Chinese Law Prof Blog

Editor: Donald C. Clarke
George Washington University Law School

Monday, July 4, 2011

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.

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Thanks for the post! Great discussion. I just finished a reply (should be up live around 5pm China time).

Short answer: it seems that I'm either a formalist or realist depending on whether I'm wearing my practioner's or teacher's hat.

Posted by: Stan | Jul 5, 2011 10:14:45 PM

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