Introduction

China is fast becoming the global investment hotspot and more and more foreign investors are expanding their business operations into the country. This situation may be attributed to China's competitive production cost, sound macro-economic policies, strong economic growth, and favourable business environment. The nature of the legal environment is one of the most important factors that determines the extent of foreign investment in a country. Foreign investors are most concerned with the presence of a transparent, reliable and efficient legal system by which to conduct their business. In China, however, problems of various kinds are encountered in the legal system. This paper will analyse the legal environment affecting foreign enterprises and investments in China. The first part of the paper will discuss the existing legal environment concerning foreign investment and the next will examine some of the problems that foreign investors have to contend with. The final section will suggest possible solutions to those problems.

The Legal Environment for Foreign Investment in China

In order to encourage foreign investment and protect the legal interests of foreign investors, China has established a legal system that is being strengthened by numerous domestic legislations as well as bilateral and multilateral agreements.

With reform and opening to the outside world, China is increasingly taking part in many international trade pacts. To fulfill its obligations and commitment as a new member of WTO, China has enacted new laws and constantly revised existing ones to improve its legal environment for investment. At the same time, about 30 government departments have up-dated regulations contained in more than 2,300 documents. With its laws and policies on foreign investment being brought into conformity with requirements of the market economy and international rules, China is gradually creating a legal environment that is favourable to foreign commercial interests.

The legal framework governing foreign enterprises comprises three basic legislations. ' These laws as well as their provisions constitute the core of the legal system governing foreign investments in China. To supplement these laws, a series of regulations and measures concerning the establishment, management, reform, purchase, investment, reinvestment, termination, and liquidation of foreign enterprises had been introduced (国家法制办公室 / National Legal Administration Office, 2001).

Industrial policies and guidelines on foreign investments are attempts by which China seeks to regulate the entry of foreign capital. Based on the national economic and industrial development strategy, the government issued the newly-revised Directory- of Guidelines for Foreign-Capital Investment in April 2002 to encourage foreign investments to flow to targeted trades and industries such as agriculture, resource development, infrastructure construction, export and high-technology industries. At the same time, policies were put in place to disallow foreigners to participate or hold a controlling share in certain enterprises of strategic significance.

Polices on regional development and its regulation have also been introduced. For example, the Director) on Favorable Conditions of Investment in Industries by Foreign Enterprises in the Central and Western Regions was released to specify preferential policies for participation by foreign enterprises. In order to revitalize the industrial base in the Northeast, preferential treatment for the old-established industries was announced in two circulars released in 2004.

In order to meet its obligations to the WTO, China allows foreign participation in many more industries, including the hitherto state-controlled telecommunication industry, and the financial, insurance, commercial and foreign trade sectors. The latest sector to open its door to foreign participation is the service industry. The regulations of the General Agreement of Sen'ice and Trade and official statistics display 142 service and trade industries grouped under 11 broad categories of activities. The conference and exhibition industries, still in the initial stage of development, are not included in the list, but the Board of Trade of China is introducing the Interim Provisions Concerning the Foreign-Capital Investment Exhibition Companies to provide the legal basis for the involvement of foreign business interests (王道富 / Wang Daofu. 2004).

Legal Mechanisms for Capital Protection and Withdrawal

Foreign investors who desire to operate in China would require a legal investment environment that allows them to obtain satisfactory and high returns on the one hand and, on the other, provides the mechanisms for them to withdraw their capital in accordance with their strategic plans. As institutional investors, they may opt to convert their investment to shares in the form of stocks to liquidate capital and there should be mechanisms that allow them to do so. However, for a considerable period of time many foreign investors believed, and consequently worried, that they could not withdraw their investments because of the absence of relevant legislations.

In fact, foreign investments have various options to withdraw their capital in China, such as through initial public offers, equity transfers, management takeover, share buy-back and corporation liquidation. However, under the current legal framework, restrictions and imperfections still exist. The China Securities Regulatory Commission and Board of Trade in November 2001 jointly issued Some Suggestions on Listed Companies Concerning Foreign-Capital Investment to spell out conditions for listing in the A-share stock market. Such listing provides a proper mechanism by which foreign enterprises may withdraw from China.

Initial Public Offer (IPO)

IPO is normally the preferred method by which international investors withdraw their investments. Investors may create a holding company through IPO in a foreign country and most countries and stock exchanges generalh accept this internationally popular method.

Under the current legal framework in China, foreign investors may also exit from China through IPO, and some has indeed adopted this option. This method no longer constitutes a legal problem in China and several companies have been so listed abroad as an ideal method to quit operations in China.

The foreign enterprise in China may also apply for IPO abroad. This refers to the restructuring of a foreign enterprise in the form of joint-stock limited company. After approval by the China Securities Regulatory Commission of the State Council, the company may make the listing abroad. According to the Circular on Application of IPO Abroad for Enterprises issued in 1999 and related regulations such as the Approval and Supervisory Guidance of Applications of Listing in Hong Kong Growth Enterprise Board for Domestic Enterprises, foreign enterprises may apply for listing in the main or other boards in foreign countries after restructuring.

Another channel is to apply for domestic IPO in the form of A-shares or B-shares that may be listed in the Shanghai or Shenzhen Stock Exchange. A-shares are issued to local individual investors and transacted in Chinese currency. B-shares are issued to both local and foreign individual investors as well as foreign institutional investors, and transactions are in US currency in the Shanghai exchange and in Hong Kong dollar in the Shenzhen exchange. The China Securities Regulatory Commission and Board of Trade have jointly issued three circulars for B-shares in 2000-02. Before listing. B-share joint-venture enterprises have to seek the approval from the securities department of the State Council. Upon approval, they would submit the transaction scheme for the non-listed foreign-capital shares to the China Securities Regulatory Commission. With the approval of the latter, the founder share of the B-share companies may be transacted in the B-share market after a period of three years, whereas the non-founder shares of foreign-capital investment may be transacted directly in the same market. Hence allowing the foreign-capital shares (B-shares) and non-listed foreign-capital shares to be transacted in the market provides an ideal and unimpeded withdrawal system for foreign-capital investors.

Other Options

Equity conversion is a basic legal procedure in corporate law. The current legal system governing foreign enterprises in China allows for the transfer of their shares to other shareholders or a third party as a means to withdraw the original investments. There are two methods that may be resorted to, namely, offshore share transfer and domestic share transfer.

In the case of offshore stock rights transfer, the foreign enterprises do not have to obtain the approval from the relevant authorities in China as the transfer of shares involves foreign shareholders. The transfer is subjected only to the rules of their home country. Domestic share transfer, on the other hand, is governed by stipulations in various legislations.³

Foreign enterprises that desire to liquidate their shares may resort to merging into bigger enterprises or split into separate entities. Both afford opportunities for the withdrawal of shares through transfers to either domestic or other foreign investors. Conditions governing these changes are spelt out in the Provisions Concerning the Discretion and Combination for the Foreign-Capital Investment Enterprise issued jointly by the Board of Trade and State General Administration for Industry and Commerce.

Foreign investors may also let the management buy their shares as a withdrawal mechanism. Management buyout (MBO) is regarded as a practical method to minimize the cost of company agents and the opportunity cost for the management. The current legal provisions in China forbid members of the management team of a company to purchase shares of foreign-capital enterprises directly. The MBO would be deemed lawful if the management of the company creates an investment company to take over the original company.

The decision to terminate investment through liquidation or dissolution is often the last resort open to most companies. The regulations dealing with the principles of three types of dissolution and liquidation of the foreign-capital enterprises are contained in three pieces of legislation.⁴ Complete rulings regarding ordinary liquidation and special liquidation of foreign enterprises are covered by the Liquidation Measures of Foreign-Capital Investment Enterprise issued by the Board of Trade in 1996.

The Administration of Laws and Transparency

Justice is a crucial element of a good legal environment. Through the years, China has established the legal mechanism by which to administer justice. In this regard, the function of the legal department and People's Congress to monitor the proper administration of the law has been enhanced.

The quality of law enforcement and administration has also improved. One way by which this is done is through a judicial examination system that has been implemented for many years. Entry into the legal administration system is mainly through examinations for civil servants. There are also mechanisms to monitor the legal service and a system of appeal in order to guarantee that the law is fairly administered.

Information is an important resource but it is largely under the custody of the government. When information is freely available, the market is in a position to arrive at rational and accurate decisions. Although WTO has put forward the general principles of an open and transparent government information disclosure system, China has not enacted special laws on information. The public has no access to information that it requires except, for some, through "abnormal means". On the other hand, officials who are in control or possession of information resources often regard this as a "right" that is often abused for selfish ends (王峰 / Wang Feng, 2003). A survey by the Statistics Bureau of China in Hubei province in 2004 confirms that foreign investors are generally not satisfied with government transparency (国家统计局湖北企业调查队 / National Statistics Bureau Hubei Enterprises Investigation Team. 2004). Lack of government transparency and inadequate disclosure of information lead to corruption, distort free competition and work to the detriment of public interests.

Despite years of economic reform and opening in China, the legal framework governing the control and disclosure of public information has yet to emerge in a way that can ensure the timely and beneficial use of such information. It was only in 2004 that the central government enacted the Laws on Administrative License of the People's Republic of China to regulate administrative disclosure of information on a legalized basis.

Some provinces have made the disclosure of information as a legal requirement. For example, Guangdong province in 2003 adopted the Regulations on Guangzhou Government Information Disclosure, requiring that all government information be disclosed according to the regulations to guarantee the rights of individuals and organizations for information and to increase government transparency. Other provinces have followed suit. In late 2004, Hubei province decided initially that four kinds of information be disclosed. The first refers to government regulations, standard documents and those relating to economic and social management and related public services, general plans on social and economic development, town and land-use layouts and related statutes. The second category concerns serious epidemic diseases and their conditions, basic statistics on population, natural resources and local economic development. The third deals with government budgets, final account and actual and audited expenditures, government purchases, major special spending, major capital construction projects, the construction and operation status of social benefit facilities invested by the government. The final one concerns the conditions and procedures of administrative licenses and the basis and standards of administrative items of charges, and the terms and procedures of employment for government employees.

Problems Arising from the Legal Environment

Although China has established a comparatively satisfactory legal framework governing foreign investments, yet many problems still remain. For example, the current Corporation Law and Bankrupt Law are yet to be consolidated. Laws and regulations relating to foreign-capital mergers and acquisitions are less than perfect. Despite the numerous laws governing, the operation of foreign-capital enterprises, such as stock rights alterations, mergers or split-ups, the rights of investment companies, or questions of reinvestment, there are still deficiencies concerning legal issues involved in investments and mergers. There are also insufficient legal provisions to regulate the behaviour of the market. For example, there is as yet no anti-trust law. Instead, there is only a law on unfair competition that applies to retailers but not the producers.

At the same time, many institutional problems still persist. The current regulation on mergers and acquisitions involves many government departments and each has its own law enforcement procedure. Thus it is difficult for foreign investors to enter China by means of mergers and acquisitions. In addition, the current foreign exchange management system, especially the control of capital account, often compels transnational companies to adopt an evasion method to invest by setting up a foreign-capital enterprise in China and then to expand their operations through mergers and acquisitions.

Some laws are strong on principals but weak on enforcement, and in reality are often subjected to interpretations that are seen to be "flexible" and arbitrary. Other laws are administered according to a two-tiered system. The taxation laws governing preferential regulations on foreign-capital investments are a case in point, Although China applies a unified tax system for value-added tax. consumption tax and sales tax for both domestic and foreign enterprises, yet in the taxation on income, domestic and foreign enterprises are treated as separate entities. The unequal treatment of unconsolidated domestic and foreign-capital investments is a characteristic of Chinese laws and is a clear reflection of an immature legal system on taxation.

Consolidation of the laws remains to be seen. As different departments are often involved to draft laws on related subjects, variations in interpretations, which are not uncommon, often dent the confidence of investors.

The regulations, stipulations and documents of different government departments have the effect of laws and so are various governmental policies. However, being issued by different departments and having effect at different levels of authority, they lack universal applicability even for the same departments in different parts of the country. The result is the occurrence of conflicts of interests at both the departmental and regional levels.

High Legal Business Cost

Legal costs are part of the cost of doing business. An enterprise that applies for a license, for example, must obtain permission from a number of different administration agencies. Interpretations of certain rules may vary according to different regions or at different times. The need to navigate through legal and administrative passages will invariably add to the cost of doing business.

Legal commercial costs are incurred by the need to disentangle the uncertainties arising from policy changes, practices that deviate from stipulations of laws, or arbitrary enforcement decisions. This cost is distinct from the normal operation cost of an enterprise and represents an added burden due to legal causes.

Commercial enterprises are often liable to charges arising from various kinds of administrative services. Many departments extract payments for services provided and these payments are "protected" by "red title documents" of the government.⁶ Enterprises could be made to pay for services that are not provided. The common psychology of some departments was that enterprises have to bear some "penalties" in managing their business and that services rendered come with a price. For example, the Bureau of Measurement levied a charge of 2,000 yuan when a pharmaceutical factory asked for an instrument test in 2003, but the same "service" was charged 12,000 yuan in 2004 (张小青与胡敏 / Zhang Xiaoqing and Hu Min, 2004).

Hidden Rules and Creditability Gap

The issue of "hidden rules" has attracted much attention in recent years. "Hidden rules" are applied arbitrarily and are generally violations of the laws. In reality, these rules have become the "norms" by which business enterprises are compelled to observe in the conduct of commercial activities. Foreign investors have often to operate in a "legal" environment that has a negative impact on business.

The market economy is characterized by competition and based on a system in which credibility on the part of the government, society, and business enterprises is important. However, under prevailing conditions, this is still not the case throughout China.

The need for credibility on the part of the government at all levels is a fundamental requirement for investment. Incentives have been offered to attract foreign investors but were later found to be inapplicable. Local governments have offered promises in contradiction to stipulations issued by higher authorities. Foreign companies are known to pay hefty sums to secure financial guarantees from local governments or to receive payments due to them. Company houses built on the promise of exemption from taxation by local governments are often subjected to taxes when the factories are completed. Also, the price of land to be paid by foreign investors may not be regulated by market demand but decided by the taxation department.

The creditability gap is manifested in other forms. It has been known that local governments may amend their promises to suit local interests. Terms agreed upon originally may be rejected arbitrarily to meet the interests of various local departments. Again, some local governments rely on their administrative power rather than the provisions in legal enactments. For instance, the director of a local tax bureau may waive the tax of an investor on instruction of a provincial authority (熊家余等 / Xiong Jiayu et al., 2004a).

The question of trust and credibility of the business sector and society also leave much to be desired. A survey in 2003 revealed that more than a third of the investigated enterprises were affected by dishonest dealings such as failure to repay loans, infringement of contracts, and production and sale of faked goods. That the government, business and society itself need to seriously foster a climate of trust cannot be over-emphasized. The government itself is particularly responsible for cracking down on fraudulent dealings. In late 2004, Hubei provincial authorities issued a publication expressly to exhort all sectors of society and business to be honest and trustworthy. With such efforts, one may hope to see that the need for mutual trust in business dealings will be taken more seriously than before.

Legal Enforcement

The law is the ultimate source of justice and it is administered by the court acting in its sacred capacity as the judicial authority of the country. Disputes on economic matters that are often unavoidable should be resolved to the satisfaction of the parties concerned. This is possible only when the judiciary is independent of the executive branch of the government. However, as often happens in China, if the court is seen to be biased in favour of vested interests, justice will not and cannot be done.

The arbitrariness of the court often gives rise to injustices and undermines the reputation of the judiciary system. One case involved a foreign investor who had rented a factory warehouse to be used as a restaurant on a lease of eight years. The factory was sold by the owner before the lease expired without any compensation to the restaurant operator. Having failed in his legal recourse to the court, the foreign investor had to appeal to the mayor of the city to receive the compensation that was due to him. In a more incredible case, a foreign businessman leased his house to a local person who refurbished the house for his catering business. The failure of the lessee to pay the lease money compelled the foreign businessman to terminate the contract. The lessee brought a lawsuit in a court which ruled that the foreign businessman was to compensate the lessee a sum of one million yuan!

The enforcement of court judgments is yet another source of legal problems. In a dispute involving the claims to the rights of land and house between the local and foreign partners and in which the court ruled in favour of the latter, the judgment could not be executed for eight years and became a case of "hollow justice". Justice in this case was severely interfered with by the influence of certain department officials, and justice that is not seen to be done is a mockery of the law.

Granted, gross injustices of law rarely occur. That they do, however, indicate that the administering of justice can be biased and abused. The consequent lack of reliability of the law will only serve to undermine investors' trust in the judiciary system (熊家余等 / Xiong Jiayu et a/., 2004a and 2004b).

Foreign investors are often caught between the rivalries between local and other interests. In China local economic interests often take precedence over other interests and local governments are prone to act in ways as to protect their own interests. The overlapping judicial and administrative systems mean that the judicial department at the local level is subordinate to both the local government and the judicial authority at a higher level. This system makes for opportunities for local protectionism. Among investors of joint ventures are domestic investors who are well connected with the government or are themselves the representatives of government departments. Disagreements or conflicts involving these domestic investors would often be difficult to resolve, and least of all through the avenue of legal redress.

Intellectual property rights are a form of foreign capital investment and require legal protection. Upon entry into WTO, China signed the Intellectual Property Agreement Relevant to Trade and similarly amended corresponding laws and regulations. China is a party to almost all relevant agreements on the protection of intellectual property rights.

Despite the existence of legal provisions, the protection of intellectual property rights is still ineffective and infringements persist. Many foreign enterprises have complained of having suffered from such infringements. The authorities may overlook infringements unless the aggrieved party brings up relevant charges, but then the cost of prevention is relatively high. It was only in August, 2004, that the State Council made special arrangements for the protection of intellectual property rights and one may expect infringements to be dealt with more severely in the future.

Suggestions for Improvement

Both the Chinese government and investors have to work hard to improve the legal environment for the benefit of foreign-capital investments. Attention has to be focused on several fronts.

The existence of a fair and well-developed legal system is the prerequisite of a healthy environment for business. Putting in place this system will take time but may be speeded up by special efforts in the enactment, administration and enforcement of laws of the country. It also entails, among other things, revising existing laws and plugging loopholes, and to devise a proper system of co-ordination among law-enforcement departments.

Timely disclosure of information and improved transparency are basic ingredients in support of a strong legal environment. China may benefit from the experience of other countries in devising a system to facilitate the disclosure of and access to information on a legal footing. Openness may be promoted through improved transparency in all aspects of government. Procedures for official approvals should be simplified to improve efficiency for the benefit of the public. Officials and governments at all levels should act according to stipulations embodied in the laws so that their actions and decisions are held accountable to the people.

In a market economy, a fair and just system can only work when there is trust. The integrity and honesty of government and individuals are the essential elements of a system based on trust. Trust is a traditional virtue of Chinese culture. "Benevolence, righteousness, courtesy, wisdom and honesty" are the basic principles that guide one's conduct. In the modern society, both the government and its officials would have to act with openness and honesty to earn the trust of the people.

The trust in the government is founded on a sound legal system and China can improve the integrity of its government firmly buttressed in the rule of law in which everyone is equal before the law. Any breach of law, whether by the government, its agencies or officials, or any individual in his personal or official capacity, is strictly a matter before the law. A tradition by which high officials found guilty of wrongdoing and willingly accept the blame and relinquish his position would build up an image of a responsible and honest government, and thereby improve its credibility. At the levels of the private persons and business enterprises, a system of trust arbitrated by legal instruments would make for efficient business transactions and would constitute both tangible and intangible assets to society.

While putting in place the necessary laws is the first step towards improving the legal environment for business, impartial enforcement is equally significant. Effective law enforcement requires a legal infrastructure and qualified personnel. Both can work with maximum effect only if they are independent and free from interference, and imbued with a strong sense and tradition of carrying out justice without fear or favour.

A sound legal system is always complemented by an effective appeal mechanism. The role of this mechanism is to remedy omissions and wrong judgments committed by relevant departments in the course of exercising their duties. To be effective, it has been suggested that this appeal mechanism should divorce itself from the concerns of vested interests of the local government, relevant departments or individual persons.

The existence of the modern sovereign country is based on the rule of law rather than the rule by man. It is the laws that constitute the source of the sovereignty of the country. It therefore behooves all investors to abide by the laws and to understand the relevant laws in order to avoid uncertainties.

Conclusion

A sound legal environment is a prerequisite to safeguard the interests of foreign investments in China. The government has worked hard to make China an attractive place for foreign capital and large inflows of foreign investments are indeed taking place. But it cannot be denied that that there exists imperfections and deficiencies in the Chinese legal system with regard to foreign investment. Investigations have shown that problems such as the low level of trust and the routine use of "hidden rules" are among the most serious. These problems damage the interests of foreign investments, dampen the confidence of foreign investors, and increase the costs for foreign business. The government is keeping close attention to these problems in an attempt to ease the situation. Given the serious commitment of the government, the prospects for the improvement of the legal environment for foreign investment in China are encouraging.

Notes

1. These are Laws of the People's Republic of China on Chinese-Foreign Equity Joint Ventures, Laws of the People's Republic of China on Chinese-Foreign Contractual Joint Ventures, and Laws of the People's Republic of China on Foreign-Capital Enterprise.

2. These are the Circular of Adjustment on Resource Tax Amount of Part of the Mine and Oil Field Enterprise in Northeast China Old Industrial Base and the 2004 Interim Measures for the Compensation Scope of Value Added Tax in Northeast China (刘溟 / Liu Ming. 2004).

3. Such as the Laws of the People's Republic of China on Chinese-Foreign Equity Joint Venture, Laws of the People's Republic of China on Chinese-Foreign Contractual Joint Ventures and Laws of the People's Republic of China on Foreign-Capital Enterprise.

4. Rules for the Implementation of the Laws of the People's Republic of China on Chinese-Foreign Equity Joint Venture. Rules for the Implementation of the Laws of the People's Republic of China on Chinese-Foreign Contractual Joint Venture and Rules for the Implementation of the Laws of the People's Republic of China on foreign-Capital Enterprise.

5. To illustrate, a factory that has an annual capacity of handling 100.000 tons of palm oil and soybean oil is granted a quota of 7.000 tons by the relevant department. At the same time, the department continues to approve quotas to several factories that had already closed down but from which the operating factory has to buy over these quotas at a higher price. As a result of the failure of the department to reveal the truth, "ghost" factories continue to receive quotas to be converted into hard cash for the benefit of vested interests.

6. Chinese official documents bear titles in red and are called "red title documents".

References

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