China Law: Don’t Blame it on the Gray

For years I have been fighting against the claim that Chinese laws are gray. China’s business laws are generally as well written and clear as any other country’s. My contention has always been that those who claim China’s laws are grey are usually just saying that to excuse their own failure to abide by them. The laws are plenty clear; the issue — if there is one — is usually enforcement.

I wrote on this way back in 2007, [link no longer exists] where I talked of how the so-called lack of clarity in China’s laws on forming companies arises from those who have not actually read them or from those who benefit from propagating this idea:

We recently took on three new China WFOE formations for Two of these matters are for lawyers working on behalf of their clients and one is for a lawyer who owns the (non-law related) business. All three of these lawyers told me they had spoken with company formation firms and had grown frustrated with the information they were being given. They relayed that these formation firms were not giving clear answers to many of their questions, but were instead responding by saying China’s WFOE laws were “vague” and/or “ever changing.”

What these company formation firms are saying is just not true.

Chinese law on WFOE formations is actually quite clear and I suspect these company formation firms were claiming otherwise only because the laws are vague to them. Near as I can tell, these company formation firms typically consist of a foreign voice or two (oftentimes in Hong Kong) who takes in the work and then farms it out to a Chinese lawyer in a low cost city to do the work. The people on the phone or at the other end of the e-mail at these firms have never read China’s laws on WFOE formation and so those laws are vague to them.

As for “ever changing,” on January 1, 2006, there was a sea change in China company formation laws for foreign companies, but they have remained static since then.

By far the biggest source of confusion/frustration for those seeking information on forming a China WFOE is the minimum registered capital requirement.

The law on minimum registered capital is clear, but the amount of capital that will be required does vary, depending mostly on the nature of the business of the company to be formed and on the city in which it is going to be registered.

I wrote on this again in 2009, [link no longer exists]:

But what about the grey areas in China’s laws? China’s laws are simply not that grey. They were grey five years ago, but their business laws are now, for the most part, pretty clear, particularly as they apply to issues important to foreigners.

I really do not see much more gray in China’s business laws than in those in the US.

In the post, Rationalizing Risk: Phantom Gray Areas in Chinese Law, China lawyer Stan Abrams seems to concur. Stan’s post is on VIEs and he gets worked up by those who attribute the problems that arise from them to gray areas in China’s laws. Stan starts out by talking of how the media (and others) have been ascribing Yahoo’s Alibaba problems to “gray areas in Chinese law” and Stan ain’t buying it:

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.”)

Western businesses come into China and they want to know what the rules are. 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.

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.”

I agree. Just as my firm always makes clear in writing that VIE structures are inherently risky and are of questionable legality in China, I am quite certain every other legitimate international law firm does the same thing. Or as Stan puts it, gray areas in Chinese law “does not explain Yahoo/Alibaba.”

And lest anyone out there think VIE structures are gray, Stan emphatically tells us they are not; they clearly go against the spirit of Chinese law:

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.

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.

Stan then points out the real issue with VIEs is not their legality, it is whether the Chinese government will continue to look the other way and allow them to continue:

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.

I am going to go a step further and say that the Chinese government generally does not crack down on foreign companies unless their violations of Chinese law are clear. So the next time a foreign company claims its Chinese legal problems were due to “gray areas”, at least ask them to explain the law they are discussing. I have done this multiple times and so far not a single person has mentioned any laws. They usually just mouth something about what they read or what someone told them.

I also like Law Professor Donald Clarke’s post, Phantom gray areas in Chinese law, in which he notes how “gray areas” are used as an excuse for contravening what was actually quite clear:

These are areas where the law really isn’t uncertain at all, but people for various reasons like to pretend it is. Sometimes it’s just because they don’t like the rule; sometimes it’s so that they can blame unpredictable government policy instead of themselves when things go wrong. Stan’s example is that of the use of contractually-based Variable Interest Entities to attempt to get around Chinese restrictions on foreign ownership in various industries.

One favorite area of mine is the uncertainty I often heard alleged about what would happen to long-term land-use rights under the Urban Real Estate Administration Law when their term expired. (This is before the Property Law injected real uncertainty into the process.) Well, the answer was always quite clear: everything goes back to the state, including all buildings on the land, without any further compensation. But holders of LURs didn’t like this result – they would conjure up pictures of granny being thrown out onto the street as year 70 expired. (As if the LUR holder hadn’t had a full 70 years’ advance notice that this was going to happen!)

Where’s the gray?

What do you think?

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