China is hurtling along the path of technological advancement and investors are facing a whole new world of opportunity and growth
China is in the midst of a technological revolution. With the development of telecommunications infrastructure and a rapid increase in the internet penetration rate comes a voracious appetite for technology related services and media content. “People talk about the potential of a ‘colour’ revolution in China. Basically, because the population is rapidly becoming much more educated and financially prosperous, there’s an increase in demand for the sorts of services that people were less likely to demand when they were less educated and less prosperous. They want content, they want to read about interesting ideas, and they want access to that sort of stimulus,” says Connie Carnabuci, a partner at Freshfields Bruckhaus Deringer.
China has the greatest number of Internet users in the world and yet the penetration rate amongst its population is relatively low. If you add to this the size of the country and its large – and increasingly wealthy – population, you’ll start to see why investors are racing to be a part of the TMT sector in China. Meanwhile, the Chinese government is straining to resolve the balance between the demands of its populace and its desire to maintain control over telecommunications and the media.
Regulations versus technology
Lawyers in the region all point to the challenges presented by a developing legal framework. A case in point is the public spat between the Ministry of Culture (MOC) and the General Administration of Press and Publication (GAPP) in respect to the regulation of online gaming.
In China, an online game is a cultural product and accordingly, online game operators require a cultural product-operating permit from MOC. As an online game is ‘published’ on the Internet, GAPP has jurisdiction over its publication and a publishing permit is required. “There is confusion – you go to GAPP and MOC for a permit but who is responsible for regulation?” says Jeanette Chan, a partner at Paul Weiss. “The State Council has issued three principles which set forth in general terms how the media sector is to be regulated, and this includes online games, but it is not very clear.”
Both GAPP and MOC have issued conflicting notices which expands on their authority over the implementation and management of online games. “While we recognise that there are different layers of government administration over the sector, we certainly do not wish to see any conflicts or loopholes that it may create, and hope that along with the rapid development of the industry there will be more coherency and certainty in the regulatory environment,” says Anthony Zhao, a partner at Zhong Lun.
Online gaming operators are now in a state of limbo about their operations while the debate continues. “Our online gaming clients are a bit confused. Our advice is to ‘watch this space’, keep doing what you’re doing and continue to get permits from both MOC and GAPP,” says Chan. In the meantime, a solution may come only from the State Council or from the Propaganda Department of the Chinese Communist Party.
Foreign investment
In China’s online gaming business, foreign investment is not permitted. However, foreign investors have long circumvented prohibitions against direct foreign investment in certain sectors in China, including the internet sector, through the use of the variable interest entity (VIE) structure. This involves contractual arrangements between a wholly foreign-owned domestic entity and a domestic license-holding operating entity. Lawyers working within the TMT sector in China are very familiar with the VIE structure and its use has long been tolerated by regulatory authorities in China.
However, the recent release of a joint notice by GAPP, the National Copyright Administration, and the “National Office of Combating Pornography and Illegal Publications” (Notice 13) has thrown up some confusion about the validity of the VIE structure. "It prohibits foreign investors from entering into arrangements to gain control over online gaming operators. It’s noteworthy that Notice 13 to date has not been endorsed by other PRC government authorities, in particular the Ministry of Commerce and the Ministry of Information Industry,” says Morrison & Foerster’s Shanghai office managing partner, Charles Comey. “This is one in a continuing series of pronouncements in an area in which we expect further developments. It is premature at this point to write off the VIE structure,” he adds. With all this uncertainty, foreign investors in online gaming in China will no doubt be turning to their lawyers for regulatory advice.
Consolidation
As the TMT sector faces increasing competition and demand for services, many smaller companies are looking to consolidate with other TMT players to either obtain or maintain a share of the market. For example, Paul Weiss’ Chan recently acted for The Carlyle Group in a US$1.8bn deal to create the largest pay-TV operator in Taiwan. And Carlyle Asia Partners exchanged its holdings in kBro, a large cable TV operator, to become the second largest shareholder in Taiwan Mobile Co (TWM). “Other cable operators are going to follow suit, a Telco merger or a combination,” says Chan. “They are getting together and asking ‘what can we do together?’ We can share the resources – amortise amongst different users.”
Other media operators are also seeking consolidation: VisionChina Media (VCM) entered into an agreement to acquire all of the shares in Digital Media Group (DMG). The merged company will combine VCM’s outdoor digital network and DMG’s national subway network to create the largest mobile television advertising network in China. “This transaction exemplifies the emerging strength of the Chinese technology economy, [and] it also highlights a growing consolidation in the Chinese media sector,” said David Lee, a partner at Orrick, Herrington & Sutcliffe, who advised DMG on the transaction.
Consolidation is also likely to occur in the outsourcing market where domestic IT outsourcing companies will seek consolidation to form a force against foreign competitors.
Outsourcing – China versus India
The Chinese government has identified the IT outsourcing sector as an area in which the nation can excel, in much the same way as China became a global leader in manufacturing. “If you look at it, it’s almost like a sleeping giant. The amount companies spend on services is staggering, the peripheral support for computers is huge,” says Geofrey Master, partner at Mayer Brown JSM. “China has very much been looking to the amazing experience that India has had and has targeted the development of the services industry. China sees huge potential in being a service provider to the world.”
The country has grand ambitions to develop its domestic expertise in the outsourcing industry. “China wants to be a world leader in the provision of outsourcing services, to compete with and surpass India for being the country of choice for offshoring multi-national corporations,” says Mark Parsons, counsel at Freshfields Bruckhaus Deringer. To that end, the Chinese government is currently stimulating the growth of an IT outsourcing sector and encouraging people to embrace outsourcing. It has introduced tax incentives and invested in resources to train its workforce.
Yet although the outsourcing market in China is growing, it is still very fragmented. China hasn’t yet built up the expertise and confidence that the big providers in India have – the reality is that Chinese outsourcing companies face a steep development curve in this sector. “Customers will expect defined services, service levels and solid methodology. [The contract] allows the supplier and the customer to work together to give the customer a level of assurance that in fact what it thinks it is going to receive and what it needs to receive is what it is going to receive. It elevates the contract to a position it hasn’t historically been in,” says Master.
The success of China’s outsourcing sector will also depend on the development of language skills and an understanding of the protection of IPR.
IP rights
The protection of intellectual property rights in China is an issue that looms large. Any large multi-national corporation is going to think carefully about its IP, when making the decision to outsource its IT services to a provider in China. There is always the risk of a breach of IP rights anywhere in the world, but the framework in China which regulates IP rights is still relatively young. This means that the cultural awareness of IP rights and what constitutes a breach of IP rights is still developing. “You’ve got to have in your business plan a line item for how you will implement an IP strategy. You can’t go into China and register your IP and think you’ll be fine… I am a big believer in self-help,” says Carnabuci. Enforcing IPR through the legal system is a viable option but it should be viewed as a last resort. There are better ways of minimising the risk of something being misappropriated. This means establishing security systems and processes to prevent an initial breach of IP rights.
The Chinese government has highlighted the importance of IP rights and is working on educating people about the value of intangible property. The landscape is changing and as confidence grows, business activity will increase as well.
On the horizon
Given the huge potential for growth in China there continues to be an enormous amount of interest in the TMT sector, from both foreign and domestic players. However, despite strong consumer demand for technology and media, China has not been immune to the effects of the financial crisis. It comes as no surprise that TMT lawyers have also taken a bit of a hit. “There has been a change in the deals that we are doing. Before the GFC, there were a lot of M&A or securities-related transactions – a lot of deals from private equity funds or other industrial players that would like to expand their market share in China very quickly,” says Janet Hui, partner at Jun He. “All of a sudden they stopped, but it was in line with the market. We are now acting for industrial players who think that this is the right time to expand their business in China. These are long-term investors who are less affected by the GFC and are committed to China.”
Hui also points out that clients are still concerned about funding and so price remains an issue. “Before the crash the prices went up like crazy, but now it needs to get to a more realistic level,” she says. Investors remain conservative – and perhaps even over-cautious – about committing to deals. However, there is an increase in enquiries from clients and Hui predicts that activity will pick up in 2010.
This is a sentiment shared amongst other law firms. As a strategic move to capture the growing outsourcing market, Master recently relocated to Hong Kong to drive Mayer Brown JSM’s business & technology sourcing practice in Asia. “As a specialty group, we believe that the region warrants it. We will support transactions that are coming into the region but also those [domestic] companies that are developing and require global capabilities,” he says.
Carnabuci and Parsons also have observed an increase of work flowing in from the consolidation of the outsourcing market and contracts, both domestically and globally, for outsourcing services. “In terms of outsourcing, there’s a huge amount of potential work for the banks – both for Chinese domestic banks and foreign banks, who are setting up presences within China. On the outsourcing side, we typically find ourselves acting on the customer end,” says Carnabuci.
M&A work will continue – though it will be slow and investors may choose to cherry-pick assets. Certainly, some are taking advantage of the times and investigating if there are any bargains to be had. Lawyers will also be closely monitoring regulatory changes within China. In particular, advice work on regulatory changes and compliance may arise as a result of the restriction of foreign investment in the TMT sector. Lawyers may have to be ready with alternatives or more creative solutions to circumvent prohibitions if such restrictions eventuate. ALB
