China as One Giant Casino

When assessing business risks, consider China as one giant casino.

Let me explain. . . .

1. China as One Giant Casino

Yesterday, in How to Maintain Control of Your China Operations: WFOE or JV or Something Else? my law firm’s lead international attorney, Jonathan Bench, wrote about the typical “control issues” our clients face when doing business with China. I posted Jonathan’s post on Linkedin and get an interesting and insightful comment on it from Corbett Wall, who I’ve known since forever and who has been doing business with China (in various capacities and at high levels) since 1994.

Corbett’s comment was as follows:

You have as much control [when doing business with China] as you would playing poker in someone else’s house, based on their house rules, using their credit line, their dealer, and their cards. If you start winning, someone locks the door behind you.

Corbett is completely right about China being one giant casino, and yet his comment is not as bad for doing business with China as it initially sounds. Again, let me explain, starting with my Linkedin response to Corbett’s comment:

That’s a good analogy. What I always say about China is that if you sit back and do nothing to protect yourself I can guarantee you the results, and they will not be good. If you protect yourself in advance, you have a shot. The game is rigged, but just like at a casino, they have to let you win often enough so that you and your friends keep coming back.

2. China’s 90-10 Rule

I have hundreds of times used similar analogies to explain China to clients, and even to the United States Congress, from which I pull my congressional testimony from less than two months ago, where I discussed China’s 90-10 rule:

As a lawyer, the best example I see of the tension between investment and economics on the one hand and CCP power and control on the other hand is China’s court system. Our clients often ask me about the fairness of China’s courts and my answer is always the same. If you are suing a Chinese company for breaching your contract to make rubber duckies, you will get a fair trial. If you are suing a Chinese government company for stealing your cutting-edge semiconductor IP, well . . . good luck. Many China lawyers call this the 90-10 rule. Ninety percent of the time the Chinese courts will rule fairly because that allows China’s economy to function and that benefits the CCP. But when a case is important for the CCP, fairness instantly gets tossed out the window as the court will always rule to benefit the CCP. Legal scholars describe this as rule by law, as opposed to rule of law.

The same is true for Chinese IPOs in the United States and for VIEs. China allows select companies to IPO in the US — oftentimes via VIEs – because it wants the money. But if for any reason the balance shifts the CCP will – as it has done frequently lately – block them.

Variable interest entities (VIEs) are an excellent example of how the CCP operates. The CCP has allowed VIEs because they bring in foreign capital, but it has never formally legalized them. Now that the CCP is making clear in various ways it no longer values VIEs as much as it once did, investors and underwriters are panicking. But this writing – actually, more accurately, lack of any writing – has been on the walls all along for anyone interested in looking. VIEs have always operated in a legal grey zone; never clearly legal or illegal. This grey zone allows China to permit them while also allowing them at any moment to prohibit them or shut them down.

The same is generally true for China’s new laws and regulations on data privacy, which are geared more towards giving the Chinese government access to data than towards protecting Chinese consumers. The media has recently come out with many articles on China’s “new” data privacy laws, but at their core, the new laws do not differ much from those that preceded them. The Chinese government has for years had essentially full access to all data, even data held by foreign companies operating overseas. The new laws mostly just reiterate and clarify this and should be viewed not so much as new laws, but as the CCP signaling that companies that collect data the CCP does not want them to collect or that seek to hide data from the CCP are at risk of government action.

Put simply, China’s 90-10 rule is that the typical foreign company that does everything correctly (as per the CCP) will prevail roughly 90 percent of the time. Is China’s legal system rigged? Should you view China as one giant casino? Yes to both of these things, but do not ignore that China is rigged to favor those who act correctly 90 percent of the time. On the flip side, it is rigged to disfavor those who act incorrectly roughly 100 percent of the time. So if you have a 90 percent chance of crossing a street safely at one corner and a 99 percent chance of getting hit by a car at another corner, which corner does the wise person choose? But in reality, your odds are even better than 90 percent because you have the ability to assess your odds before you go into China and even while still there. See How to Evaluate your China Risks.

Do not forget that even though your odds at a Macao casino are stacked against you, you will still win close to 50 percent of the time because that casino knows that if its players never win, it will make considerably less money because nobody will ever come back. The CCP knows the same thing about foreign companies and so while it is tilting the odds against them, it still let’s those foreign companies that play by CCP rules and laws win often enough to keep playing and to not tell everyone else not to play. So feel free to view China as one giant casino, but do not for a minute think you can never win or that how you play does not influence your chances of winning.

3. Your Actions Impact Your Risks

Put simply, if you are in the business of having your rubber duckies made in China, your chances are better than 90 percent of being treated fairly by China (rigged system or not) and if you are in the business of making high-end semi conductors your risks of being treated unfairly will be considerably higher because the system is rigged against you. But in the end, this means you have all sorts of options for increasing your protection against China.

And Jonathan’s post talks about how our China lawyers have for years been encouraging our clients that do business with China to do so while having as light a footprint in China as possible, or as Jonathan puts it:

Ultimately, all these companies ask us if they must set up an entity in China. The answer is usually no. Often, clients do not want to set up formal operations in China if they can avoid it due to the costs and ongoing regulatory burdens. For many reasons, we have been advising clients to establish and maintain as light a footprint in China as possible. We advise them to enter into arm’s length business relationships if possible, and to ensure that those relationships are clear, secure, and can be undone and enforced if the other side does not uphold its part of the relationship.

Many of our clients understand this and have been having our China lawyers conduct risk audits for them. I did one the other day for a publicly traded company that appears to be “in deep” in China, but actually is barely there at all because its footprint there consists strictly of licensing its brand name and products and “secret sauce” to Chinese companies. We explained how their structure meant their risks were considerably lower than if they were themselves in China completely — largely because the CCP is less concerned with Chinese companies it knows it can control than with foreigners who are more free and independent.

In Why Court Corruption Does Not Mean Lights Out, I explained why even when dealing with the most corrupt of legal systems, it pays to have a good contract:

Let me put it right out there: most North Americans and Western Europeans do not understand court corruption. They have heard about it, of course, but they generally do not understand how it impacts their business. Otherwise they would not so frequently say there is no point in having a contract or bringing a lawsuit in such and such a country because it’s corrupt. Corruption influences (sometimes greatly) court cases, but not as often or as much as widely believed.

When dealing with corruption, one has to be sensitive to location, type of case, and relative influence of the parties. In other words, a $100,000 breach of contract case between a U.S. private company and a Chinese private company is much more likely to get a “fair trial” in a Chinese court in Shanghai than a case against a massive China SOE (State Owned Entity) involving stolen trade secrets that might have military applications in the small Chinese city in which that SOE is based. Sometimes this is due to corruption and sometimes this is due to what lawyers commonly call getting  home-towned. There are Wall Street lawyers who are as afraid of going to trial in a rural Mississippi court as US companies are of going to trial in China.

But when Americans think of a corrupt court they usually think of the opposing party paying a judge in cash for the ruling of their dreams. But it is rarely that simple and knowing how court corruption works can be important.

I was schooled in the “finer points” of court corruption by a very smart, very honest Russian lawyer friend of mine who used to practice law in the Russian Far East — where many a prosecutor and judge live in multi-million dollar mansions on $35,000 a year salaries. What he explained to me works pretty much the same in other emerging market countries with a less than pristine court system — or at least that is what lawyers in some of these countries have told me.

My schooling on Russian court corruption was in “real time” as it involved a real case and a real client. It has been many years so I may be a bit off on the numbers, but bear with me here. It is possible things have changed in Russia since then and it is also quite possible this information held true only for this one region in Russia. It is also possible I am the King of Prussia.

My client had a contract with a Russian company under which the Russian company clearly owed my client $2 million, but the Russian company was refusing to pay and all but challenging my client to sue it in a Vladivostok court, the only place my client could pursue its claims. Legally, my client’s case was about as close to a slam-dunk winner as you will see in a business dispute. But my client was rightfully concerned how corruption would influence its case.

Our Russian local counsel explained how we should view the case, corruption warts and all, and he did so by explaining the following:

Nine of the fifteen judges are corrupt. The other six are not. So we have a less than 50-50 chance of getting a fair trial. But I still like our case even before one of the corrupt ones. Our case is so strong that none of the corrupt judges will just give it to the other side without a very substantial payment. No judge wants to be thought of as corrupt and ruling against our client in this case will definitely raise eyebrows.

The Russian company will probably need to pay the lower court judge approximately $300,000 for the ruling it wants. And then we can appeal to a three judge appellate panel, made up of judges from throughout the province. A lower percentage of the appellate court judges are corrupt and those that are require large payments, especially on a case like this. The odds of all three of our appellate judges being corrupt are quite low. The odds this Russian company has close connections with any of the judges are lower than when all of the judges are based in its home city. This means that to try to bribe two of the three appellate judges will be risky and very expensive. Risky because, though rare, people sometimes do go to jail on bribery charges. Expensive because we are talking about three appellate judges. So in the end, I estimate that for the Russian company to be assured of winning through the appellate level, it will need to pay maybe a million dollars and there is a chance no amount under $2 million will work. And this ignores our ability to at least try to appeal to the Supreme Court in Moscow.

My numbers are obviously just estimates but what I am telling you is that though corruption is a factor, our job is to not allow our client to panic in the face of it. We can settle this case on good terms and that is what we should be trying to do. The Russian company would rather pay us to eliminate risk than pay judges and take on new risks.

We did end up settling the case and at a figure not all that much lower than what we would have accepted in the United States.

I am not by any means trying to minimize the impact of court corruption; I am merely trying to show that it oftentimes is not as overwhelming as it may initially appear.

Note also that we never discussed our client paying a bribe to anyone. That is always the worst alternative because it puts people at real risk of going to jail without anything close to a guarantee that it will even work. When our Russian lawyer said that people in Russia rarely get arrested for bribery, he was talking about Russians, not foreigners. Do you really think that you have the savvy to engage in risk-free bribery in a foreign country? I can tell you that none of my law firm’s international lawyers would make that claim.

Court corruption is a much bigger threat with cases that can reasonably go either way. In those situations — or so I am told — the lower court judges in Vladivostok (and this was many years ago) would have taken $15,000 to throw a case like the one we had, knowing nobody could be certain whether their decision was due to having taken a bribe or to the facts in the case. An interesting sidelight: this lawyer also told me that if after accepting a bribe the judge no longer felt comfortable in ruling in favor of the bribe-payer, he or she would return the funds before issue its ruling against the company that paid the bribe. In other words, the judges were (as he laughingly put it) “honest thieves.” On cases that are close to 50-50, appellate courts tend to favor not overruling the lower court.

So go ahead and describe China as one giant casino. And go ahead and call its legal system rigged. All this is fair. But do not let any of this be be an excuse for you not doing whatever you can to increase your own company’s odds when doing business with China. Because if you do not do what it takes to protect yourself, I can guarantee you will have bad results.

What are you seeing out there?