Why is China Relevant for International Companies?
China will be too big for international autonomous car suppliers and service providers to ignore. Biggest automotive market, continued strong growth, right infrastructure, ability for government to implement, early adopter consumers, popularity of car sharing and sharing economy, new and innovative companies on the rise all point to China being pivotal to the development of autonomous cars.
Also as China’s share of the world economy rises and it becomes the largest economy it may well be that for a company to be “global” in the autonomous car sector then you will also need to “win” in China.
However, it will not be easy for these international companies though – China will be a major opportunity but also a major challenge.
Time and time again international companies have underestimated the competitiveness of the Chinese market – it can be crowded – both international and home grown Chinese competitors bitterly fight it out. In addition as the Chinese economy is now so big even niches are worth fighting over.
In addition to business competition international companies will also have to contend with regulatory controls in China and in particular restrictions on foreign investments in specific sectors.
China Regulating of Foreign Investment
For many years, China did not have specific legislation setting out restrictions or encouragements granted to specific types of foreign investment. The approval authorities based their decisions on vaguely worded legislation contained in diverse laws or regulations regulating foreign invested enterprises or upon “internal policies”, which were not published, not available to the general public or indeed often thought to be not existent.
China began to issue the Investment Direction Procedures and its accompanying Industrial Catalogue in 1995. This gave international investors a far clearer picture regarding the Chinese Government policies and “internal guidelines” in respect of their attitude to foreign investment. The Investment Direction Procedures divides foreign investment into four categories:
- Restricted; and
The reason why international companies interested in autonomous cars will face challenges is that many of the main elements are highly restricted such as complete vehicle manufacturing, big data, cloud services, value added telecoms and mapping.
One positive bit of news is that China is relaxing restrictions upon foreign investment in purely electric powered vehicles. Before mid-2017, foreign car manufacturers were subject to restrictions as to how many joint ventures they could have in China to manufacture the same type of passenger or commercial vehicle (i.e. two joint ventures). In addition the Chinese partner was required to hold no less than 50% of the joint venture’s equity.
Under the 2017 Industrial Catalogue, effective July 2017, the restrictions on the number of joint ventures that could be established by an international investor to manufacture purely electric vehicles (i.e. not diesel, gas-fueled or hybrid vehicles) was lifted. However, such manufacturing joint venture must still have a Chinese partner with at least 50% equity. There are rumors the authorities may be considering reducing the minimum level of equity to be held by Chinese partner.
China has big plans for new energy cars namely – purely electric, hybrids, plug-ins and fuel-cell. The development of purely electric vehicles is the main strategic direction. China aims by 2020 to be capable of annually manufacturing 2 million purely electric and hybrid vehicles. In 2017 alone, China sold 770,000 new energy cars. China’s 1.6 million new energy cars account for 50% of new energy cars globally.
Many observers in the auto industry expect most self-driving cars will be electric for a number of reasons:
- environmental protection – electric vehicles have no emissions;
- autonomous friendly – electric vehicles are easier for computers to drive; and
- costs – electricity is cheaper than petrol. Self-driving car technology is currently expensive but in the longer run the per-mile cost to operate these vehicles is projected to be substantially lower due to use of electricity.
What Options Available?
At present, foreign investors wishing to carry on active business in the PRC have a choice of setting up an equity joint venture (“EJV”), co-operative joint venture (“CJV”) or wholly foreign owned enterprises (“WFOE”) (collectively referred to as “Foreign Investment Enterprises” or “FIEs”).
Basically, JVs (including both EJVs and CJVs) are jointly invested enterprises with one or more Chinese and foreign partners. In the vast majority of cases such JVs are separate corporate entities with a limited liability status.
By contrast, a WFOE refers to a separate legal entity with limited liability status set up in China pursuant to the WFOE Law and its Regulations. In such a newly created entity, one or more of the foreign investors would hold 100% of the investment interest (shares). In other words, WFOEs are wholly foreign-owned subsidiaries in China.
In addition to the FIE models the other possibilities that are being used by international companies such as a variable interest enterprise (“VIE”) or other form of co-operation.
How to Choose?
WFOE – today the WFOE is the most popular choice for international investors seeking to set up in China. Originally when it was introduced in 1986, the WFOE was only available as an alternative to JV in certain specific high-tech areas and for export-oriented businesses. As a result the WFOE was not a practical alternative for many international investors until it was opened up in the late 1990s.
The difference between a JV and a WFOE is … clearly … a Chinese partner. In the early days of foreign investment in China many international companies entered into JVs as China was seen as too complicated and too difficult for the international investor to navigate alone. However, many of these international investors found to their chagrin that much of their difficulty and complexity originated from having the wrong Chinese partner. Accordingly, for international investors the preference has been to establish a WFOE as they have more control and do not need to consult with a Chinese partner. Another part of the reason may have been that many more companies started investing in China than in the early days immediately after the opening up. In the early days, China was very much for international investors that were large, foolhardy or large and foolhardy. As more medium and small companies invest in China they are more comfortable with the WFOE model rather than a JV.
“The decision to welcome joint ventures … is an exciting experiment in mutual tolerance and education, as well as profit, and in future centuries it may be seen as the measure which contributed most to bringing China and the Western world together after two centuries of mutual suspicion and conflict.” — David Bonavia, The Chinese (1980)
Although one cannot foresee what will be written in future centuries, it is a fair bet that JVs will not be seen as having done much to end mutual suspicion and conflict between the West and China but rather JVs were poised to foster suspicion and conflict.
However, JVs remain an important vehicle for China in some cases by law and in other cases by choice. This is very much so for autonomous vehicles for the following reasons:
Only Legal Option – autonomous cars are at a cross section of sensitive sectors including car manufacturing, mapping, telecommunications etc. In some cases these activities can only be realised in the form of a JV. In other cases FIEs are off limits and the only option is to establish a VIE or some form of cooperation.
Good Business Reasons
Although many JVs owe their birth to legal requirements there are many more that come to fruition for persuasive, practical business reasons.
Naturally, these will vary with every project but recurring reasons include:
1. The JV partner is the major customer or stakeholder
In some cases (notably in the automotive sector), foreign investors perceive an advantage in establishing a JV with the Chinese partner of the automotive JV as they believe the relationship will assist in obtaining orders or support that a stand-alone operation may not receive.
2. The Chinese partner is a major supplier to the international investor – a number of foreign companies have sought to increase their level of influence within a Chinese supplier by taking a stake in the company. As autonomous cars go global it may well be that international players may find themselves reliant on Chinese suppliers not only in China but across the globe.
3. Teaming up with a Chinese rising star
China 2018 is not China 1998. Today, Chinese companies are leading or may lead the way in key technologies that are vital to autonomous vehicles. AI, sharing economy, blockchain are all technologies where China is or may well end up leading. International companies may find Chinese partners vital for both the China market but also for global plans.
The Role of the VIE
For many years international investors confronted with foreign investment restrictions in key sectors have employed alternative contractual control structures – most commonly referred to VIEs.
In essence, a VIE refers to a structure whereby an entity established in China that is wholly or partially foreign owned (“Controlling Company”) has de facto control over a PRC operating company (“Operating Company”). Such Operating Company would obtain the necessary business scope and licenses to operate in an FDI restricted or prohibited sector.
As the relevant sector of investment is subject to foreign investment restrictions in China the international investor will not be able to directly invest in the Operating Company. In order to protect their interests the international investors will enter into contractual arrangements between the Controlling Company and the Operating Company and its shareholders in order to obtain contractual control over the operation and management of the Operating Company. The profits of the Operating Company generally flow back to the Controlling Company (usually in the form of a consultancy, services or royalty fee) and ultimately are consolidated with the finances of the Controlling Company.
The VIE structure remains a grey area in the Chinese legal system. Although there is no express prohibition against the VIE structure in China, there has also been no express endorsement of the VIE structure by PRC authorities. In addition, some authorities have taken steps in 2013 to restrict such arrangements (for example, MOFCOM has required that parties not use VIE control structures as an express condition to giving merger control approval). As the VIE structure allows domestic and foreign investors to circumvent mandatory government reviews and regulations the structure does not have the backing of the Chinese authorities and therefore presents a heightened investment risk for the international investor. It also can create practical enforcement challenges in the event of breach by the Chinese license holding partners of their contractual obligations. The risks and uncertainties facing VIE structures include:
- level of protection of the rights of beneficial owners in VIE arrangements are far lower than a direct equity interest in the operating company;
- potential conflicts of interest between the legal shareholders of the operating company and the “actual controllers”; and
- the uncertainty in whether VIE contractual arrangements are enforceable between the controlling company and the operating company in the event of a dispute.
Despite these risks and uncertainties it is likely that many international investors (including large global ones) confronted with restrictions will turn to VIE models at least as part of a solution. Although risk in this model cannot be excluded it can be reduced by intelligent drafting and implementation.
As the world’s largest auto market China’s number of cars and strong growth makes it a jurisdiction central to business strategy. It may be that if you are not present in China then you may not be able to succeed globally.
International companies already with a presence in China are deepening their footprint in China to ready themselves for the new opportunities that autonomous vehicles will provide. For many this will involve setting up their first JVs (even if they have had WFOEs for decades in China) or by cooperating with domestic companies that have expertise or licenses in restricted sectors. There will be opportunities for WFOEs but these are unlikely to be the most important or lucrative businesses. Accordingly for many investors success will necessitate working with Chinese partners – whether they be fellow shareholders or cooperative partners.