perspective and a US securities-law and accounting perspective. So what is the position under Chinese law of these structures? Is it clear or gray?
As a practical matter, I think we would all agree that these structures are OK until they aren’t OK. In some ways that’s not a very helpful answer, but it encapsulates the reality that deals using this structure go forward all the time, with full knowledge on the part of the Chinese central and local governments that this stuff is going on, and nobody objects. But sometimes objection arise later, and then you’ve got a problem. This is what happened with an early version of the VIE structure, the so-called “CCF” (Chinese-Chinese-foreign) structure used in telecommunications deals in the 1990s. The central government knew it was going on and allowed it until a decision was made in 1999 to disallow it. At that point the government declared itself to be shocked – shocked! – that this kind of thing was going on and issued a notice requiring foreigners to divest their interests. (This is all nicely explained in a China Unicom corporate disclosure here.) This story is true for a lot of foreign investments in China. Carrefour blithely ignored rules limiting foreign-invested retail outlets, opening them in city after city with the support of local governments. Did the central government know? Well, if you’ve seen a Carrefour, they’re not exactly easy to conceal. And at some point the central government said, “Hey, you’re breaking our rules!” And Carrefour, having now got the jump on its competition, said, “So sorry – we promise not to do it again.” After a mild slap on the wrist, they got to keep their stores. (See Stanley Lubman, Looking for Law in China, 20 Colum. J. Asian L. 1, 58-59 (2006-07).)
Did Carrefour’s investments, like the VIE investments, violate Chinese law? Well, yes and no. It all depends what you mean by “law”. This is not just Clintonian hairsplitting. There’s a respectable definition of law out there – the legal-realist “prediction theory” – that says that law is basically what legal officials actually do. Of course, there are problems with this theory – for example, it requires us to reject as self-contradictory the notion of mass official violations of law – but it helpfully draws our attention to the idea that it is at least odd and often not very helpful to consider unenforced rules as part of the legal system.
Let’s consider Stan’s statement about VIEs in this light:
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.
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. Actually, I doubt that Stan or Dan totally buy the former definition, just as I don’t totally buy the latter. Let’s explore the ground in between, then.
First, let’s get one matter out of the way. Why we use a definition depends on our purposes. Suppose you as a lawyer anticipate that your client could get sued by disgruntled stockholders in a jury trial when your investment in retail stores in China goes sour because the government decided to enforce the rule as written. You can imagine the cross-examination:
Plaintiff’s lawyer: “So tell me, Mr. CEO, how many retail outlets did you have in China?”
Defendant’s CEO: “Twenty.”
Plaintiff’s lawyer: “And isn’t it true, Mr. CEO, that the State Council, representing China’s central government, had a rule in effect at that time stating that foreign investors could have no more than two retail outlets in China at any time?”
Defendant’s CEO: “Well, but we’re sure they knew what we were doing and weren’t really enforcing it, and according to Professor Clarke’s legal-realist theory of the Chinese legal system…”
Plaintiff’s lawyer: “Just answer the question Yes or No, please.”
In that case, a legal-formalist theory of the Chinese legal system might indeed be the best one to have. But I’m not talking here about those purposes. I’m talking about the question of what it means to call something “clearly illegal” under Chinese law, and whether uncertainty in enforcement (even though the formal law is clear) can ever be an appropriate excuse for a risky investment that goes bad. 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. In other words, we should treat a government crackdown on a practice that was formally illegal but widely tolerated in practice very differently from a formal change in law that makes unlawful something that used to be lawful.
To repeat, sometimes this might be true. But I don’t think it’s always true. Let’s take the issue of local government legislative experimentation. This often violates, clearly and unambiguously, central laws that have priority under China’s Law on Legislation. At this very moment, for example, Beijing (in Zhongguancun) and several other cities will approve Sino-foreign equity joint ventures in which the Chinese partner is an individual, contrary to the rule established by the Equity Joint Venture Law and its implementing regulations, passed respectively by the National People’s Congress and the State Council. You don’t get any higher than those two in terms of legislative authority. The questionable formal legality of this local rule was even admitted at the press conference at which it was announced.
That was in 2004. I don’t have the numbers, but I assume that many joint ventures with individuals have been approved since then under these local rules and haven’t run into problems. It is now seven years later. I’m not sure where it gets us to say, “This isn’t a gray area under Chinese law. China’s Law on Legislation is quite clear that local law cannot trump contrary central law. This structure is illegal. If you try it and get burnt, it’s your own fault.” In explaining why people like to see uncertainty when it isn’t there, Stan posits the following conversation at a Board of Directors meeting (possibly a post-mortem):
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.
But I can imagine another conversation:
Board member to CEO: “Do you mean to tell me that all our competitors are doing this, the central and local governments know about it and permit it (a minister attended the kick-off ceremonies for a competitor’s investment), everyone has been doing it for twenty years, nobody has ever got burnt, tons of money are available to be made, and still you refuse to do it because of some obscure law on the books that nobody cares about?”
If it weren’t for the tremendous latitude given corporate managers by the business judgment rule, one could almost imagine circumstances in which it might be a violation of fiduciary duty for management not to make the investment. It seems to me that at some point we have to say, “The Chinese legal system as it actually is does seem to permit this, and the uncertainty in enforcement is indistinguishable from an uncertainty in the substantive rules of the legal system.” Let me repeat this key point: At some point uncertainty in enforcement is not usefully distinguishable from uncertainty in the substantive rules.
I might also add that there’s substantial (not unanimous) support among Chinese legal scholars, and even more among officials, for the idea that since the formal law simply cannot keep up with developments in the economy, breaches of the formal law should be tolerated and not really considered breaches when they serve a good purpose. (See, for example, the theory of “benign violations of the Constitution” (良性违宪).)
Yes, I know all the problems here – who gets to decide, and in what forum and according to what principles, what counts as a good purpose? But I’m just reporting the theory here, not endorsing it. The point is, should foreigners be more strict about the Chinese legal system than the Chinese? Should they treat it in a way that Chinese don’t? As noted above, sometimes this will be necessary for practical purposes. Foreign businesses and FIEs are held to a higher standard; that’s a fact of life. But Stan’s and Dan’s posts seem to go beyond that by suggesting that it’s just wishful thinking, a kind of foolishness, to see uncertainty in the substantive legal system when it’s just a question of uncertainty in enforcement.
I want to suggest here that that’s a big “just”; substantive rules and actual enforcement practices can’t be easily separated in any legal system, and certainly not in the Chinese legal system. How much weight you want to give to actual practice in your definition of what counts as a legal system will depend on your theory of law, but only a very extreme formalist theory would give no weight at all. For that reason, taking actual enforcement practices into consideration can’t uniformly be derided as foolishness and wishful thinking, and if they are uncertain, it could be quite reasonable to speak of that part of the legal system as being a gray area.
Comments welcome; since they have to be approved by me, they won't appear immediately. That doesn't mean they weren't received; you don't need to re-post.
JULY 7, 2001 UPDATE: Here's Stan's response.
July 3, 2011
Government says no once more to citizen monitoring
Bribery is a big problem in China. One question that often arises is whether it's supply-driven or demand-driven: do private citizens tempt otherwise incorrupt officials, or do corrupt officials force citizens to pay bribes? (As far as lawyers and judges are concerned, I get mixed responses from people when I ask their views.) If it's the latter, we might expect citizens forced to pay bribes to be unhappy about it, even to expose the bribe-taking official. And we might expect the government to welcome such exposures. But we would be wrong, at least as to the latter point.
Inspired by the Indian web site ipaidabribe.com, three web sites (www.woxinghuile.info, www.522phone.com, and www.ibribery.com) recently sprang up in China dedicated to the exposure of corruption. Citizens could post their own stories of bribe-giving. But last month an official of the Beijing Municipal Procuratorate announced that, while citizens' enthusiasm in combating corruption was of course welcomed (of course!), such sites were illegal. (He did not state which part of which law they violated.) "All citizens should have faith the procuratorial organs; the struggle against corruption must proceed within a legal environment. One can't say that just any citizen or organization can engage in this kind of activity; that would not be serious." (全体公民应相信检察机关，与腐败作斗争必须在法制环境内进行，不能说任何一个公民或组织就能从事这样的活动，这是不严肃的。) The offending web sites have since disappeared.
The Chinese state has historically been suspicious of subjects citizens getting directly involved in governance; I've written elsewhere about the dim prospects for private-attorney-general-like enforcement mechanisms. This is another example of this "trust us" attitude. Interestingly, the state is willing to allow a modest amount of citizen participation via administrative litigation in order to help the center exert better control over local governments, but such litigation has little potential to involve really explosive stuff, such as the naming of names of individual officials, possibly at a high level, involved in corruption. (An excellent article on what administrative litigation in China is and isn't about is He Xin, ‘Administrative Law as a Mechanism for Political Control in Contemporary China’ in Stephanie Balme and Michael Dowdle (eds) Building Constitutionalism in China (Palgrave Macmillan 2009) 143-161.)