Two Lawyers Assess China's Lack of Internet Law

By DANIEL WALFISH

(Beijing, May 22) Lawyers specializing in helping U.S. companies invest and do business in China have been chuckling recently over a passage in the SEC filing for a planned public offering of Sohu.com, a hot Intel-invested Chinese Internet portal.

The statement's section on risk declares: "It is possible that the relevant PRC authorities could, at any time, assert that any portion or all of our existing or future ownership structure and businesses, or this offering, violate existing or future PRC laws and regulations."

Translation: There's no reason Sohu.com couldn't be fined, shut down, or forced to unload investments.

As one Hong Kong-based China legal specialist said to me, "It basically says you're a moron if you buy these things."

Investment in China has always entailed uncertainty. But as Beijing's Zhongguancun district is turning into a miniature Silicon Valley -- partly on the strength of excited foreign investors discovering the Internet market in China -- China's central government has not yet decided how to regulate foreign investment in its Internet sector.

No Existing Law

Foreign investment in China's telecommunications sector, which has always been illegal, is proving an especially thorny case because some Internet operations, namely the so-called "Internet content providers" (ICP's), distribute such materials as headlines, news articles, and photographs that Beijing might consider illegal for political or other reasons.

However, there is no existing Chinese law that addresses the legality of foreign investment in companies that distribute content over the Internet. The only law that exists is the one that says foreign investments in telecom companies is illegal. And even this law doesn't specify whether the so-called Internet Service Providers (ISP's) qualify as telecommunications companies or not.

At the moment there are no laws whatsoever governing foreign investment in Chinese Internet companies, so lawyers have been looking to the rules governing foreign investment in telecommunications companies for guidance. Foreign investment in telecommunications operators has always been illegal, and that would seem to make foreign investment in Internet service providers illegal as well.

Two Lawyers

But there's no telecommunications law that would seem to fit so-called Internet content providers (ICP's), the kind of company that produces Web sites like Sina.com, Netease, Sohu.com, and Renren.com. And the whole area of Internet content is extremely sensitive for a government intent on controlling information.

So right now, all content providers -- including many of China's hottest Internet properties -- are in legal limbo so long as they're backed by foreign dollars.

Two lawyers smack in the middle of the action are Cole Capener and Steven Toronto. One is a China lawyer by training who is now based in Silicon Valley. The other is a Silicon Valley lawyer by training who now practices in China. Capener has spent most of his career with Baker & McKenzie in Hong Kong and Beijing. A partner of the firm, he recently moved to its Palo Alto office to capitalize on emerging investment in China's information technology sector.

Toronto practiced corporate and securities law in Silicon Valley before coming out to Asia seven years ago. Both men first learned Chinese as Mormon missionaries in Taiwan.

Hopeful Investors

The two men have differing views on foreign investment in Internet companies in China, with Capener's being decidedly the sunnier.

To Capener, certain parameters are already fixed. Most significant is the bilateral agreement between the U.S. and China, in which both sides agreed to terms under which China could join the WTO. The agreement calls for the maximum allowable foreign investment in Chinese Internet companies to rise to 50% within two years.

The document has not yet been signed, however, and Wu Jichuan, the powerful head of the Ministry of Information Industry (MII), is in Capener's view already trying to make foreign investment in all kinds of Internet companies illegal -- especially content providers.

While Capener, like many hopeful U.S. investors, believes it would be fair to grandfather companies that received foreign investment prior to November 1999 (when the WTO agreement was reached), he cautions that the existing grandfather clause in the agreement is extremely vague.

Sina's Structure

"It's a weird situation where the future is more predictable than the present," he said.

The companies with real cause to worry, Capener says, are the ones that are fully invested by foreigners. This is true, he says, even if they are supported by local government officials who are eager to attract foreign investment. Beijing might decide to crack down on such companies, Capener guesses, while staying out of the way of companies whose foreign investment conforms to the limitations in the WTO agreement.

Capener also has some confidence in the complicated structure that Sina.com used in its offering earlier this year, on the theory that it was "blessed" by both the China Securities Regulatory Commission (the CSRC, China's version of the SEC) and the MII.

In that case, Sina.com adopted an unusual corporate structure to protect the company and shareholders against unforeseen regulatory intervention by Beijing. Three corporate entities were formed: a Cayman Islands parent company being offered to the public; a PRC company that operates the Web site; and a PRC subsidiary of the Cayman parent that provides the PRC operator with various services.

A Chinese Partner

The catch is that to prevent foreign investment into the company that might attract unwanted regulatory attention, the parent company no longer owns the portal operator. The parent's income instead comes from a loose contractual arrangement with the PRC subsidiary.

In the future, Capener says, one strategy that could reduce risk for Western venture capitalists in China is to invest with a Chinese partner. The venture capital industry in China "has just started to grow feet," with universities, provincial governments, and businesses beginning to establish their own venture capital funds, Capener says. "If I were a Western venture capital firm," he said, "I would feel more secure if I knew a PRC firm was investing along with me."

Steven Toronto, a partner in the Beijing office of the San Francisco firm Morrison & Foerster, offers a terse summary of Internet investment regulatory law in China: "There's a lot of ambiguity in this area."

For one thing, Toronto calls the WTO agreement "a mess" and says he is by no means sure that even after the agreement is finalized, possibly as early as later this year, that the Chinese government will uphold its side of the bargain.

A Crucial Step

Toronto reads Minister Wu's pronouncements a bit differently from Capener. Taken together, he says, they add up to mixed signals -- not the clear indication that Wu wants to make all foreign investments in Internet companies illegal, that Capener reads into the minister's statements.

Toronto points out that while Minister Wu wields enormous influence, talk alone does not add up to law: "In the absence of any formal directives," says Toronto, "it's all jawboning."

Also, Toronto cautions that while companies like Sina.com have indeed spoken to government ministries to make sure their offering will be looked upon favorably -- a crucial step for any company raising its profile in China -- he hastens to remind us that that process does not constitute formal approval.

"There is [still] no formally approved structure for Internet content providers in China," he says.

Toronto dismisses with a scoff the corporate structure devised by Sohu.com, the Beijing-based portal whose SEC registration statement has many securities lawyers in China laughing.

Under the Sohu structure, a Delaware company directly owns a Beijing-based subsidiary. The legal reasoning is that since there are no laws governing foreign-invested Chinese Internet companies, the company assumes that its structure is legal.

Toronto calls this a "head in the sand" approach.

"Their structure has some problems," he says.

Daniel Walfish is a reporter at The American Lawyer in New York City. From 1998 to 1999 he taught English to University students in Tianjin. To reach him by e-mail: daniel.walfish@aya.yale.edu