There seems to be a broad consensus, even within the Chinese media, that China has not yet fully implemented ‘rule of law’. William Soileau from Pinsent Masons LLP and Rosario di Maggio from Vistra explain that, instead, in the last 35 years of reforms, China has in essence instituted a form of ‘rule by law’. Regardless of the current state of play they encourage all foreign businesses operating in China to ensure that they are fully compliant with all prevailing laws and regulations.
‘Rule of law’ in essence just means that society is governed by law, and that law givers and law enforcers are subject to the same rules as everyone else. China has developed a plethora of laws and legal-regulatory institutions, tools for governing all aspects of society. But the system is incomplete, and the rulers themselves remain above the law.
This situation poses compliance risks for individuals and businesses, and for foreigners in particular. This article will explore China’s ‘rule by law’ and the implications for foreign business, and offer some suggestions for coping with this reality.
The following are some observations garnered from our practices over the years helping foreign business set up and operate in China.
Foreigners, being aware of the more limited scope of law here, often seem to minimise the importance of compliance. This attitude is perhaps more common among new entrants to the market, and also perhaps to smaller companies with less developed cultures of compliance, and fewer resources to devote to it.
All foreigners should adopt a policy of full compliance in China. They should not assume that the consequences of non-compliance will be easier to bear than the costs of complying in the first place.
With the rapid development and recent history of law in China it is not surprising that there should be gaps, inconsistencies and ambiguities in the legal and policy framework.
Rapid development means rapid change, as laws are constantly explained, revised and updated in line with shifting practical concerns and policy priorities. Often, overlapping series of regulations will affect fundamental changes in policy, imposing, reversing and modifying requirements in subtle ways. The foreign exchange control regulations are a good example of this, being subjected to major, frequent changes as policy has vacillated between tightening up and liberalisation.
Legal drafting is not always as clear as one would hope. Chinese drafters favour simplicity and directness, aiming to make laws intelligible to a far flung rural populace. But, as a result, there can be significant questions about new regulations. It can take quite some time for the import and workings of new regulations to become clear.
Of course, across China, there is significant local variation in the application of central laws and regulations. Local enactments cannot violate national law, but local authorities are free to innovate in implementing national regulations. These factors can make it difficult to know what the law actually is, resulting in increased discovery and compliance costs, and less certainty in choosing outcomes.
A particularly difficult situation can arise when local officials propose procedures that are beneficial to the foreign party, but that are of questionable legality. Since the officials have broad powers to interpret the law, it is difficult (and could be deleterious) to question the legality of the officials’ proposal. But if one also cannot say that the proposal is legal, the result is inevitably some modicum of residual risk.
Fundamental legal ambiguity can even affect whole areas of foreign investment. This is the case, for example, with so-called variable interest entity (VIE) structures, which are of questionable legality but have nevertheless been used by a large number of Chinese internet companies that have listed abroad.
Broad anecdotal evidence suggests that extra-legal discrimination against foreign enterprises is practiced widely by the administrations responsible for enforcing all types of domestic law. This is perhaps inevitable. Lacking natural allies in the local government, foreigners are simply much easier targets than domestic enterprises when it comes to tax, workplace safety, environmental, labour and any other type of enforcement.
This is a key factor causing increased compliance and enforcement risks for foreigners. Foreigners should be aware that their domestic competitors and disgruntled employees may have every incentive to whistle blow against them, for issues legitimate or otherwise.
There is also an element of commercial risk here, since one’s domestic competitors may be able to gain competitive advantages by not complying with the law.
Foreigners should always avoid going to court against a Chinese party in the Chinese party’s home city. But local protectionism can also be a problem for Chinese parties from out of town. The smaller and more remote the venue, and the more influential the local party, the more likely is the local court to be materially biased in its favour.
Foreign investors often consciously choose a powerful local Chinese party as their joint venture partner. That tends to work fine as long as the interests of the parties are aligned. However, when the interests of the parties diverge, the foreign party will be at a definite disadvantage in any dispute with the strong local partner.
A range of problems arise in legal enforcement.
Enforcement of court and arbitral judgements still remains challenging, primarily because the courts’ lack of certain contempt, seizure and other enforcement powers. Ultimately, this may result from a reluctance to subject all organs of the Party and government to the full scope of independent judicial power.
The quality of administrative enforcement varies widely, from time to place. At all times, the quality of administrative enforcement is impaired by gaps in the law and the discretion left with local officials not able or willing to honestly or effectively exercise it. Also, the thoroughness and accuracy of enforcement are highest in top-tier cities, and decrease from there.
Judicial appeal of administrative decisions seems to be quite rare. Private parties are understandably reluctant to challenge their local bureaucratic masters. Administrators have broad discretion in exercising their authority, and any major action that they take is likely to be coordinated in advance through bureaucratic and Party channels. Peter Humphrey’s show trial is perhaps a good example of this. No matter the merits, where there is no possibility of appeal the result will be a foregone conclusion.
Humphrey’s case also illustrates the possibility for non-legal factors to play a large role in official proceedings. Sometimes, who one deals with can be as important as what one does.
In practical terms this all means that, once official enforcement action has begun, it is too late to exercise any real control over the situation. It is much better to scrupulously comply with the law, and to carefully manage one’s personal relations in the first place.
Ultimately, China’s underdeveloped culture of compliance may be both the most fundamental cause and most important result of its underdeveloped rule of law.
Chinese individuals, like people everywhere, are naturally reluctant to comply with the law when to do so is costly to them. But the underdeveloped legal system enables non-compliance. And the lack of voluntary compliance in turn directly undermines the policy power of law, and also the ‘rule of law’ as an ethical imperative in the broadest cultural sense.
Clearly, one lesson is that, if it will not be provided by society, companies themselves must inculcate a culture of compliance in their own businesses.
China’s lack of ‘rule of law’ and its approach to ‘rule by law’ may create both challenges and opportunities for foreign enterprises here. But foreign companies should not assume that a lower standard of compliance should prevail here than at home. They should commit to full compliance in China.
Top local management and overseas headquarters should be actively involved in compliance processes in order to send the appropriate message from the top, ensure consistency with global best practices, and help build a culture of compliance within organisations here.
Vistra is a global independent provider of trust, fiduciary, corporate and fund services, with 30 offices in 22 jurisdictions. Pinsent Masons LLP is a London-based international law firm that has been in Greater China for over 30 years.