HARD TO FOLLOW
China’s economic referees are starting to enforce a staggering number of new laws. Will the result be clarity or chaos?
By Don Durfee

A choking gray haze that hangs over the cities. Appalling working conditions, with some employees—adults and children—in a state of virtual indentured servitude.
Food safety scares. Collusion between businesses and local officials. A central government more concerned with growth than regulation.

The United States of the 1890s was a country with big problems. Industrialization had propelled the nation into the ranks of the world’s great powers in just a few decades. But the high cost of unconstrained growth had become clear: wrenching booms and busts, an alarming gap between rich and poor, and the specter of social instability.

Like the Chinese government in the 1990s, U.S. authorities were slow to respond. But they did, in fits and starts, beginning with the Sherman Antitrust Act in 1890 and continuing well into the 20th century with major laws to regulate areas such as food safety, the securities industry, and worker rights.

Nearly 120 years later, China has embarked on its own epic reform program. Like much in China, the change is proceeding at a breakneck pace. In just two years, the country has enacted 15 new pieces of major business legislation and several hundred additional laws—and more are on the way. Taken together, it’s a remarkable list, representing many of the legal building blocks of a modern market economy. There’s a new bankruptcy law, an anti-monopoly law, new partnership and company laws. There’s a big new labor contract law and a corporate income tax law. And last year, China introduced a property law, which took the radical step—for a nominally socialist country—of granting property rights to individuals.

“The pace of change has been unbelievable,” says Jason Chang, an Australia-based partner in charge of Asia markets for KPMG. “From a regulatory perspective, life has been more challenging in China than ever before.”

Such developments would pose difficulty for businesses in any country. That’s doubly true in China, where laws come into effect quickly and with little explanation. Enforcement, while improving, remains spotty and often depends on the whims of bureaucrats. The courts are unreliable.

Most observers—both Chinese and Western—of the country’s ongoing reform effort agree on one thing: the legislative changes happening today are monumental and probably historic. Less clear is how it will all work out. Will China’s legal reform effort rationalize an often bewildering business environment? Or will it create new confusion that businesses and their advisors will struggle to sort out for decades to come?

Help, Please

Some of China’s new regulations have been in the works for years. For example, the new bankruptcy law and last year’s accounting rules began as World Bank-sponsored projects in the 1990s. Many others, including the tax and labor laws, are more recent efforts. “This flurry of laws...represents policy changes engineered by [president] Hu Jintao and [premier] Wen Jiabao away from the policy model of the 1990s,” says Yasheng Huang, a professor at MIT’s Sloan School of Business in the United States. “The pace of legislation has picked up in large part to address the huge imbalances in the Chinese economy.”

Several of the laws draw praise from experts. Policy makers modeled the bankruptcy legislation, for instance, closely on similar laws in the United States and EU and took advice from international experts. “This is a very modern insolvency law,” says Tom Lauria, chair of the restructuring practice for law firm White & Case. “China wouldn’t be doing it unless it contemplated broad moves in private finance.” Like the United States’ Chapter 11, the bankruptcy law includes protections that allow companies to try and revive themselves.

Similarly, last year’s accounting rules represent years of careful work and shows the desire of China’s leaders to adopt the best standards available, says Stephen Taylor, a Hong Kong-based technical partner with Deloitte. “They’ve embraced the concept of international standards,” he says. “There’s now a Chinese member of the International Accounting Standards Board. In the end, we’ll get a better quality standard and better buy-in.”

The praise isn’t unanimous, though. Perhaps inevitably, many companies complain that the laws will make business more expensive at a time when they’re already coping with rising levels of inflation. One consumer products MNC, for instance, says it will have to spend US$7 million in order to comply with the terms of the labor law.

More worrying, from a CFO’s perspective, is the way China implements laws—quickly and with little, if any, guidance. The tax law is a good example. It came into effect on January 1, but without detailed instructions. Regulators have issued guidance since then, but many areas of uncertainty remain, according to KPMG’s Chang.

This is particularly problematic in China’s case, because laws tend to be long on goals and short on detail anyway. The tax law, for instance, runs to a mere 10 pages. By contrast, the Australian tax code comprises four volumes and stands a foot high. “You marvel that the Chinese can say things so simply,” says Jason Chang. “But it also means that they aren’t covering every situation. You still need three levels of detail.”

For anyone trying to comply with the law, this can be exasperating. Referring to the passage of the tax law without the supporting detail, one multinational CFO says it is “like a joke.” In response to such complaints, the government has set up a process for companies to obtain “advance private rulings”—a decision by tax authorities on whether or not a particular transaction will be acceptable. But because of a staff shortage, it’s generally not possible to get such a ruling, according to Chang.

Issuing broadly worded rules has long been standard practice for Chinese lawmakers. “A lot of law in China is expressed in wild generalities,” says Jeff Blount, a partner with Fulbright & Jaworski in Hong Kong and Beijing. “There are cases where we all know where the government wants to go, but we don’t know what bus to take. There are regulations needed to explain the laws, but you don’t see them for months at a time. You go through a six-month or a year-long process of scratching your head trying to figure out what you need to do to comply.”

Ong Yew-Kim, a visiting professor at the China University of Political Science and Law in Beijing, agrees. “China has passed many of the laws it needs to regulate the market,” he says. “But the laws are principles-based. They don’t have very good rules for particular circumstances. This creates a lot of disagreement on interpretation.”

Such vagueness has benefits for bureaucrats—a broadly defined law allows plenty of administrative leeway when it comes to enforcement. But it can breed damaging confusion and unexpected consequences. Blount points to the M&A rules China issued in August of 2006. Among other things, the new rules were intended to stamp out certain types of “round-trip” structures that foreign investors were using to avoid limitations on domestic Chinese participation in offshore reinvestment vehicles. But the intended fix only introduced new uncertainties.

“Ambiguities in the new rules are causing a lot of domestic Chinese investors to get false hope that you can use essentially bogus transaction structures—such as [ones] that strip all of the economic substance out of an entity, and then claim that the entity, which has no real economic interest in the transaction, is really the party to the deal for regulatory purposes,” says Blount. He adds: “This wouldn’t be happening if the government had issued more comprehensive regulations dealing with substance over form.”

Another problem: as China’s rules pile up, they are starting to intersect. But the government has done little to sort out the resulting tangle. Consider tax and accounting. Before the new tax rules, there was no concept of deferred tax in China. Now there is, and companies that report their financials using the country’s new fair value accounting method must account for next year’s tax.

Implementing the rules without issuing guidance “has created a lot of issues for companies trying to ascertain how to account for next year,” says Taylor of Deloitte. “They didn’t bring in implementation guidance until after year-end, after a lot of companies had reported their taxes.” The good news, he says, is that the Ministry of Finance is starting to address these points of overlap.

Two Faces of the Law

Then there’s the question of enforcement. Like other developing countries, the laws written on the page are one thing; their actual application can be quite another. You don’t have to look far for evidence of lax or inconsistent enforcement. There are drug safety scandals, disregarded environmental rules, and routine violations of worker safety rules. In many cases, local officials have been willing to look the other way.

This can produce frustration. Recently, the CFO of an American electronics company was speaking with the tax auditors sent to his company’s operation. He asked the auditors how the major Chinese telecom firm nearby had reacted to a similar examination. “Oh, we don’t audit them,” came the reply. “We only audit you.”

Francis Hu, CFO of 3M China, says that it’s not the welter of new laws that troubles him, but instead the probability of uneven enforcement. “We want the new laws—such as labor and environmental rules—in place, because as a responsible company they give us an advantage,” he says. “But that’s provided that they’re implemented evenly across the board.”

Consider the pattern for tax collection. Most of China’s corporate tax revenues come from foreign businesses, even though they only represent a small proportion of the country’s total economic output. Many of the state-owned firms, claim foreign executives, simply aren’t paying taxes. The same problem applies to the Labor Contract Law. “You don’t hear many complaints about the new labor law from the state-owned companies,” says one CFO. “That’s because they don’t care—it’s not likely to be enforced for them.”

Lawyers acknowledge that in many parts of China—particularly rural areas or in the far west and northern parts of the country—enforcement problems remain common. Sometimes the trouble stems from provincial governments implementing rules according to the interests of their officials. At other times, says Alexander Pan, a tax partner with PricewaterhouseCoopers, bureaucrats simply aren’t ready. “When China announces a new law, the enforcement agency has to be trained to understand the rules—which, in most cases, it doesn’t,” says Pan.

But certainly, the vagueness of China’s laws helps make erratic enforcement more probable. “The fundamental problem in China is not a lack of laws but lack of rule of law,” says Huang of MIT. “Rule of law means that bureaucrats and officials are constrained by laws. Some of the recent laws do exactly the opposite—they increase the power of bureaucracy and they are arbitrary, for example, providing no grandfather clauses.”

This, of course, raises a basic question: what’s the point of comprehensive market legislation if it can’t be implemented clearly and fairly?

Getting Better

But wait, say a number of legal experts—if you were to take a snapshot of China today and compare it with other developed economies, such as the United States, which has been refining its still-imperfect regulatory system for over 100 years, the regulatory environment would look chaotic. Hold that photo up next to a picture of China just 10 years ago, and the progress is unmistakable.

That’s clearest in how China develops its laws, say lawyers. “We’ve been imploring the government for years to try and be more transparent when it comes to rule making,” says Blount. “The government is actually reaching out to the legal community now, which a couple of years ago was unheard of. It’s not like the old days, where something would pop up out of nowhere and we’d scramble trying to figure out what’s going on.”

Lesli Ligorner, partner with law firm Paul Hastings Janofsky & Walker in Shanghai, agrees. “China is moving toward a more transparent legal drafting process,” she says. She points to the Labor Contract Law as an example. When a draft of the law first came out in March of 2006, there was a 30-day comment period, during which the government received hundreds of thousands of written comments. “Responding was not an empty exercise—we saw many changes that reflected our clients’ concerns addressed in the final version of the law.”

Even implementation is improving. Blount, who has been practicing law in China since the early 1990s, sees clear progress in enforcement. It’s unfair, he says, to suggest that the law in China is enforced unfairly everywhere. “Many of our clients in cities like Shanghai and Beijing get a fair shake from the government. If you look at the kinds of problems we used to run into 10 years ago, you see that things have gotten so much better in such a short period of time. We don’t see many cases of pure arbitrary, unlevel-playing-field enforcement practices, anymore.”

While far from perfect, oversight in areas such as financial reporting shows promising signs of improvement. For example, Taylor sees the China Securities Regulatory Commission heavily questioning listed companies on their use of fair value accounting principles. “They are staffed up to handle some of the difficult implementation issues,” he says. “Whether they have the right level of people is another matter, but they are enthusiastic about the task.”

Another hopeful sign: the emergence of specialization in China’s still-troubled judiciary. One foreign lawyer in Beijing points to early signs that the courts are developing areas of expertise—a precondition for reliable implementation of regulations. One example is the emergence of special courts in Beijing to handle intellectual property issues.

Politics First

This is real progress, to be sure. But soon, say China’s critics, this forward motion may stall as it encounters the realities of an economy that’s ruled as much by politics as by rules.

For one thing, the judiciary remains highly malleable. Jerome Cohen, a law professor at New York University, says that despite improvements in some areas, companies and individuals coming before a Chinese court aren’t guaranteed a fair hearing. “If a government official goes to a judge and says, ‘If we lose this case, it’s going to cost the government US$35 million,’ there’s still a good chance that the judge will rule in the government’s favor,” says Cohen.

The supremacy of politics over law, of course, may grant the government more power, but it undercuts the rules themselves. It may also hamper China’s move toward a market economy in other, more oblique, ways. Consider the bankruptcy law. Under the insolvency rules, China’s courts will have jurisdiction over a company’s assets, even if they are outside of China. But for any ruling by a Chinese court to be respected in the United States and Europe, that court needs to be seen as independent. According to Lauria of White & Case, U.S. courts would have to affirm that the Chinese court was fair and not politically motivated. “It will be a long process for China to get there,” he says.

Another problem is that enforcement patterns shift with the political winds. Victor Shih, a professor at Northwestern University in the United States, studies the effect of elite power struggles on the enforcement of central government rules in China, particularly its monetary policies. In a new book, Factions and Finance in China: Elite Conflict and Inflation, Shih shows that local bank officials feel free to exceed central government lending targets when they see that their patrons are in control of the government. This is true in many other areas of regulation, too, where local party officials and heads of state-owned enterprises feel free to flout the law.

This problem, says Shih, will not fade as China enacts better laws or hires more regulators. “The Chinese Communist Party is in a bind,” he says. “They learned during the revolution that to succeed, you couldn’t have a centralized, rule-based entity, because the fighting changed every day in every area. So by design, the system aims to give a lot of authority to local party secretaries.”

But regulating the economy and protecting the environment both call for a more centralized, rule-based system. “The Party is dealing with the contradiction between these two sorts of systems, and it hasn’t figured out a really good answer. Ultimately you have to choose: you can have a rule-based system, but you’d have to give up the supremacy of the Chinese Communist Party, since today the PRC constitution says the Party can rule on everything regardless of the law. I don’t think the Party is ready to do so.”

How will China’s legal transition look 10 years from now? When America’s Sherman Antitrust Act was signed into law in 1890, the goal was to curb the power of the country’s growing monopolies. But for the first 12 years after it was passed, the broadly worded law did anything but. Instead, it was used mainly to combat labor unions. It wasn’t until the presidency of Theodore Roosevelt that the government began—belatedly—to apply the law as envisioned by the drafters, when it broke up the Northern Securities Company, a big railroad monopoly. And not until 1914 was the Federal Trade Commission, the regulatory body charged with enforcing anti-monopoly rules, set up.

In a sense, China has just passed its own Sherman Antitrust Act. “I predict that we’re halfway through a 10-year period during which China will rewrite the whole landscape for business,” says Blount. “They have a lot of issues to grapple with, and it will all be tested when China has its next, grinding recession. But we’ll probably look back at this period very favorably.”

Don Durfee is managing editor of CFO Asia