Are Western Firms Growing Too Fast in China?

Seeking to reestablish the rule of law in the aftermath of the Cultural Revolution, China's government in 1980 set an ambitious goal: increase the number of licensed Chinese lawyers by 50-fold. Twenty-six years later, the aspiration has almost been realized. China's domestic legal industry has about 122,000 lawyers, compared to 3000 in 1980. Now the government may be turning its attention from adding to the ranks of those lawyers to protecting their business ' at the expense of foreign firms looking to strengthen their presence in China.

A scathing memo passed unanimously by the Shanghai Bar Association on April 17 accused foreign firms of 'threatening China's legal system and economic safety' [see, The American Lawyer, Bar Talk, 'Walk the Line,' August 2006]. Among other things, the memo accused foreign lawyers of illegally practicing Chinese law, evading taxes, engaging in false advertising, and establishing or controlling Chinese firms. Foreign lawyers have long been barred from practicing Chinese law, but the specifics are vague. Under a regulation that took effect in 2002, foreign firms can 'provide information about the legal environment in China, but not interpretation of the applicability of Chinese laws.' Appearing in court and writing opinions are clearly off-limits, but advising clients about specific Chinese laws and domestic legal strategies is murkier. Although the bar association does not legislate, the menacing memo hinted at a future crackdown. (Fearing potential sanctions, foreign lawyers declined to comment on the record about the matter for this article.)

For the hundreds of foreign firms operating in China, the effect of new restrictions could be wide-ranging. Hildebrandt International, Inc., estimates that there are 250 foreign firm offices in China; last year alone, 14 firms set up shop there. Most of these are small outposts, staffed by fewer than 10 expatriate lawyers on 2-year junkets.

Much of the highest-profile corporate work coming out of China, such as the initial public offerings of China's Big Four banks, was handled by New York firms with small Chinese operations. Skadden, Arps, Slate, Meagher & Flom, which represented China Construction Bank in its $9.2 billion IPO last year, lists 27 lawyers in Hong Kong and seven in Beijing. Davis Polk & Wardwell, which represented the underwriters in the IPO, has 16 lawyers in Hong Kong. But a handful of Western firms are trying a different approach, moving beyond the traditional outpost strategy and aggressively expanding into the market. They include Baker & McKenzie; Latham & Watkins; Jones Day; Morrison & Foerster; O'Melveny & Myers; and Paul, Hastings, Janofsky & Walker. Taking a cue from Chinese mythology, these firms aim to be dragons: huge, strong, and ready to burn their way across China's legal landscape. That is, if the government lets them. Although the memo doesn't single out any firm or lawyer, it's clear that the Shanghai Bar Association is hunting for dragons.

The would-be dragons usually have at least 25 lawyers in mainland China, divided between offices in Beijing and Shanghai. They are doggedly expanding, competing for high-stakes work, aggressively hiring talent, and fighting to keep their rates high without losing business. The firms are staffed by two groups of lawyers: foreign-born lawyers who see China as a life choice, and local Chinese who ' although forbidden to practice Chinese law while employed by a non-Chinese firm ' are attracted by the Western firms' higher salaries and international prestige.

They also are homing in on high-end, complex transactions: multi-jurisdictional private equity, capital markets, and mergers and acquisitions matters. It's a departure from the sort of work that large firms have traditionally found in China. Until recently, clients focused on making joint investments with Chinese partners ' building manufacturing plants, for instance. So law firms picked up matters related to joint venture negotiations, technology transfer, foreign exchange control, and labor and tax law. Lately, though, such direct investment has tapered off, as clients look to such cheaper locales as Vietnam and Malaysia. And much of the remaining direct investment in China has become less lucrative. 'Over time its gotten more commoditized, especially at the lower end,' says Shanghai-based Howard Chao, the head of O'Melveny & Myers's Asia practice. 'A lot of smaller-end work has migrated to Chinese firms.'

Increasingly, dragon firms are pursuing work involving the purchase of existing assets by such investors as private equity firms or venture capitalists ' complex transactions in the hundreds-of-millions-of-dollars range. Most of these matters involve creating new legal structures or modifying existing structures for the Chinese market. In December 2005, for instance, Paul, Hastings represented GZI REIT Asset Management Limited, the first real estate investment trust with exclusively mainland Chinese properties to list on the Hong Kong stock exchange. Paul, Hastings created a new legal structure for the $216 million trust to comply with both Chinese and Hong Kong laws.

Much of the challenge in this sort of work involves reconciling the expectations of corporate clients in New York or Tokyo with the realities of the Chinese market. The Chinese government is a multi-armed bureaucratic beast, so getting deals approved can take much longer than in Western countries. When Latham client The Carlyle Group tried to purchase 85 percent of the state-owned Xugong Group Construction Machinery Co., Ltd., in October 2005, a crackdown on foreign takeovers was the result. New rules enacted by the central government require approvals by the Ministry of Commerce and the China Securities Regulatory Commission on a range of M&A transactions, and reinforce the government's ability to prohibit transactions that would result in foreign control. As a result, approvals on leveraged buyouts may now take as long as 2 years, says Paul, Hastings partner Neil Torpey.

Laws are also often kept deliberately vague to give discretion to local courts and ministries. So foreign lawyers spend a lot of time anticipating which laws will be enacted and interpreting new regulations once they are. 'Every time the Chinese government tries to restrict something, all the clients want to know how to get around it,' says Paul, Hastings real estate partner Joel Rothstein.

Handling such transactions requires some bulk. 'We've finally gotten to the point where we have adequate staff, and even that requires moving people around,' says O'Melveny's Patrick Norton. 'If you get four or five or six deals with $23 million at stake, you can't do it with a small office.' (O'Melveny has 28 lawyers on the mainland and 14 in Hong Kong.) Morrison & Foerster partner Venantius Tan puts the necessary minimum at 30; his firm has 50 lawyers in China ' 24 in Hong Kong and 26 on the mainland, divided equally between Beijing and Shanghai.

Finding bodies can be a challenge. U.S.-educated lawyers often don't understand Chinese law, while lawyers educated in China lack international exposure, says Jones Day's Winston Zhao. The ideal candidate is completely bilingual and bicultural, with big-firm experience and an American legal education. 'I don't think I've done as much recruiting in my career as I've done since I've been here,' says Rothstein. Firms sometimes send young Chinese-born lawyers abroad for several years, reversing the traditional outpost mentality. Finding senior-level lawyers is even harder, because of the legal profession's rapid growth in the last 25 years. 'There are a fair number of quite talented Chinese lawyers, but not too many who are senior enough to run big deals,' Norton says.

And then there is Paul, Hastings's approach. It picked up an entire Chinese firm, merging with Hong Kong's 50-lawyer Koo & Partners in 2002. Koo had two lawyers doing regulatory work in Beijing. Paul, Hastings expanded that office (now at 25 lawyers), and a year later opened an office in Shanghai (now at 42 lawyers). 'I personally don't like to call ourselves a foreign law firm in China because we're licensed here,' says Beijing-based David Livdahl. 'We have some foreigners here, but most of our lawyers are Chinese.'

Latham maintains a smaller head count, with seven lawyers in Shanghai and 16 in Hong Kong. (The firm says it is considering moving into Beijing.) Nonetheless, it has obtained desirable work. It was issuer's counsel on five of the seven Chinese IPOs in the United States last year. Hong Kong partner David Zhang, who joined the firm in 2003 from Dewey Ballantine, says the firm's strategy is to hone in on Securities and Exchange Commission-registered transactions; such deals are a source of compliance matters.

It's not clear exactly how lucrative Latham's IPO work was, though. Zhang says that fee pressure in China is intense, and other foreign firms say privately that Latham got the work due to discounting. 'The goal is to realize our rates, and over time in Asia we've been very successful in making sure that we realize a full rate,' he says.

In a nation obsessed with the bottom line, discounting pressures are a fact of life. Chinese clients often ask for fee caps, contingency arrangements, or flat rates. 'We've repeatedly gone in and bid on work for Chinese companies and offered them very fair rates and found that competitors were offering fixed fees of less than half what we were quoting,' says Norton. Multi-nationals doing business in China have learned from the natives, pushing harder for discounts. For some firms, taking the lower rate can cost money in the short run but pays dividends in branding, especially in high-profile deals. 'The question has always been, 'Once you get your foot in the market, can you ever get fees back up?” Norton says. 'Some firms have been unpleasantly surprised with the results.'

An even bigger question might be whether foreign firms can continue to support their growing operations as the Chinese market changes. Citing Lenovo, Inc.'s successful acquisition of International Business Machine Corporation's personal computer business last year, foreign lawyers say the next big trend is outbound Chinese investment. In a speech in March, Chinese premier Wen Jiabao encouraged Chinese companies to go global, invest internationally, and establish operations abroad.

Livdahl says that outbound work is currently only 10% – 20% of Paul, Hastings's Chinese practice, but he says he expects that percentage to grow. Last year the firm represented China's Semiconductor Manufacturing International Corporation in a Northern District of California patent case against Taiwanese competitor Taiwan Semiconductor Manufacturing Company Ltd.

But as Chinese companies go abroad, so do top Chinese lawyers. The 'Red Circle,' a growing group of Chinese firms mostly run by Western-trained lawyers, is actively pursuing foreign markets. Jun He Law Offices, one of China's top firms, has offices in New York and Hong Kong. King & Wood, a 450-lawyer firm with five offices in mainland China and outposts in Hong Kong, Tokyo, and Palo Alto, plans to hire 100 more lawyers and open an office in New York. The Red Circle firms are getting serious work, sometimes from Western clients. Last year Jun He handled a $3.1 billion investment in Bank of China by The Royal Bank of Scotland Group plc. King & Wood represented China Shenhua Energy Limited in its $2.9 billion IPO in Hong Kong.

Yet even as China encourages its domestic law firms to globalize, the threat of a crackdown looms over foreign firms doing business in China. Will the West's dragons hold their fire? After all, many a Chinese folk tale ends with villagers saving their homes by killing a dragon.

Seeking to reestablish the rule of law in the aftermath of the Cultural Revolution, China's government in 1980 set an ambitious goal: increase the number of licensed Chinese lawyers by 50-fold. Twenty-six years later, the aspiration has almost been realized. China's domestic legal industry has about 122,000 lawyers, compared to 3000 in 1980. Now the government may be turning its attention from adding to the ranks of those lawyers to protecting their business ' at the expense of foreign firms looking to strengthen their presence in China.

A scathing memo passed unanimously by the Shanghai Bar Association on April 17 accused foreign firms of 'threatening China's legal system and economic safety' [see, The American Lawyer, Bar Talk, 'Walk the Line,' August 2006]. Among other things, the memo accused foreign lawyers of illegally practicing Chinese law, evading taxes, engaging in false advertising, and establishing or controlling Chinese firms. Foreign lawyers have long been barred from practicing Chinese law, but the specifics are vague. Under a regulation that took effect in 2002, foreign firms can 'provide information about the legal environment in China, but not interpretation of the applicability of Chinese laws.' Appearing in court and writing opinions are clearly off-limits, but advising clients about specific Chinese laws and domestic legal strategies is murkier. Although the bar association does not legislate, the menacing memo hinted at a future crackdown. (Fearing potential sanctions, foreign lawyers declined to comment on the record about the matter for this article.)

For the hundreds of foreign firms operating in China, the effect of new restrictions could be wide-ranging. Hildebrandt International, Inc., estimates that there are 250 foreign firm offices in China; last year alone, 14 firms set up shop there. Most of these are small outposts, staffed by fewer than 10 expatriate lawyers on 2-year junkets.

Much of the highest-profile corporate work coming out of China, such as the initial public offerings of China's Big Four banks, was handled by New York firms with small Chinese operations. Skadden, Arps, Slate, Meagher & Flom, which represented China Construction Bank in its $9.2 billion IPO last year, lists 27 lawyers in Hong Kong and seven in Beijing. Davis Polk & Wardwell, which represented the underwriters in the IPO, has 16 lawyers in Hong Kong. But a handful of Western firms are trying a different approach, moving beyond the traditional outpost strategy and aggressively expanding into the market. They include Baker & McKenzie; Latham & Watkins; Jones Day; Morrison & Foerster; O'Melveny & Myers; and Paul, Hastings, Janofsky & Walker. Taking a cue from Chinese mythology, these firms aim to be dragons: huge, strong, and ready to burn their way across China's legal landscape. That is, if the government lets them. Although the memo doesn't single out any firm or lawyer, it's clear that the Shanghai Bar Association is hunting for dragons.

The would-be dragons usually have at least 25 lawyers in mainland China, divided between offices in Beijing and Shanghai. They are doggedly expanding, competing for high-stakes work, aggressively hiring talent, and fighting to keep their rates high without losing business. The firms are staffed by two groups of lawyers: foreign-born lawyers who see China as a life choice, and local Chinese who ' although forbidden to practice Chinese law while employed by a non-Chinese firm ' are attracted by the Western firms' higher salaries and international prestige.

They also are homing in on high-end, complex transactions: multi-jurisdictional private equity, capital markets, and mergers and acquisitions matters. It's a departure from the sort of work that large firms have traditionally found in China. Until recently, clients focused on making joint investments with Chinese partners ' building manufacturing plants, for instance. So law firms picked up matters related to joint venture negotiations, technology transfer, foreign exchange control, and labor and tax law. Lately, though, such direct investment has tapered off, as clients look to such cheaper locales as Vietnam and Malaysia. And much of the remaining direct investment in China has become less lucrative. 'Over time its gotten more commoditized, especially at the lower end,' says Shanghai-based Howard Chao, the head of O'Melveny & Myers's Asia practice. 'A lot of smaller-end work has migrated to Chinese firms.'

Increasingly, dragon firms are pursuing work involving the purchase of existing assets by such investors as private equity firms or venture capitalists ' complex transactions in the hundreds-of-millions-of-dollars range. Most of these matters involve creating new legal structures or modifying existing structures for the Chinese market. In December 2005, for instance, Paul, Hastings represented GZI REIT Asset Management Limited, the first real estate investment trust with exclusively mainland Chinese properties to list on the Hong Kong stock exchange. Paul, Hastings created a new legal structure for the $216 million trust to comply with both Chinese and Hong Kong laws.

Much of the challenge in this sort of work involves reconciling the expectations of corporate clients in New York or Tokyo with the realities of the Chinese market. The Chinese government is a multi-armed bureaucratic beast, so getting deals approved can take much longer than in Western countries. When Latham client The Carlyle Group tried to purchase 85 percent of the state-owned Xugong Group Construction Machinery Co., Ltd., in October 2005, a crackdown on foreign takeovers was the result. New rules enacted by the central government require approvals by the Ministry of Commerce and the China Securities Regulatory Commission on a range of M&A transactions, and reinforce the government's ability to prohibit transactions that would result in foreign control. As a result, approvals on leveraged buyouts may now take as long as 2 years, says Paul, Hastings partner Neil Torpey.

Laws are also often kept deliberately vague to give discretion to local courts and ministries. So foreign lawyers spend a lot of time anticipating which laws will be enacted and interpreting new regulations once they are. 'Every time the Chinese government tries to restrict something, all the clients want to know how to get around it,' says Paul, Hastings real estate partner Joel Rothstein.

Handling such transactions requires some bulk. 'We've finally gotten to the point where we have adequate staff, and even that requires moving people around,' says O'Melveny's Patrick Norton. 'If you get four or five or six deals with $23 million at stake, you can't do it with a small office.' (O'Melveny has 28 lawyers on the mainland and 14 in Hong Kong.) Morrison & Foerster partner Venantius Tan puts the necessary minimum at 30; his firm has 50 lawyers in China ' 24 in Hong Kong and 26 on the mainland, divided equally between Beijing and Shanghai.

Finding bodies can be a challenge. U.S.-educated lawyers often don't understand Chinese law, while lawyers educated in China lack international exposure, says Jones Day's Winston Zhao. The ideal candidate is completely bilingual and bicultural, with big-firm experience and an American legal education. 'I don't think I've done as much recruiting in my career as I've done since I've been here,' says Rothstein. Firms sometimes send young Chinese-born lawyers abroad for several years, reversing the traditional outpost mentality. Finding senior-level lawyers is even harder, because of the legal profession's rapid growth in the last 25 years. 'There are a fair number of quite talented Chinese lawyers, but not too many who are senior enough to run big deals,' Norton says.

And then there is Paul, Hastings's approach. It picked up an entire Chinese firm, merging with Hong Kong's 50-lawyer Koo & Partners in 2002. Koo had two lawyers doing regulatory work in Beijing. Paul, Hastings expanded that office (now at 25 lawyers), and a year later opened an office in Shanghai (now at 42 lawyers). 'I personally don't like to call ourselves a foreign law firm in China because we're licensed here,' says Beijing-based David Livdahl. 'We have some foreigners here, but most of our lawyers are Chinese.'

Latham maintains a smaller head count, with seven lawyers in Shanghai and 16 in Hong Kong. (The firm says it is considering moving into Beijing.) Nonetheless, it has obtained desirable work. It was issuer's counsel on five of the seven Chinese IPOs in the United States last year. Hong Kong partner David Zhang, who joined the firm in 2003 from Dewey Ballantine, says the firm's strategy is to hone in on Securities and Exchange Commission-registered transactions; such deals are a source of compliance matters.

It's not clear exactly how lucrative Latham's IPO work was, though. Zhang says that fee pressure in China is intense, and other foreign firms say privately that Latham got the work due to discounting. 'The goal is to realize our rates, and over time in Asia we've been very successful in making sure that we realize a full rate,' he says.

In a nation obsessed with the bottom line, discounting pressures are a fact of life. Chinese clients often ask for fee caps, contingency arrangements, or flat rates. 'We've repeatedly gone in and bid on work for Chinese companies and offered them very fair rates and found that competitors were offering fixed fees of less than half what we were quoting,' says Norton. Multi-nationals doing business in China have learned from the natives, pushing harder for discounts. For some firms, taking the lower rate can cost money in the short run but pays dividends in branding, especially in high-profile deals. 'The question has always been, 'Once you get your foot in the market, can you ever get fees back up?” Norton says. 'Some firms have been unpleasantly surprised with the results.'

An even bigger question might be whether foreign firms can continue to support their growing operations as the Chinese market changes. Citing Lenovo, Inc.'s successful acquisition of International Business Machine Corporation's personal computer business last year, foreign lawyers say the next big trend is outbound Chinese investment. In a speech in March, Chinese premier Wen Jiabao encouraged Chinese companies to go global, invest internationally, and establish operations abroad.

Livdahl says that outbound work is currently only 10% – 20% of Paul, Hastings's Chinese practice, but he says he expects that percentage to grow. Last year the firm represented China's Semiconductor Manufacturing International Corporation in a Northern District of California patent case against Taiwanese competitor Taiwan Semiconductor Manufacturing Company Ltd.

But as Chinese companies go abroad, so do top Chinese lawyers. The 'Red Circle,' a growing group of Chinese firms mostly run by Western-trained lawyers, is actively pursuing foreign markets. Jun He Law Offices, one of China's top firms, has offices in New York and Hong Kong. King & Wood, a 450-lawyer firm with five offices in mainland China and outposts in Hong Kong, Tokyo, and Palo Alto, plans to hire 100 more lawyers and open an office in New York. The Red Circle firms are getting serious work, sometimes from Western clients. Last year Jun He handled a $3.1 billion investment in Bank of China by The Royal Bank of Scotland Group plc. King & Wood represented China Shenhua Energy Limited in its $2.9 billion IPO in Hong Kong.

Yet even as China encourages its domestic law firms to globalize, the threat of a crackdown looms over foreign firms doing business in China. Will the West's dragons hold their fire? After all, many a Chinese folk tale ends with villagers saving their homes by killing a dragon.