China-U.S. Trade Law : International Trade Lawyer & Attorney : Baker Hostetler Law Firm : Trade Remedies, Customs & Export Controls

        U.S. Trade Representative Ron Kirk announced, on October 20th, 2011, that the United States, pursuant to World Trade Organization (“WTO”) rules, is requesting China to provide more information on its Internet restrictions. More than a week passed with Chinese media and the public paying the request little attention.

        It is not surprising that China is giving this sensitive request the silent treatment. Although Kirk claimed that the WTO request relates “specifically to commercial and trade impact of the Internet disruptions,” China is likely to perceive it from a geopolitical point of view. Public communications, or propaganda, is one of the three pillars of the ruling Chinese Communist Party. Moreover, the timing of this request, whether deliberate or coincidental, is less than ideal – submitted in the wake of the Arab Spring, in which the mass public was mobilized by social media via Internet and mobile phones. Most importantly, China has little if anything to lose in extending this process, even if it could lead to a WTO dispute settlement proceeding.

Why China?

        According to Google’s White Paper – Enabling Trade in the Era of Information Technologies: Breaking Down Barriers to the Free Flow of Information, more than 40 governments engage in broad-scale restriction of online information. Yet, the Office of U.S. Trade Representative (“USTR”) singled out Chinese Internet restrictions for a WTO request.

        Internet based services companies, such as Apple, Facebook and Google, are playing a central role in the U.S. economy and probably in the submission of this request. Apple reported $6.62 billion in third-quarter profits, slightly below quarterly earnings expectations for the first time in years. Google’s third quarterly earnings soared to $9.72 billion and rebounded to its highest growth rate since before the 2008 financial crisis. It also added more than 2,500 jobs in the same period.

        Expanding overseas is crucial to these companies’ growth. For instance, more than half of Google searches come from outside the United States, and revenues from abroad totaled $5.3 billion, representing 55 percent of its total revenues in the third quarter of 2011.

        China is the largest market in terms of Internet population. The number of China’s Internet users has exceeded 500 million, according to the Economist Intelligence Unit’s data, which is larger than the total population of the European Union, and roughly twice the size of the U.S. market. More importantly, the Chinese number has been growing at double-digit rates since 2008, far exceeding the 2.5 percent to 4.5 percent U.S. growth rate. 

        No other market will be able to reach the size of the Chinese market any time soon. For instance, the second most populous country, India, has only 83 million Internet users, less than one third of the U.S. size. The growth rate of India’s Internet population is lagging behind the Chinese as well.

        U.S. companies face challenges from Chinese Internet entrepreneurs in the Chinese market. A Silicon Valley venture capital investor – Dave McClure – recently praised his Chinese hosts as “most likely smarter and more aggressive” than their U.S. competitors. He probably went too far because the best-known Chinese Internet companies are copies of the leading U.S. high-tech companies. RenRen, which was modeled after Facebook, went public this year and is now valued at $2.25 billion as reported by the Financial Times’ Kathrin Hille. But McClure responded that, due to the vast size of the Chinese market, “it would be foolish not to copy” an idea that works.

China’s Internet Great Wall

        USTR stated that the WTO request focuses solely on “commercial and trade impact of the Internet disruptions,” but it also pointed out that “the United States believes that economic and social development of the Internet globally is best served by policies that encourage the free flow of information and prioritize individual empowerment and responsibility” in its letter to the Chinese Ambassador to the WTO. Thus, the United States is aware that it is pressing China on one of its most sensitive policy issues. 

        Richard McGregor, Washington Bureau Chief and former Beijing Bureau Chief of the Financial Times, and author of the widely acclaimed book The Party: The Secret World of China's Communist Rulers, has written, “[t]he party is like God. He is everywhere [in China]. You just cannot see him.” He pointed out, at a Washington, DC seminar last July, that the Chinese Communist Party actively utilizes “3Ps” – personnel (the Central Organization Department, the world’s most powerful human resources outfit), propaganda, and PLA (the People’s Liberation Army) to maintain its power. The Party has fully realized the importance of the Internet in the digital era. Not surprisingly, outsiders have complained that “China has devoted extensive resources to building one of the largest and most sophisticated filtering systems in the world.” 

        The United States has been actively advocating human rights abroad and sees Internet freedom as an extension of traditional human rights contained in the universal declaration of human rights: free speech, free assembly, free association and freedom of the press. Secretary of State Hilary Clinton last year stepped in when Google clashed with the Chinese government over its Internet restrictions. After Google briefed the State Department, Secretary Clinton issued a statement: “[w]e look to the Chinese government for an explanation.” Despite USTR’s reference to commerce and trade, U.S. policy on human rights is bound up with the Internet.

        As propaganda plays such an important role in China, Chinese policy makers most likely would perceive the Google incident and the USTR request as events in a series of plots against China orchestrated by the U.S. government. China looks warily upon the destabilizing implications of the Arab Spring for authoritarian governments. In both China and the United States these revolutions are thought to have been fueled by Google and Facebook. It would be foolish to think that the Chinese government perceives the WTO request related only to the commercial and trade impacts of its Internet policies.

What’s Next?

        USTR submitted its informational request under paragraph 4 of Article III of the General Agreement on Trade in Services (“GATS”): “Each Member shall respond promptly to all requests by any other Member for specific information on any of its measures of general application or international agreements within the meaning of paragraph 1.” According to the BNA International Trade Daily, this request could lead to a formal consultation request, which is the first step toward a WTO Dispute Settlement Body (“DSB”) proceeding. Paragraph 1 of GATS Article XXIII says: “If any Member should consider that any other Member fails to carry out its obligations or specific commitments under this Agreement, it may with a view to reaching a mutually satisfactory resolution of the matter have recourse to the DSU.”

        China has little if anything to lose if it were not to respond to the U.S. request promptly. As we pointed out in previous blog articles, both the United States and China tend to exaggerate the significance of WTO DSB proceedings, and the United States treats every WTO defeat as sui generis, applicable to the immediate case and no others. Consequently, although the DSB Appellate Body issued a panel report favoring the United States in the case of market access to foreign audiovisual products (WTO DS363), China stalled for four years before taking action that would satisfy the United States. There is nothing to stop China from doing the same thing again were the United States to prevail, eventually, in an Internet case.

        WTO DSB proceedings are notoriously prolonged. For instance, in Brazil’s challenge of U.S. upland cotton subsidies (WTO DS267), it took the two sides almost eight years to enter a framework for a mutually agreed solution. In the case of China, the United States spent four years trying to tackle China’s restrictions on market access of foreign audiovisual products. The United States submitted a consultation request in April 2007, and the WTO Appellate Body did not circulate its report until December 2009. In the following months, the United States “expressed concern over the lack of any apparent progress by China in bringing its measures into compliance” at DSB meetings. It was not until April 2011 that the two sides reported to the DSB their agreed procedures to implement the panel recommendations. 

        The United States-based Internet services companies are not likely to gain much while waiting four years for a favorable outcome, and they are not waiting. Instead, Silicon Valley venture capitalists are continuing frequent visits to China seeking investment opportunities. The WTO case may create political theater, but is not likely to achieve a legal resolution to a political problem. 
 

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Editor’s Note: Dr. Elliot Feldman on October 5, 2011 presented the following speech at China-U.S. Investment Forum 2011.

Our firm has published a treatise, in English and Chinese, entitled Mergers & Acquisitions in the United States: A Practical Guide for Non-U.S. Buyers. I am one of the authors and the overall editor. My status as Senior Partner in the firm has made me a book peddler.

The treatise contains twenty chapters covering how to make a deal, how to paper it, how to arrange for the best tax situation, due diligence for labor, pensions, intellectual property and government contracts, dealing with national security issues and reviews, the Foreign Corrupt Practices Act, export controls, trade, customs, immigration, tax and bilateral investment treaties, Sarbanes-Oxley, antitrust, products liability – all focusing on issues arising from foreign ownership of corporations and subsidiaries in the United States. We have paid special attention to Chinese investors. One might say that this treatise has been written for you.

The overwhelming message of this conference is that your investments are welcome in the United States. People here, people you may engage to help you, want you to succeed. We all understand and recognize the importance of your mission for you and for us.

Good wishes and good will count a great deal in producing success, but business is business. It is competitive and it can be tough. As China has embraced capitalism it has come to understand competition. In every business dealing, your adversary is potentially your friend, and your friend is potentially an adversary. Because of this paradox, we memorialize just about everything in legal documents.

Perhaps more than in any other country, the American tradition has been to rely on legal systems to prevent, or alternatively, to resolve business disputes. An inability to appreciate this aspect of American culture can become a competitive disadvantage, even a liability.

For these reasons, I want to begin our discussion with three things the treatise does not say, at least not explicitly, and I want to present these points as questions:

First, welcome to the United States. Do you have a lawyer? In the United States, business is not conducted without lawyers. My partners, in writing the treatise, constantly wanted to say, “Don’t try this on your own,” or “You need a lawyer to understand the labor laws,” for example. I removed all of that language in editing because I thought it obvious that, in a book written about law by lawyers, once a corporate decision-maker understands generally the subject matter, he would know to get a lawyer. The decision-maker would know that there is a wide range of legal issues that may affect the success of an acquired investment – the point of the book—and he would ask informed questions of a lawyer so he could understand the impact of those issues on his particular investment. He then would make well-informed decisions and would know that it is most efficient for the lawyer, first, to provide counsel, and then to handle the details and documents necessary to execute decisions. My experience, however, at least with China, has been that these conclusions are not so obvious. So, I am telling you. You can’t enter complex transactions – you can’t make deals here – without a lawyer.

A recent issue of the China Business Law Journal makes this point. Entitled “Culture Clash,” the article notes, “Chinese businesspeople may still prefer to do deals on a handshake and a prayer, rather than to do their homework,“ and “our research suggests that foreign and even Hong Kong companies are more likely than their Chinese counterparts to engage advisers to tackle pre-merger due diligence. They are also more likely to seek external help with issues involving human resources, and other matters that can be the key to the success or failure of a merger or acquisition.” Your partners and your competitors for investment opportunities in the United States seek competitive advantages based in large part on the knowledge and advice they take from lawyers. You will miss opportunities for success if you are not equally well informed and advised.

Second question, in two parts: do you have a lawyer in China? Do you trust her? I ask these questions because there is an important cultural difference between China and the United States when it comes to lawyers. Here, lawyers owe a fiduciary duty to their clients. They take an oath to be loyal to their clients, and they take their oath seriously. It is not only a business matter. It is a matter of ethics. Lawyers here frequently tend to be trusted advisers and confidantes because information provided to the lawyers typically cannot be disclosed to the government, and because the more information the lawyer has, the more accurate, insightful and valuable is the advice that the lawyer can give. In China, in our experience, at least, lawyers are treated more like employees. They are used for technical purposes, not as trusted advisers. The relationship, and the expectations, are different here.

Third question: If you were to be dissatisfied with the legal services your lawyer might provide, would you expect to pay the lawyer’s bill? For lawyers, time is money, and when you use your lawyer’s time, even if you don’t like the result, you need to pay for it. Chinese companies unfortunately have acquired a reputation in the United States for not paying their legal bills, even when the agreed upon advice has been given. Perhaps because of the different relationships and expectations that I mentioned, Chinese companies do not seem to value legal advice as much, and agreements to pay for such advice are given less significance. There are exceptions of course, but it is the overall impression that may matter most. In the United States, engagement of counsel is a contract and bills must be paid. Over time, it will become more difficult for Chinese companies refusing to pay bills to find good counsel, which will become a critical problem for companies seeking valuable advice to keep pace with their competitors.

These are candid, perhaps even tough, opening remarks, especially on a panel of lawyers. But, as you can see, I have been around for awhile, and I am devoted to the proposition that China and the United States must understand each other, learn from each other, and work closely together for the prosperity of the whole world.

Too often, now, I have seen contracts major Chinese corporations have entered with Americans in which the Chinese either engaged inadequate counsel, or no counsel, or did not trust their counsel enough to achieve agreements favorable for their objectives. Such failures lead to resentments, misgivings, and missed opportunities for Chinese corporations to succeed. They are not necessary. So, as you consider investing in the United States, get a lawyer, preferably a legal team of many specialties, and trust them.

I urge you to think strategically about your investments, and for the long term. Even as the United States population is only about 25 percent the size of yours, we continue to be the world’s greatest consumers. Until recently, you have been making things we have been buying, but enormous pressure has built up that Americans need to be making more of the things that Americans are buying. In capitalism, profits still go to the owners of the means of production. There is no reason why Chinese cannot be the owners of some of the means of production in the United States, making things for Americans to consume, and to sell to other parts of the world.

The first wave of Chinese foreign investment has concentrated on the natural resources of other countries, buying and shipping them back to China. China must now embark more seriously on a second wave, not in a race to control the resources of others, but to invest in the long term for everyone’s prosperity. The opportunities for such investment and engagement are without limit.

You must start your quest by determining what it is you want to buy, and how it will fit with who you already are and what you or your company want to be. Americans – lawyers, investment bankers, consultants – can all help you identify specific targets of acquisition or merger, but only when you are able to articulate what you want, why you want it, the form you want it in, and what you can afford to pay for it.

Most of those first considerations are internal to your companies, but if you want a lawyer to understand fully what you are trying to do, you should include a lawyer in the discussions from the beginning. In negotiating the deal and packaging it with proper and legally complete documents, lawyers are not merely draftsmen decorating your thoughts with the right phrases. They are craftsmen making sure your interests are protected under the law. You cannot negotiate agreements and sign documents without lawyers who appreciate fully what you are trying to do.

There is a lot to do before getting to a handshake. We have encountered Chinese companies that understand taxes to be an important part of a deal, but few who have appreciated that the domicile of an enterprise and its structure (whether wholly foreign-owned or a subsidiary or sheltered through an offshore holding company, or a number of other possibilities) can determine whether the deal will be profitable or will lose money and fail. Taxes should not decide whether to make a deal, but certainly must be part of the consideration as to where and how to make it.

In deal-making a favorite phrase is “due diligence.” Conventionally, it refers to examining the financial books of a company – assets in buildings and equipment, liabilities in loans and accounts due, inventory on hand and in the pipeline. Traditional Mergers & Acquisitions lawyers concentrate on these considerations. In our treatise, we think of due diligence a little differently. A great attraction to investing in the United States is the presence of a highly educated and skilled work force. However, the work force can also be a serious liability. You need to know, before entering a deal, whether the labor force is unionized, whether there are health and pension plans that must be honored. There is a law in the United States – the WARN Act -- that prevents you from taking over a company and firing all the workers. Due diligence requires knowing all about the work force and its contractual and legal entitlements.

As the United States has become a service-based economy, the value and importance of intellectual property has become so important that it often exceeds, by far, the value of factories and inventory. In our view, potentially the greatest value in a deal will be found in intellectual property. However, intellectual property can also be contested. Before you invest, you need a complete inventory of the intellectual property. You need to know who owns it, whether and how it will convey in a merger or acquisition, and whether it is subject to pending or potential patent or trademark or trade secret lawsuits. Losing such lawsuits can destroy the value of a company.

Foreign ownership can mean the termination of contracts with the U.S. government. You need to know whether the company in which you are considering investment does business with the government, how dependent it is on that business, and whether the kind of business it is doing will be impacted by your financial intervention. A thorough examination of government contracts is also part of the due diligence process.

China is not unfamiliar with proposed projects implicating national security in the United States. There is a myth in China, however, that these projects always and must turn out badly. In fact, they can and usually do succeed, but there must be proper preparation, not only as to the legal process known as “CFIUS,” but the political process that lines up popular support. My partner Mike Oxley dealt with these issues intensively in Congress, and has written a chapter for our treatise all about them.

There is much more, of course, but I have no more time. I urge you to leap the first hurdle and get lawyers you trust and will engage from the very first steps in your journey. Then, start the journey with a detailed check list of what you need to know in order to make a deal. Finally, be prepared to make the deal. Become an investor here. Share in the profits of operating in the most technologically and economically advanced place in the world.

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