China: China Law Bulletin - July 2005

The Measures for Administration of Foreign Investment in the Leasing Industry (the "Leasing Measures") were promulgated on February 3, 2005 by the Ministry of Commerce ("MOFCOM"), and took effect on March 5, 2005.

The Leasing Measures replace prior regulations governing foreign investment in the leasing industry issued in 2001 and liberalize foreign investment in the sector in compliance with China’s commitments associated with its accession to the World Trade Organization ("WTO").

Under the prior regulations, a foreign investor was permitted to hold no greater than an 80% interest in a foreign-invested leasing enterprise. The Leasing Measures permit wholly foreign-owned enterprises ("WFOEs") to be established to undertake leasing business.

The Leasing Measures also reduce the minimum registered capital of a foreign-invested leasing enterprise from US$500,000 to the minimum requirement under the Company Law of Renminbi (RMB) ¥100,000, and that of a foreign-invested financial leasing enterprise from US$20 million to US$10 million. Prior regulations required foreign investors in the leasing sector to have at least US$50 million in assets and those in the financial leasing sector to have at least US$400 million in assets. The Leasing Measures significantly lower these thresholds to US$5 million.

The Leasing Measures also extend the scope of assets that can form the subject matter of a lease, which now expressly includes software and technology ancillary to leased movable property, provided the value of such intangible assets does not exceed half of the value of the movable property.

Finally, the Leasing Measures introduce an element of certainty to the approval process for foreign-invested leasing enterprises. Approval decisions are required under the Leasing Measures to be made within 45 days in respect of applications to establish foreign-invested leasing enterprises and within 60 days in respect of those to establish foreign-invested financial leasing enterprises.

Foreign Exchange Administration

The State Administration of Foreign Exchange ("SAFE") recently issued two notices restricting residents of the PRC in respect of their investments in offshore companies. Morrison & Foerster recently prepared a Legal Update on the impact of these notices. For the full text of this Update, please follow the link below:

http://www.mondaq.com/article.asp?articleid=33657

Intellectual Property Rights

The Measures for the Administrative Protection of Internet Copyright (the "Internet Copyright Measures") were promulgated by the National Copyright Administration ("NCA") and the Ministry of Information Industry ("MII") on April 30, 2005. The Measures provide procedures to protect the copyright of performers, producers of audio or video recordings and other right holders whose works can be transmitted over the Internet.

Key provisions in the Measures include:

Take-down Notices: A copyright holder can send a notice to an Internet Service Provider ("ISP") informing the ISP that copyrighted materials are being made available by an Internet Content Provider ("ICP") without authorization. The ISP is then obligated to block access to the identified material and to retain the copyright holder’s notice for six months. The ISP must also record and maintain for 60 days information on the ICP and all end users accessing the identified material.

ICP Counter-notice: An ICP may send a counter-notice to an ISP and the copyright holder stating that the identified material is not infringing copyright. The ISP may then immediately permit the identified material to be accessed. Once the counter-notice is dispatched, the ISP is relieved of administrative liability for any potential copyright violation.

ISP Liability: The NCA may impose administrative sanctions on an ISP that has reason to know that an ICP is illegally publishing copyrighted materials or has received a take-down notice and fails to block access to such materials. The NCA may order the ISP to block access to the infringing materials, may confiscate all proceeds derived from the infringing activity, and may impose a fine of up to three times the illegal proceeds or, if the illegal proceeds are difficult to calculate, a fine of not more than RMB 100,000. If an ISP fails to comply with a take-down notice, the MII may impose a fine of up to RMB 30,000. If the NCA determines that an ICP is intentionally engaging in infringing activities, it may notify the MII, which shall take responsibility for imposing appropriate administrative sanctions under the relevant telecommunications regulations.

The State Council promulgated the Regulations on Collective Management of Copyright (the "Copyright Regulations") on December 28, 2004. The Copyright Regulations, to be administered by the National Copyright Administration ("NCA"), clarify the rights and obligations of social organizations called collective management organizations ("CMOs") which can be authorized by copyright holders to exercise the rights of those copyright holders. CMOs are intended to simplify the management of copyrights which would be too burdensome for individual copyright holders to effectively exercise. CMOs are permitted to:

• conclude licensing contracts for use of the copyright and related rights with users;

• collect royalty fees from users;

• transfer collected royalty fees to the copyright owners; and

• participate in litigation or arbitration involving the copyright or related rights.

The Regulations provide detailed prerequisites for the establishment of a CMO, including:

• there must be at least fifty copyright holders to establish a CMO;

• a CMO’s business scope cannot overlap with that of existing CMOs;

• the CMO must be able to represent the interests of the relevant copyright holders throughout the country; and

• it must have draft articles of association, draft standards for collection of royalty fees, and draft methods of transferring royalty fees to copyright holders.

The Regulations then provide detailed guidance on application procedures to set up a CMO, establishment of a members’ assembly to govern the CMO, appointment of a Board of Governors to implement decisions of the members’ assembly, operational management of the CMO, implementing a copyright database inquiry system, legal liability of CMOs, supervision of CMOs by the NCA, setting of fees, and the procedures for handling collection of royalties, calculation of the CMO’s fees, and the onward remittance of royalties to the copyright holders.

On June 2, 2005, the PRC Ministry of Labor and Social Security promulgated the Regulations for Administration of the Employment in Mainland China of Residents of Taiwan, Hong Kong and Macau (the "New THM Regulations") to replace prior regulations promulgated by the then Ministry of Labor on February 21, 1994 (the "1994 THM Regulations").

The New THM Regulations streamline the employment of residents of Taiwan, Hong Kong and Macau ("THM Residents") by entities in mainland China. Mainland employers are still required to obtain an employment permit in order to hire THM Residents. However, to be eligible to obtain a permit, they are no longer required to show that there are no suitable domestic candidates for the position. Employment permits are also no longer subject to an annual inspection requirement.

At the same time, the New THM Regulations more tightly regulate the employment of THM Residents in mainland China. Mainland employers are required by the New THM Regulations to pay social insurance premiums for THM Resident employees. The New THM Regulations also expressly impose a requirement to obtain an employment permit when a THM Resident works for an overseas employer (including an employer in Taiwan, Hong Kong or Macau) and spends more than three months in the aggregate in mainland China in a year. Historically, many THM Residents worked in China, traveling out of the country from time, without complying with the 1994 THM Regulations by traveling on a multiple entry permit (hui xiang zheng; 回乡证) or the equivalent without a separate visa. The authorities may clamp down on this practice with the promulgation of the New THM Regulations.

MOFCOM issued the Measures for the Administration of Commercial Franchise Operations on December 30, 2004 (the "Franchise Measures") and took effect on February 1, 2005.

The Franchise Measures are intended to fulfill China’s commitment to open its franchising sector to foreign participation as part of its accession to the WTO. Issuance of the Franchise Measures comes on the heels of promulgation by MOFCOM in April 2004 of the Measures on the Administration of Foreign Investment in the Commercial Sector (the "Commercial Measures"), which govern foreign investment in commercial operations generally, including franchising. On March 10, 2005, MOFCOM issued the Notice Concerning Strengthening the Administration of Franchise Activities (the "Franchise Notice"), which came into effect on the same day. The Franchise Notice stresses the importance of the Franchise Measures in regulating the franchising market in China and requires departments of commerce at all levels to enforce the Franchise Measures and implement relevant policies and procedures thereunder.

The legal framework put in place by the Franchise Measures and the Commercial Measures has a number of features that are significant for foreign franchisors looking to expand operations in China.

The term "franchise operations" is defined in the Franchise Measures to mean "an arrangement whereby a franchisor, by way of a contract, authorizes a franchisee to use its operational resources such as trademark, trade name, and business model and whereby the franchisee in accordance with the contract conducts business according to the franchisor’s uniform business model and pays franchise fees to the franchisor".

The Commercial Measures expressly stipulate that franchising may only be carried out by an enterprise established in the PRC. Given the breadth of the definition of the term "franchise operations" in the Franchise Measures, it would appear that a broad range of cross-border franchise and other licensing arrangements are effectively prohibited by operation of these two pieces of legislation. The Franchise Measures require that a franchisor or its parent or subsidiary entity has itself operated at least two stores in China for more than one year before it may franchise operations to third parties in China. This provision has proved controversial among foreign franchisors, since it has the effect of delaying access by foreign franchisors to the Chinese market. Officials at MOFCOM have responded by saying that it is reasonable to require foreign franchisors to have operating experience in the Chinese market before being permitted to franchise their operations to third parties.

Adopting the legislative approach taken by other jurisdictions, the Franchise Measures impose detailed disclosure obligations on franchisors. No less than 20 days prior to the execution of the franchise agreement, a franchisor must provide the franchisee with a full copy of the franchise agreement, together with other "basic information and materials" about the franchise. The scope of this information is defined to include not only information about the franchise business, but also the franchisor’s litigation history for the prior five years and personal information about the franchisor’s senior management. The Franchise Measures impose liabilities on the franchisor for the franchisee’s losses caused by the franchisor’s misrepresentation or omission in connection with such disclosure.

The Franchise Measures also stipulate certain minimum content of franchise agreements. With respect to the franchise term, the Franchise Measures provide that the duration of a franchise agreement must normally be no less than three years.

Most provisions of the Franchise Measures apply equally to domestic and foreign-invested franchise operations. However, the Franchise Measures include one chapter with supplementary provisions applicable only to foreign-invested franchisors. Among the provisions in this chapter is a requirement that a foreign-invested franchisor file an annual report of its franchise operations for the prior year not only with its own approval authority but also with the relevant departments of commerce where its franchisees are located.

The Franchise Notice expressly acknowledges that franchising is a new industry sector in China and interests the departments of commerce at all levels to promote franchising activities. However, while the Franchise Notice reconfirms the importance of the Franchise Measures in regulating the franchising sector in China, it does not provide interpretative guidance relating to the Franchise Measures.

The disclosure and other provisions of the Franchise Measures are vague compared with franchise legislation in other jurisdictions. Nonetheless, they represent a meaningful step by China to liberalize its franchising sector and regulate the franchising market in China.

Morrison & Foerster has prepared a full English translation of the Franchise Measures. If you would like a copy, please send an email to Lesley Wright at lwright@mofo.com

Securities

As a first step in creating a domestic securities market, China established the Shanghai and Shenzhen stock exchanges 15 years ago. At first, in order to address the government’s concern not to lose control of the economy, shares of listed companies owned by the government or by state-owned enterprises (the "Non-Tradable Shares") were not allowed to be traded on the stock market or to be sold by private transactions to investors unaffiliated with the State.

According to the China Securities Regulatory Commission (the "CSRC"), only approximately one-third of the shares of listed companies in China are tradable shares. Market commentators have observed that such a limited supply of tradable shares has resulted in unreasonably high price-to-earnings ratios for listed companies. The public subscribes and/or buys tradable shares at a premium while holders of Non-Tradable Shares are allotted their shares on a net asset value basis, normally at the face value. The CSRC is in the process on instituting reforms that will draw Non-Tradable Shares into the public stock market with the objective of eliminating these price anomalies.

Following the liberalization of instructions on the transfer of Non-Tradable Shares, many non state-owned companies, including foreign companies, were able to acquire Non-Tradable Shares on a net asset value basis and generally at a considerably lower price than the share price of the tradable shares of the relevant company.

Following earlier efforts to integrate Non-Tradable Shares with tradable shares that led to significant price instability, the CSRC has made another attempt at integration with promulgation of the Notice Relevant to Pilot Reform on the Segmented Shares Structure of Listed Companies (the "Pilot Reform Notice") on April 29, 2005.

The Pilot Reform Notice leaves with the market considerable autonomy to determine the mechanism for integration. The CSRC does not impose a particular mechanism on listed companies or their shareholders. The Pilot Reform Notice allows individual companies to develop and present to shareholders plans for conversion of Non-Tradable Shares into tradable shares, while stipulating related disclosure requirements, the procedures for the shareholders meeting to consider the plan and the requirements for the lock-up of converted shares before they become freely tradable.

Various plans have been proposed by listed companies under the terms of the Pilot Reform Notice. In some cases, holders of tradable shares are given a certain number of shares by the holders of Non-Tradable Shares; some are given a certain amount of shares plus cash; and some are given a certain amount of shares, plus cash and even warrants. Converted shares may not be transferred for a lock-up period of six or more months.

In order to facilitate implementation of the Pilot Reform Notice, the Ministry of Finance and the State Tax General Bureau have promulgated a series of notices (the "Tax Notices"). According to the Tax Notices, share transfers resulting from the integration of Non-Tradable Shares with tradable shares are exempted from stamp tax and income tax while income tax on dividends from publicly listed companies is reduced by 50 per cent.

The Pilot Reform Notice is just the start of a complicated process. Many issues remain unanswered or unresolved. For example, what is the status of Non-Tradable Shares which are held by foreigners as the result of lawful share transfer out of the stock market after integration? Are they A Shares, which are tradable shares denominated and tradable in Renminbi and not allowed to be held by foreigners, or are they B Shares, which are tradable shares denominated and tradable in foreign currency and allowed to be held by foreigners? Do the relevant requirements for conversion of Non-tradable foreign-owned shares to B Shares need to be met before the integration plan can be adopted by relevant companies? We expect there will be more regulations promulgated to resolve or clarify these outstanding issues.

The State-owned Assets Supervision and Administration Committee and the Ministry of Finance jointly issued the Tentative Provisions on the Transfer to Management of Enterprise State-owned Assets (the "Provisions") on April 11, 2005, in an effort to prevent leakage of State-owned assets for less than their proper value when a State-owned enterprise undergoes a management buy-out.

The Provisions impose an outright ban on management buyouts in large-scale State-owned enterprises, in listed Stated-owned enterprises and in relation to their major assets. For small to medium size State-owned enterprises, qualified local government may consider a management buyout.

Transparency is another focus of the Provisions. To prevent the undervaluation of State-owned assets, the Provisions require that transfer of interest in State-owned enterprises must be audited by government appointed intermediaries and the management personnel may not participate in matters relating to the transfer plan.

The Provisions also impose a disclosure obligation on management personnel in relation to their source of funding, aiming to prevent the target enterprise or a related company from providing acquisition funding.

We understand that according to Ma Xiuhong, the deputy Minister of Commerce, who spoke at April’s EU-China Conference on Competition Policy in Beijing, China’s long-awaited Antitrust Law, is likely to be promulgated in 2006.

A number of drafts of the law have circulated in recent years as MOFCOM and other government agencies have sought to tailor legislative approaches in the European Union (EU) and other foreign jurisdictions to the requirements of the Chinese market. At a general level, prior drafts of the law circulated for comment adopt an approach most similar to EU legislation. The draft law includes express prohibitions against agreements and other forms of coordination among firms with the purpose or effect of restricting or eliminating competition as well as abusive practices by firms with a dominant market position. The draft law also imposes a comprehensive review of mergers and acquisitions, with a view to preventing over concentration of ownership in particular industries.

Building on the approach taken in the antitrust provisions of the Provisional Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors , jointly promulgated by MOFCOM, the State Administration of Industry and Commerce (the "SAIC"), the State Administration of Taxation and the SAFE on March 7, 2003, the draft Antitrust Law also makes transactions taking place outside China subject to review in China to determine if the transactions have anti-competitive effects on the Chinese market.

The much-anticipated Regulations on the Administration of Direct Selling (the "Direct Selling Regulations") are expected to be promulgated by the State Council soon. The Direct Selling Regulations will be read and implemented together with two other new rules, namely the Procedures on the Administration of Training of Salespersons and the Regulations on Prohibition of Pyramid Selling . It is known that MOFCOM and the SAIC will be the approving and administrative authority, respectively. The Regulations are intended to balance the fulfillment of China’s commitments associated with its accession to the WTO, prevailing international practices and the practical and social needs of the Chinese government in order to properly regulate the once-disputed business of direct selling in China.

Anticipated key features of the Direct Selling Regulations include:

Direct selling defined: Legitimate direct selling is to be clearly defined in the Direct Selling Regulations so as to distinguish direct selling from pyramid selling, which will remain illegal. Direct selling enterprises must be manufacturing enterprises and will need to operate under the model of "service outlets + salespersons", i.e., they must establish service outlets where they exhibit their products and prices and provide product refund and exchange services to customers. The main features of legitimate direct selling include that sales representatives not be charged an entry fee; that service outlets and sales representatives sell products at the same price; and that refunds be guaranteed.

Single-level mode and multi-level mode: One of the issues that has been most extensively discussed by enterprises in the sector and the government agencies seeking to regulate it is whether multilevel or only single-level sales would be permitted. We understand that only the single-level mode is permitted under the Direct Selling Regulations, with the effect that the compensation paid to a sales representative may only be calculated based on the revenue arising from the sales made by that sales representative directly to customers. (Under the multi-level mode, a sales representative is entitled to be paid on the basis of the total sales of a team of sales representatives, including those representatives he recruits.) We also understand that the Direct Selling Regulations set a 30% cap on the revenue that may be paid to a sales representative.

Restrictions on products and sales representatives: We understand that the final draft of the Direct Selling Regulations restricts a direct selling enterprise to sell products it and its parent or holding company manufacture. It was previously reported that only five categories of products would eligible for direct selling. We understand that this strict limitation has been replaced with a more flexible arrangement under which the government will designate from time to time what products are eligible to be distributed through direct sales.

Sales representatives must be Chinese citizens aged 18 years or above who have obtained the sales representative certifications from the relevant direct selling enterprise. Military personnel, civil servants, medical staff, teachers and students may not be engaged as sales representatives. A sales representative may only conduct direct selling activities within one province and where service outlets are located.

Entry threshold: While both domestic and foreign enterprises are allowed to engage in direct selling, the Direct Selling Regulations set high entry thresholds for them. For example, they must have registered capital of no less than RMB 80 million; pay a deposit of not less than RMB 20 million; and have established production enterprises and service outlets in China.

Licensing and certification: A direct selling enterprise must obtain a direct selling operation license issued by MOFCOM and a business license issued by the SAIC.

Information disclosure system: The Direct Selling Regulations also require direct selling enterprises to set up an information filing and disclosure system. Such disclosure system is to ensure that direct selling is conducted in an open and duly supervised manner. However, details of the filing and disclosure requirement are to be formulated in separate rules.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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