December 21, 2010

The Wild East: Managing Compliance Risk in China

Darin Bifani

Protecting the interests of clients in China requires a flexible compliance approach focusing on ethically preserving business value in the face of complicated operating realities.

Due to increasing foreign investment in China, more and more lawyers even outside of China will be required to directly or indirectly manage China-related legal compliance risk. This is extremely difficult, even for experts who are fluent in Chinese and have worked in China for years. For the non-China specialist, even with the support of local experts, helping to ensure that a client's investments are executed in accordance with internal compliance policies and relevant laws in a rapidly changing country thousands of miles away with a different culture, government, and legal system will pose significant challenges.

The economic, reputational, and personal costs of non-compliance when doing business in China can be extremely high. In a highly publicized case in March, four Rio Tinto mining executives were convicted by a Shanghai court of bribery and theft of commercial secrets and received lengthy prison sentences. While various forms of bribery have been widespread in China for a long time, corruption is punishable by death. In July of this year the former director of the Chongqing Justice Bureau was executed on corruption related charges. Adding further regulatory risks, U.S. officials have indicated that they will step up enforcement of the Foreign Corrupt Practices Act, which includes penalties of fines and imprisonment.

Apart from corruption, there have been many cases in China of doctored products, substandard construction practices, and employee strikes, acts that in the United States would expose a firm to substantial legal liability and reputational risk.

Also, and what may pose a greater risk to a firm's China operations, are less sensational failures to follow politically driven interpretations of local regulations or practice requirements that result in increased operating costs and delays or lost local government support. Over time, these costs can have a significant impact on, if not wipe out, the profitability of a China business venture.

Given the risk, it is important to have a well-thought-out compliance and risk management strategy that combines a client's economic objectives and compliance imperatives with a hardheaded view of on-the-ground China realities. As comforting as the wisdom in the Chinese classic the Dao De Jing that states "wei wu wei, ze wu bu zhi" ("everything will be put in order if nothing is done") may be, practically minded attorneys should keep in mind the famous statement of the more likely client view that "history is the sum total of things that could have been avoided."

Challenges of Emerging Legal System Compliance

Legal compliance in the United States is often thought of as the relatively narrow task of following existing laws, regulations, and rules. This is because for most lawyers working in developed legal systems, there is a working analytical assumption that the law is reasonably clear, reasonably stable, and interlocks in a reasonably coherent way with individual rules and regulations. In a developing legal system like China's, however, which is struggling to rapidly adapt to tremendous internal changes and a flood of incoming investment, laws can be highly ambiguous or even contradictory.

Dr. Lutz-Christian Wolff, a China scholar, has stated that in China "legal practice may not necessarily follow applicable laws and regulations and may even differ between two adjacent districts of one municipality."

There are also many uncertainties in China's judicial process. Due in part to cultural reasons which favor collective problem solving, litigation is viewed as an absolute last resort where the best that usually can be hoped for is some degree of defeat. While it has continued to improve, the Chinese judiciary suffers from deficiencies in professionalism, resources, and perhaps most importantly, independence.

As a consequence, government officials can be involved in the legal process in a number of ways which affect the outcome of legal disputes.

Managing the "government variable" for compliance planning purposes in China is extremely complicated. There are multiple levels of government in China which have wide authority to interpret national policies or rules in a way that best suit their particular regional or local interests. These levels of government operate against a backdrop of complicated relationships with various government officials and committees. Far from guaranteeing a coherent regulatory picture for the foreign company, this creates ambiguities far in excess of what would ordinarily be encountered in the United States.

An insight into these operating realties is captured in the Chinese expression "shang you zhengce, xia you duice," which means "the higher authority has policies and the lower authority has countermeasures." Adding to these tensions is the fact that the officials responsible for approving a project or providing ongoing support can change over time, causing a change in official views as to how project related issues should be handled.

The enforcement stage of legal disputes can also be highly uncertain. Courts struggle to keep up with changing laws and are highly conscious of the political impact of their decisions. Due to lack of resources or political factors, decisions may also simply not be enforced at all. It therefore can be very difficult to understand what the law to be complied with actually is.

Foreign investors often opt for arbitration as a way to avoid the ambiguities or biases of China's legal system, but arbitration awards often must be enforced on Chinese soil, which can effectively place the dispute back in the hands of the Chinese judiciary.

Rather than thinking of China as a place where there is a fixed set of laws that can be condensed to a tick-the-box checklist, the better approach is to view China as a sea of conflicting and incomplete rules and regulations set against a backdrop of moving political realities and interests. This forces the compliance objective to become, rather than closely following a clear set of directions, an attempt to keep the transaction moving in a straight a line as possible toward the hoped for commercial outcome. This is best done through an iterative approach where a continuing dialogue develops between the China team, local advisers, and government officials to address where the safe harbors, grey zones, and likely legal violations are regarding a given project.

Viewing Legal Compliance in Business Value Terms

Due to the uncertainties in China's legal environment, a second building block for a sound compliance plan is to view a compliance breach as not merely a violation of a specific law which leads to traditional penalties for regulatory violations, but more broadly as a result of government officials' actions or failures to act which result in a project or investment not being approved or completed as scheduled. In other words, compliance should not merely be viewed as a stand-alone legal requirement which is removed from core business activities and results, but a key driver of project completion and therefore investment returns.

While investments in China may be made with a primary focus on gaining a long-term strategic foothold rather than short term profit, most China business ventures are undertaken based on an assumed future investment return based on cash flows received over a defined period of time. Each additional cost, compliance or otherwise, and each delay due to non-compliance which causes the project not to be completed on time, lowers the effective investment return. These compliance related setbacks are typically not caused by outright legal violations and government investigations but rather delays in receiving required approvals on the much less tangible ground that what is contemplated is somehow inconsistent with local practice or the locality's view of national policy.

Many attorneys might assume that this risk can be mitigated through U.S.-style legal actions, but the exact source of political or administrative roadblocks can be difficult to pinpoint, and the people you complain to can often be more closely related to the people you are complaining about than might be initially apparent. Even if offending parties can be identified, due to judicial review and enforcement uncertainties, legal actions or damages provisions cannot be viewed as an economically reliable backstop for business losses.

As specific compliance issues and applicable regulations can vary widely on a case-by-case basis, for planning purposes it can be helpful for strategic purposes to divide these issues into several categories: (1) actions which cause a project not to be approved or, worse yet, for approval to be withdrawn after a substantial amount of money has already been sunk into the project; (2) internal operating issues, including labor law breaches, misappropriation of firm intellectual property, and failure to make required filings; (3) external operating issues, including untoward acts in furtherance of the business such as bribes, and breaches of applicable contracts or regulations; and (4) issues related to investment exit, including capital repatriation. Depending on the project, these issues can be further ranked based on potential impact on project economics or timing.

Accordingly, the compliance plan objective should not merely be to avoid violating isolated laws, but more broadly to keep the project operating within a set of moving legal and political boundaries which is necessary to stay as close to original cost and timing assumptions as possible to preserve business value.

Avoiding the Profit Shangri-La Syndrome

While the natural inclination when building a compliance platform is to consider foreign operating realities and local counterparties as the key risk drivers, a substantial amount of compliance risk can in fact come from one's own client's business objectives.

The reason is that many investors arrive in China with profit expectations that simply are not realistic. While there are tremendous investment opportunities in China, Chinese companies are bound by the same economic laws of supply, demand, and profit margin sustainability that exist elsewhere. If China counterparties promise, or are pushed to agree in writing to provide unrealistic returns, when economic realities begin to set it this can increase the likelihood that the Chinese firm will resort to innovative attempts to cut costs or generate profits and create compliance risk for the foreign investor. To guard against this risk, compliance officers should not merely be a post-closing safety net but rather a vital part of reviewing the underlying business strategy from the start.

A second element of the business objective that also must be carefully taken into consideration is time expectations. Optimistic schedule predictions should be tested with careful due diligence and healthy skepticism. Additionally, key business model assumptions that work in other markets may not work in China for reasons beyond an investment counterparty's control. For example, an investment return based on asset sale assumptions that would be reasonable in a developed market may drastically understate time frames in China, especially in smaller markets with thin or highly volatile demand. From a compliance perspective it is therefore helpful to have a timeline for all significant business steps and related compliance risks to make sure that if the project realities start deviating from business team assumptions they can be detected as soon as possible.

Beyond Compliance Rule Export Strategies

A natural tendency for firms starting to do business in China is to adopt a top down strategy of "exporting" their compliance rules, which amounts to taking their compliance policies and procedures, translating them into Chinese, and sending them abroad with the expectation that they will be followed to the letter.

This is an understandable approach but it is worth remembering that even for firms with outstanding compliance records in the United States, compliance is often more due to a complicated combination of values, firm culture, and individual judgment rather than mechanical application of compliance manual provisions. A firm's compliance culture is built on many years on cultural understanding and business experience in the United States which in many cases do not have direct parallels in China.

Further, it would be extremely difficult, and certainly not cost effective, to draft a compliance manual that covers every potential compliance problem or scenario. Even policies and procedures comprised of hundreds of pages contain numerous gaps, and it is precisely in these gaps where actual business realities and tough decisions collide and make the difference between walking the path that helps the business or harms it.

Rather than relying solely on written documents, a better approach is to create a compliance process that includes a reasonably digestible set of written guidelines, but more importantly, provides an ongoing forum for collectively analyzing situations, determining whether compliance issues exist, and resolving those issues. This takes a tremendous amount of time, but it is an area where there are no easy shortcuts and the natural frictions that will arise in the course of these discussions will provide important insights into how the overall compliance strategy should be shaped and adjusted.

It is also wise for U.S. lawyers to view the on-the-ground China team not merely as a compliance risk but as a vital part of compliance strategy offense. The China-based team will always be in the best position to see compliance related risks coming and to suggest practical and culturally realistic ways that these risks can be managed. If these people are alienated through a heavy handed, top down approach, a key component of the overall compliance team will be lost.

Assembling the Advisory Team

Another key element for compliance success is assembling the right on-the-ground advisory team. China compliance risk is a moving target and the farther in the distance the problem can be seen the better. Rather than merely contacting advisors once the problem arrives, it is better to have a relationship with firms where the advisory arrangement contemplates a long distance issue spotting component tied to a thorough understanding of the business objective. These arrangements can include client alerts on key issues affecting the project, periodic meetings with government officials, and even external audits of client internal legal teams. With a little creativity, a lot of preventive legal maintenance can be done at surprisingly low cost, and certainly at a fraction of the cost that can be incurred in an emergency situation.

Another smart move is to keep the core deal team in contact throughout the life of the transaction. It is common in the United States for both practical and cost reasons that after the deal closes the deal team is dissolved and a specific outside advisor might be contacted on an as-needed basis. However, this is not the best strategy in China, where neither problems, nor more importantly, solutions typically fall within narrow advisory boundaries. It requires relatively minimal expenditure to have the core team meet on some limited basis, even once a quarter, to evaluate if the commercial objectives are on track and to discuss market or other changes which may have an impact on the underlying project assumptions and timelines.

Facing a Crisis Situation

If careful due diligence was done prior to launching a project or making an investment, the risk of a compliance catastrophe should be low, as appropriate control mechanisms are built in to the investment vehicle operating documents and an ongoing compliance oversight plan is put in place and managed with appropriate local advisers. However, as in all markets, there is a risk of partner or asset disappearance, disruptive government interference, and other extreme events which can wipe out investment capital or cause extreme reputational risk.

As with other elements of a compliance plan, crisis management also requires sensitivity to China realities. Due to the combination in the United States of the availability of different types of injunctive relief, a system of determining aggrieved party rights which generally favors speed, and a reasonable expectation of rights enforcement, there is a tendency to take immediate, drastic action against the offending party when extreme breaches occur. In China, however, which does not have a developed preliminary injunction system and where there are numerous uncertainties in the contract litigation and enforcement process, narrow, aggressive litigation strategies can cause further loss of value.

Further, if local government officials have not been brought into, or tactfully made aware of the removal strategy, it becomes very easy for the local partner to paint the foreign party as somehow at fault. This severely limits the foreign investor's exit and restitution options. To reduce this risk, by maintaining ongoing relationships with government officials involved in the project, it is more likely that the government will form a more objective view of who is at fault when investment problems occur.

Even in a situation of total investment loss, it is important to salvage future opportunity value. If a longer-term China strategy is contemplated, it is necessary to remember that how an investment is exited can have significant ramifications for investment opportunities in the future.

It is important to design an exit strategy where some semblance of "face" can be saved for the relevant persons involved, particularly the relevant government officials. Very little in China is accomplished without guanxi, or relationships, and this means that when you do business you are in reality contracting with a far wider set of people than appears in the contract. If the investment does not go well, it will negatively affect the relationships of many people who were involved in supporting the investment, indirectly or directly, and this will add tremendous barriers to any future contemplated commercial arrangements where these people or their offices are involved.


Due to China's continuing ascent as an economic powerhouse, managing or considering China risk will become an increasingly important task even for attorneys who are based outside of China. There can be no denying that, due to economic, cultural, and legal differences between China and the United States, this will be a challenging hurdle to a successful China business strategy. However the business legal track record in China for foreign firms does not necessarily need to be a painful history of "things that could have been avoided." By taking a broad view of compliance and conceptualizing compliance issues as a vital part of business performance, it is possible to formulate a working compliance strategy which substantially increases the likelihood, that not only will costly pitfalls be sidestepped, but that short- and long-term business value can be created.

Darin Bifani

Darin Bifani is the founder of Puente Pacifico.