Investing in China: What Every Investor Must Know

An investor must fully understand the corporate structure and the assets from which the debt can be collected to appreciate the risk of recovery upon default. Given the PRC's rules regarding foreign investments, it is common for this type of investment in China to occur via a “reverse merger.” A common form of “reverse merger” occurs, for example, when a U.S. public company shell acquires 100% of the stock of a company that directly or indirectly owns assets in China. Often, the U.S. public company shell acquires 100% of the stock of another corporate shell, often formed in another jurisdiction such as the British Virgin Islands (BVI), which in return owns 100% of the stock of the Chinese corporate entities. The US public company shell, whose only asset is the stock in the BVI entity in this example, goes to the public market and raises debt ' frequently, unsecured bond debt. The monies raised through the U.S. public market are then invested in the PRC subsidiaries indirectly owned by this U.S. public company. Therefore, with reverse mergers, an investor must recognize the limitations of recovery in the event of default. With this structure, the investors can only look to an equity interest for recovery on their investment and the investor will be one or two tiers removed from the PRC assets, which comprise the value of that equity interest.

In order to ensure some controls, it may be helpful to have independent board members on the U.S. public company board who are based in the U.S. and are familiar with U.S. public company requirements. The importance of independent board members is evident in the case of ShengdaTech, Inc.

ShengdaTech was the result of a “reverse merger.” It indirectly owned five PRC subsidiaries. Through the public bond market, it raised more than $230 million in bond debt. In March 2011, ShengdaTech's auditors discovered possible discrepancies in the company's financial records, and by summer 2011, various federal securities class actions had been filed. In August 2011, the company filed a Chapter 11 bankruptcy case to preserve assets for the bondholders. ShengdaTech's Chapter 11 filing was authorized and directed by a special committee of the board comprised of the independent directors, two of whom were based in the U.S. Absent the actions of these U.S. independent directors, the actions of the bondholders seeking to recover their monies may have been thwarted.

The Importance of 'Chops' And Business Licenses in China

One of the most striking legal differences between the U.S. and the PRC is the manner in which transactions are authenticated. While signatures are typically used to validate documents, create binding contracts or to execute corporate transactions in the U.S., the PRC principally relies on “chops” (or seals) to perform the same functions.

There are many kinds of chops. The Official Company Chop is the most important one, providing the bearer the authority to conduct business activities and to legally bind the company. This chop is required on all official business documents, including contracts, company memoranda, bank account applications and documents filed with the government. PriceWaterhouseCoopers, Insight into Company Chops (Seals) in China, available at download.pwc.com/ie/pubs/insight_into_company_chops_in_china.pdf. The Legal Representative Chop represents the signature of the PRC subsidiary's designated legal representative, who is often the PRC company's Board Chairman or CEO/General manager. This chop, usually used in combination with the Company Official Chop, is required for official documents, including applications for business licenses and tax certificates. Id. The Finance Chop is required for banking transactions, including withdrawals, transfers, and changes to account information. The Contract Chop can be used in place of the Company Official Chop, but can only be used for to execute contracts, while the Human Resources Chop is used for validating human resource activities, including execution of labor contracts and registering employees with governmental bodies. Id. Finally, some companies also have a Tax Invoice Chop for the purpose of validating their tax invoices. Id.

Because the person who controls the chops (and business license) controls the PRC company, there should be sufficient internal controls to protect the security, location and proper use of the chops. Absent control of the PRC company, the investor, who is looking to recover equity value in such company, may be unable to realize any value.

The Limitations of PRC Civil Litigation

PRC civil proceedings are quite different from those in the United States. First, unlike in this country, where a case is commenced by the filing of a lawsuit, in China, any potential case must be “accepted” by the court and is not considered filed until it is accepted by the court. Nanping Liu & Michelle Liu, Justice Without Judges: The Case Filing Division in the People's Republic of China, 17 U.C. Davis J. Int'l L. & Pol'y 283 (2011); see also Donald C. Clarke, Case Acceptance in Chinese Courts, March 24, 2012, available at lawprofessors.typepad.com/china_law_prof_blog/2012/03/case-acceptace-in-chinese-courts.html.

While the U.S. has similar proceedings in the context of the motion to dismiss or motion for summary judgment, wherein the parties argue whether the plaintiff's case warrants a trial, in PRC courts, such decision is made by the judge. Clarke, Case Acceptance in Chinese Courts. The judge may require the plaintiff to modify the case with additional evidence or modified relief before the case is accepted. During this stage of the lawsuit, the defendant is not involved or notified about the case. Once the case is accepted by the court, which may be a multi-week or month process, the defendant will be served by the court, either by personal service or, if personal service is not possible, by publication notice. After the defendant is served, the case proceeds in a manner similar to U.S. proceedings.

At trial, typically the plaintiff will be successful given that all evidence proving up the case had to be presented to the judge in order to obtain acceptance of the case. However, once obtaining a judgment in China, the “[l]ack of enforcement of court decisions continues to be a major problem” due to, among other things, “local protectionism, continued intervention in cases by party-state officials and administrative departments, an undeveloped credit system, and weak punishment for non-compliance with court orders.” Benjamin L. Liebman, China's Courts: Restricted Reform, 2007 China Q. 620, 626.

That said, litigating in China is worthwhile. While these cases may move slowly and enforcement of any judgment may be questionable, these cases can create pressure to force resolution of the dispute and force recovery of some or all of the defaulted investment.

PRC Criminal Proceedings Can Be More Effective in Recovering Assets

While fraud is recognized both in the civil and criminal context under PRC law, the intent required to prove criminal fraud is higher. Henry (Litong) Chen & Carlo Carani, Civil Fraud v. Criminal Fraud: Criminal Proceedings Not a Silver Bullet to Resolve Business Disputes in China, Bloomberg Law Reports (2010), available at www.mwe.com/info/pubs/Civil Fraud v. Criminal Fraud ' Criminal Proceedings Not a Silver Bullet to Resolve Business Disputes in China.pdf.

Therefore, a criminal case may be rejected, but a civil case accepted, on the basis of the same facts. If a criminal case is accepted, its mere existence will remove the burden of proof from the plaintiff, who can then “leverage the state's power to investigate and collect evidence critical to the legal dispute. Facts already accepted as evidence in criminal proceedings are generally automatically accepted by the [civil] court and do[ ] not require an additional acceptance for civil proceedings.” Id. at 5. Thus, a criminal action may prompt the cooperation of otherwise non-responsive wrongdoers and facilitate recovery of value.

U.S. Courts Can Provide Only Limited Relief

Because PRC courts do not enforce U.S. judgments, it often makes sense to sue a PRC company or individual in the U.S. only if that person or company has assets in the U.S. or in a country that recognizes U.S. judgments. Dan Harris & Rebecca Carlson, Suing Chinese Companies: The New Wave, Bloomberg Law Reports (2011), available at www.harrismoure.com/news-events/publications/bloomberg-law-report-suing-chinese-companies-new-wave.
In addition, discovery is likely to be limited despite the U.S.'s broad discovery provisions, because PRC companies “often consider compliance to be optional,” id., and the PRC does not permit American attorneys in China to take depositions for use in foreign courts. Notwithstanding these limitations, pursing litigation in the U.S. will be beneficial to recover U.S. assets or to place pressure on management to force a deal addressing repayment of the defaulted investment.

Time-Consuming Paperwork and Bureaucratic Delays

Even with a PRC subsidiary's chops safely in hand, it can be unexpectedly time-consuming to obtain the documents needed to institute an effective legal proceeding to recover assets or to take control of bank accounts or other assets of the PRC subsidiary. PRC courts (and PRC banks) typically require that documents generated outside China, such as corporate resolutions by a holding or parent company, be first notarized and then apostilled by a Chinese embassy or consulate in the country of origin pursuant to the 1961 Hague Convention abolishing the Requirement of Legalization for Foreign Public Documents. See generally Dan Harris, Litigating in China, China Law Blog, March 6, 2012, available at www.chinalawblog.com/2012/03/litigation-in-china.html. While this process is not necessarily complex, it can be time-consuming and increase costs if there are many documents that need to be formalized in this way.

PRC Privacy and Secrecy Laws

Finally, PRC banking and secrecy laws constitute another hurdle in obtaining financial information regarding a U.S.-listed company with assets in the PRC. A PRC bank may object to providing information regarding corporate assets or deposits, much less freezing a PRC bank account, even if there is a U.S. court order requiring as much. In addition, auditors of US public companies, with assets in China, have also refused to produce their audit work papers to the SEC or others investigating or pursuing litigation based upon PRC privacy and secrecy laws. Feng Jianmin, Auditors' Chinese Branches Accused of Breaking U.S. law, Shanghai Daily, Dec. 5, 2012. In short, these PRC secrecy and privacy laws can cause additional hurdles and delay for investors when their investment goes south. Investors must be prepared to navigate these laws.

Conclusion

Investing in a U.S.-listed company with PRC assets or subsidiaries requires both a working knowledge of the PRC legal and business environment, and advance planning to implement the internal controls necessary to protect the chops and licenses that are key to controlling assets in order to protect down-side risk and facilitate recovery of assets in the event an investment “goes south” ' whether via litigation or otherwise. Potential investors should take care to research these issues with respect to a particular company before investing or to require the company to adequately address these issues prior to such investment.

Nancy A. Peterman is chair of Greenberg Traurig's Chicago Business Reorganization & Financial Restructuring Practice. Miriam G. Bahcall is a Litigation Shareholder in the Chicago office; Michael R. Cedillos is a Litigation Associate in the same office. They may be reached at [email protected], [email protected] and [email protected], respectively.

There are many companies listed on U.S. stock exchanges whose assets are located in China. Recently, many of these companies have faced increased scrutiny by their shareholders, bondholders, other investors and the Securities and Exchange Commission (SEC). The SEC is reportedly investigating many of these companies for alleged accounting fraud. In addition, in the first half of 2011 alone, 24 federal securities class actions were filed against U.S. public companies with substantially all of their assets in China, accounting for 25.5% of all filings in the first half of 2011. Stanford Law School Securities Class Action Clearinghouse, Securities Class Action Filings Decrease Moderately in First Half of 2011, According to Mid-Year Report, July 26, 2011. See www.cornerstone.com/securities-filings-mid-year-2011. Such cases arise out of a variety of difficulties, from theft of trade secrets to significant discrepancies in financial information.

While not all such investments will result in SEC investigations or securities litigation, it is important to understand the risks associated with investing in a company whose principal assets are located in the People's Republic of China (the PRC or China) ' in particular, the risks associated with collecting a defaulted or troubled investment in such companies.

The 'Reverse Merger' and Its Risks

An investor must fully understand the corporate structure and the assets from which the debt can be collected to appreciate the risk of recovery upon default. Given the PRC's rules regarding foreign investments, it is common for this type of investment in China to occur via a “reverse merger.” A common form of “reverse merger” occurs, for example, when a U.S. public company shell acquires 100% of the stock of a company that directly or indirectly owns assets in China. Often, the U.S. public company shell acquires 100% of the stock of another corporate shell, often formed in another jurisdiction such as the British Virgin Islands (BVI), which in return owns 100% of the stock of the Chinese corporate entities. The US public company shell, whose only asset is the stock in the BVI entity in this example, goes to the public market and raises debt ' frequently, unsecured bond debt. The monies raised through the U.S. public market are then invested in the PRC subsidiaries indirectly owned by this U.S. public company. Therefore, with reverse mergers, an investor must recognize the limitations of recovery in the event of default. With this structure, the investors can only look to an equity interest for recovery on their investment and the investor will be one or two tiers removed from the PRC assets, which comprise the value of that equity interest.

In order to ensure some controls, it may be helpful to have independent board members on the U.S. public company board who are based in the U.S. and are familiar with U.S. public company requirements. The importance of independent board members is evident in the case of ShengdaTech, Inc.

ShengdaTech was the result of a “reverse merger.” It indirectly owned five PRC subsidiaries. Through the public bond market, it raised more than $230 million in bond debt. In March 2011, ShengdaTech's auditors discovered possible discrepancies in the company's financial records, and by summer 2011, various federal securities class actions had been filed. In August 2011, the company filed a Chapter 11 bankruptcy case to preserve assets for the bondholders. ShengdaTech's Chapter 11 filing was authorized and directed by a special committee of the board comprised of the independent directors, two of whom were based in the U.S. Absent the actions of these U.S. independent directors, the actions of the bondholders seeking to recover their monies may have been thwarted.

The Importance of 'Chops' And Business Licenses in China

One of the most striking legal differences between the U.S. and the PRC is the manner in which transactions are authenticated. While signatures are typically used to validate documents, create binding contracts or to execute corporate transactions in the U.S., the PRC principally relies on “chops” (or seals) to perform the same functions.

There are many kinds of chops. The Official Company Chop is the most important one, providing the bearer the authority to conduct business activities and to legally bind the company. This chop is required on all official business documents, including contracts, company memoranda, bank account applications and documents filed with the government. PriceWaterhouseCoopers, Insight into Company Chops (Seals) in China, available at download.pwc.com/ie/pubs/insight_into_company_chops_in_china.pdf. The Legal Representative Chop represents the signature of the PRC subsidiary's designated legal representative, who is often the PRC company's Board Chairman or CEO/General manager. This chop, usually used in combination with the Company Official Chop, is required for official documents, including applications for business licenses and tax certificates. Id. The Finance Chop is required for banking transactions, including withdrawals, transfers, and changes to account information. The Contract Chop can be used in place of the Company Official Chop, but can only be used for to execute contracts, while the Human Resources Chop is used for validating human resource activities, including execution of labor contracts and registering employees with governmental bodies. Id. Finally, some companies also have a Tax Invoice Chop for the purpose of validating their tax invoices. Id.

Because the person who controls the chops (and business license) controls the PRC company, there should be sufficient internal controls to protect the security, location and proper use of the chops. Absent control of the PRC company, the investor, who is looking to recover equity value in such company, may be unable to realize any value.

The Limitations of PRC Civil Litigation

PRC civil proceedings are quite different from those in the United States. First, unlike in this country, where a case is commenced by the filing of a lawsuit, in China, any potential case must be “accepted” by the court and is not considered filed until it is accepted by the court. Nanping Liu & Michelle Liu, Justice Without Judges: The Case Filing Division in the People's Republic of China, 17 U.C. Davis J. Int'l L. & Pol'y 283 (2011); see also Donald C. Clarke, Case Acceptance in Chinese Courts, March 24, 2012, available at lawprofessors.typepad.com/china_law_prof_blog/2012/03/case-acceptace-in-chinese-courts.html.

While the U.S. has similar proceedings in the context of the motion to dismiss or motion for summary judgment, wherein the parties argue whether the plaintiff's case warrants a trial, in PRC courts, such decision is made by the judge. Clarke, Case Acceptance in Chinese Courts. The judge may require the plaintiff to modify the case with additional evidence or modified relief before the case is accepted. During this stage of the lawsuit, the defendant is not involved or notified about the case. Once the case is accepted by the court, which may be a multi-week or month process, the defendant will be served by the court, either by personal service or, if personal service is not possible, by publication notice. After the defendant is served, the case proceeds in a manner similar to U.S. proceedings.

At trial, typically the plaintiff will be successful given that all evidence proving up the case had to be presented to the judge in order to obtain acceptance of the case. However, once obtaining a judgment in China, the “[l]ack of enforcement of court decisions continues to be a major problem” due to, among other things, “local protectionism, continued intervention in cases by party-state officials and administrative departments, an undeveloped credit system, and weak punishment for non-compliance with court orders.” Benjamin L. Liebman, China's Courts: Restricted Reform, 2007 China Q. 620, 626.

That said, litigating in China is worthwhile. While these cases may move slowly and enforcement of any judgment may be questionable, these cases can create pressure to force resolution of the dispute and force recovery of some or all of the defaulted investment.

PRC Criminal Proceedings Can Be More Effective in Recovering Assets

While fraud is recognized both in the civil and criminal context under PRC law, the intent required to prove criminal fraud is higher. Henry (Litong) Chen & Carlo Carani, Civil Fraud v. Criminal Fraud: Criminal Proceedings Not a Silver Bullet to Resolve Business Disputes in China, Bloomberg Law Reports (2010), available at www.mwe.com/info/pubs/Civil Fraud v. Criminal Fraud ' Criminal Proceedings Not a Silver Bullet to Resolve Business Disputes in China.pdf.

Therefore, a criminal case may be rejected, but a civil case accepted, on the basis of the same facts. If a criminal case is accepted, its mere existence will remove the burden of proof from the plaintiff, who can then “leverage the state's power to investigate and collect evidence critical to the legal dispute. Facts already accepted as evidence in criminal proceedings are generally automatically accepted by the [civil] court and do[ ] not require an additional acceptance for civil proceedings.” Id. at 5. Thus, a criminal action may prompt the cooperation of otherwise non-responsive wrongdoers and facilitate recovery of value.

U.S. Courts Can Provide Only Limited Relief

Because PRC courts do not enforce U.S. judgments, it often makes sense to sue a PRC company or individual in the U.S. only if that person or company has assets in the U.S. or in a country that recognizes U.S. judgments. Dan Harris & Rebecca Carlson, Suing Chinese Companies: The New Wave, Bloomberg Law Reports (2011), available at www.harrismoure.com/news-events/publications/bloomberg-law-report-suing-chinese-companies-new-wave.
In addition, discovery is likely to be limited despite the U.S.'s broad discovery provisions, because PRC companies “often consider compliance to be optional,” id., and the PRC does not permit American attorneys in China to take depositions for use in foreign courts. Notwithstanding these limitations, pursing litigation in the U.S. will be beneficial to recover U.S. assets or to place pressure on management to force a deal addressing repayment of the defaulted investment.

Time-Consuming Paperwork and Bureaucratic Delays

Even with a PRC subsidiary's chops safely in hand, it can be unexpectedly time-consuming to obtain the documents needed to institute an effective legal proceeding to recover assets or to take control of bank accounts or other assets of the PRC subsidiary. PRC courts (and PRC banks) typically require that documents generated outside China, such as corporate resolutions by a holding or parent company, be first notarized and then apostilled by a Chinese embassy or consulate in the country of origin pursuant to the 1961 Hague Convention abolishing the Requirement of Legalization for Foreign Public Documents. See generally Dan Harris, Litigating in China, China Law Blog, March 6, 2012, available at www.chinalawblog.com/2012/03/litigation-in-china.html. While this process is not necessarily complex, it can be time-consuming and increase costs if there are many documents that need to be formalized in this way.

PRC Privacy and Secrecy Laws

Finally, PRC banking and secrecy laws constitute another hurdle in obtaining financial information regarding a U.S.-listed company with assets in the PRC. A PRC bank may object to providing information regarding corporate assets or deposits, much less freezing a PRC bank account, even if there is a U.S. court order requiring as much. In addition, auditors of US public companies, with assets in China, have also refused to produce their audit work papers to the SEC or others investigating or pursuing litigation based upon PRC privacy and secrecy laws. Feng Jianmin, Auditors' Chinese Branches Accused of Breaking U.S. law, Shanghai Daily, Dec. 5, 2012. In short, these PRC secrecy and privacy laws can cause additional hurdles and delay for investors when their investment goes south. Investors must be prepared to navigate these laws.

Conclusion

Investing in a U.S.-listed company with PRC assets or subsidiaries requires both a working knowledge of the PRC legal and business environment, and advance planning to implement the internal controls necessary to protect the chops and licenses that are key to controlling assets in order to protect down-side risk and facilitate recovery of assets in the event an investment “goes south” ' whether via litigation or otherwise. Potential investors should take care to research these issues with respect to a particular company before investing or to require the company to adequately address these issues prior to such investment.

Nancy A. Peterman is chair of Greenberg Traurig's Chicago Business Reorganization & Financial Restructuring Practice. Miriam G. Bahcall is a Litigation Shareholder in the Chicago office; Michael R. Cedillos is a Litigation Associate in the same office. They may be reached at [email protected], [email protected] and [email protected], respectively.