Download Information technology, still a relatively new phenomenon, will no

INTERNET UPDATE
NOVEMBER 1999
Investors Willing To Take Risk
In China’s Growing Internet Sector
Author:
Guanxi Zheng - Stikeman Elliott, HK
Information technology, still a relatively new phenomenon, will no doubt be the most
important industrial sector well into the next century. Internet services, as the backbone of this
development, have come to prominence in the last five years in developed countries such as the
USA and Canada, but are even newer in China.
The Internet was only made available to the general public in China in 1997. But within a
short two-year period, Internet accounts have grown to 1.6 million. With a population of
1.3 billion people, and as computer hardware prices and telecommunication fees continue to
fall, the size of the potential market in China is anyone's guess. It is not surprising,
therefore, that many entrepreneurial companies, big and small, from all over the world are
eyeing the Internet sector, and some have already ventured in.
However, China still maintains tight control on its telecommunication services and
dissemination of information. Consequently, many eager companies may unwarily step over
the legal line, potentially placing themselves in an adverse position. This article intends to
examine the regulatory framework for foreign investment in China’s Internet sector. In the
process, the gap between legal provisions and commercial practice as well as the future of
the sector will be discussed. The article will limit its discussion to the regulations governing
Internet Service Providers (ISPs); those governing other components of the Internet sector
(including Internet content providers and Internet presence providers) deserve separate
attention and coverage.
General Legal Prohibition
In 1995, China introduced the Interim Regulations Directing Foreign Investment, which
classified foreign investment in all economic sectors in China into four general categories:
encouraged, permitted, restricted and prohibited. The accompanying Industrial Catalogue,
which was revised on January 1, 1998, then lists all items contained in the categories of
encouraged, restricted and prohibited. By exception, anything not listed in the Industrial
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Catalogue belongs to the permitted category. The Industrial Catalogue (both in 1995 and in
its revision of 1998) clearly provides that the operation and management of
telecommunication services fall within the prohibited category. That is, foreign investors are
legally barred from participating in the operation and management of telecommunication
services in China.
ISPs, although different from traditional telecommunication services, are nevertheless
generally construed as operating and managing telecommunication services and thereby fall
squarely within this legal prohibition.
Although such an interpretation of the
telecommunication services as including ISPs is neither legislative (the drafters of the 1995
Industrial Catalogue might not have had ISPs in mind at all) or judicial in a formal sense, it is
widely accepted. Moreover, such an interpretation is clearly supported by the fact that more
specific regulatory prohibitions regarding the Internet in China also exist.
Specific Legal Bar
Not only is there general legal prohibition of foreign participation in the operation and
management of telecommunication services in China, but a specific legal bar also presents a
hurdle for foreign investors interested in China’s Internet sector. Traditionally, China, like
many other countries, had very tight control over the telecommunication sector, maintaining
a state monopoly. This changed substantially in 1993 when the Ministry of Information
Industry (then the Ministry of Posts and Telecommunications) issued Interim
Administrative Procedures on the Approval For Carrying Out Opened Telecommunication
Business (Interim Telecom Procedures), which came into effect on 1 October 1993.
The Interim Telecom Procedures, for the first time, opened several components of China’s
state-monopolized telecommunication sector to Chinese business entities other than
postal/telecommunication-affiliated enterprises. The opened business areas include, among
others, computer information services, e-mail and electronic data interchange (EDI).
Enterprises wishing to engage in the opened business areas are required, depending on the
specific types of business they will be carrying out, either to obtain approvals from or to
register with governmental authorities in charge of the telecommunication sector. For
example, enterprises intending to engage in businesses relating to computer information
services, e-mail and EDI are required to declare and register with the governmental
authorities. Only after being issued specific licences can they legally provide the specified
telecommunication services.
It is very clear that ISPs belong to the opened
telecommunication areas and so are not subject to the state monopoly.
Unfortunately, however, the Interim Telecom Procedures (Article 6) also expressly provide
that foreign nationals and entities are prohibited from investing, operating/managing or
participating in telecommunication business. This prohibition apparently has broader scope
than the general prohibition discussed earlier. While the general prohibition only affects the
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operation and management of telecommunication business, Article 6 goes beyond that to
also cover investing or otherwise participating in the management of telecommunication
businesses. In addition, Article 6 states that the prohibition applies not only to foreign
nationals and entities but also to wholly owned foreign enterprises, as well as equity and
cooperative joint ventures. In other words, the Interim Telecom Procedures bar foreign
investors not only from directly engaging in the opened telecommunication services but also
from doing so indirectly through foreign-investment enterprises in China. The message is
very clear: foreign involvement in any way in the management and operation of
telecommunication services (including the opened business areas mentioned above) is not
allowed. It appears that the “substance over form” approach is adopted by the regulatory
authorities here. In other words, the regulatory authorities will look to the substance of the
ownership and control of the sector by foreign interests (it does not matter whether such
ownership and control are direct or indirect) rather than focussing on the technical
interpretation or construction of “foreign interests” (i.e. no longer limiting the interpretation
to foreign entities).
The Reality
Notwithstanding the unequivocal legal prohibition discussed above, foreign monies are
flowing into China’s Internet sector and many business plans are being formulated to seek
venture-capital investment in that sector. More recently, many listed companies in Hong
Kong are also reported or announced to be involved in China’s Internet sector, including
acquiring interests in ISPs in China. Apparently, there exists a huge gap between the book
law and business practice. Why is that the case? How are those deals structured in practice?
What are the risks?
Convinced that the ISP sector in China will be a very promising and profitable sector for the
next few years, entrepreneurs and investors (sometimes with local Chinese governments’
assistance and support) are seeking ways to circumvent the legal barriers. In some cases, the
local telecommunication bureaus may be directly involved, or the persons in charge of such
telecommunication bureaus or their relatives may have vested interests in the projects. This
is not surprising in China, as “innovative” structures have been employed to “get around”
express legal provisions restricting or prohibiting foreign investment in sectors such as retail
business and telecommunications (mainly mobile networks) for many years. Foreign
investors are keeping their fingers crossed that the Chinese government will take a lenient
and technical approach in assessing their projects. On the other hand, they hope to be quick
enough to cash in their projects before the Chinese government cracks down on such
innovative schemes. This is certainly the case for some listed companies in Hong Kong
where a mere announcement or a change of name (to connote Internet or high-tech
elements) has driven up significantly the stock price of such companies, sometimes doubling
or tripling it. Given the fact that enforcement generally lags behind the legal provisions,
investors may be more confident that they will be able to withdraw in time.
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As far as the ISP sector is concerned, the general approach taken resembles other
telecommunication deals with foreign-capital involvement. As mentioned, since the current
Chinese legislation does not allow foreign investment in the management and operation of
telecommunication networks in China, foreign investment in that sector has been structured
somewhat differently from investment projects in other sectors. In essence, a PRC
company (PRC Company) will own the network when it is built (including the software and
hardware required in the context of ISPs) and will hold the operating licence. A Sino-foreign
joint venture (Joint Venture) or even a wholly foreign-owned enterprise with the
participation of the foreign investor will build the network, transfer the network when
completed and then provide “consulting services” to the PRC company. The Joint Venture
will receive a consulting fee from the PRC Company, through which the foreign investor
will be able to recoup its investment in the Joint Venture.
The argument for the above structure is that while the current PRC legislation prohibits
foreign investment from managing and operating telecommunication networks in China, it
does allow foreign investors to be involved in constructing the networks. In between these
two extreme alternatives, there exist some grey areas, such as consultancy contracts and
maintenance service contracts. The general wisdom is that if those contracts can be so
drafted that they are classified as ongoing services or consultancy contracts and do not fall
into the area of management and operation, it is unlikely that the legality of the structure
would be challenged. The only proviso is that the structure may be viewed as being against
the spirit of the legislative prohibition. An official crackdown on such grounds cannot be
totally ruled out.
Indeed there has been a precedent for such government action. At the end of 1998, the
Central Government cracked down on the employment of such structures by foreign
investors, who had adopted it in many joint projects with Liantong Corporation (which is
commonly know as “Unicom” and in which several government ministries have invested).
There have been reports that such projects, some of which may even be in the operating
stage, have been ordered to stop. (Incidentally, Unicom is also allegedly working on a
compensation plan for foreign partners in order to make its proposed IPO run smoothly).
Thus, in spite of the wide use of the above structures, the risk for the foreign investor is real
(even for foreign investors who have relied on Unicom’s strong political support from its
ministerial shareholders).
In the case of ISPs, this risk may even be greater. As discussed above, the Interim Telecom
Procedures not only prohibit foreign investment in the operation and management of ISP
business, but also bar foreign investors from investing or otherwise participating in the ISP
business. However, the capital required by ISP businesses is relatively small compared with
that required for other telecom networks, and the payback period may be shorter as well.
Given the potential profitability, many investors appear to believe the risks are worth taking.
Therefore, notwithstanding the legal impediment and the substantial risk, foreign investors
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(including many small investors and listed companies in Hong Kong) are still trying to get
involved in China’s Internet services. And many of them are doing so in direct or indirect
violation of PRC law.
Conclusion and the Future
As the Internet sector is generally perceived to be lucrative, foreign investors are keen to
enter it regardless of the current legal prohibitions. Notwithstanding the apparent legal risks,
many foreign investors are gambling that the sector will be liberalized soon, once China
formally joins the WTO. It is certainly true that the further opening of China’s
telecommunication sector in general is inevitable. There has been current discussion that
foreign investors may be formally permitted to hold certain non-controlling interests in
telecommunication enterprises.
That, however, was once thought not to be true for the Internet sector specifically based on
the publicized official line. In response to the recent wave of acquisitions of Internet-related
interests of Chinese companies by listed companies in Hong Kong, the Minister of
Information Industry, Mr. Wu Jichuan, has recently reiterated firmly the government’s
position that foreign investors cannot participate in China’s Internet sector. It appears that
the Chinese government may tolerate the passive involvement of venture capital in the
country’s Internet sector but does not tolerate more active participation of foreign investors
(such as listed companies in Hong Kong), which may also derive from political
considerations. Notwithstanding the rather firm statement by the Minister, history seems to
be on the investor’s side. On November 15, 1999, China and the U.S. formally concluded
the U.S. - China Bilateral WTO Agreement which paves the way for China’s accession to the
WTO. According to the agreement, China will allow foreign investors to hold up to 50
percent ownership in this sector within two years after its accession. Within the opening of
the gate, it can be reasonably expected that competition will heat up in the China’ growing
Internet sector.