China Watch – A foreign lawyer’s view from the inside

It is no longer provocative to acknowledge that the domestic Chinese law firms are in ascendancy in the China market. The foreign firms undeniably had a stranglehold on the market in the early days, but over the last decade plus it became apparent that it was not realistic to think that a market as big and unique as China could (or should) be dominated by foreign law firms. 

It was only a matter of time before the Chinese firms started to assert themselves.  The remarkable thing is how quickly the market has developed and the positioning of the players has changed.

The best way to understand the rapid pace of development of the Chinese legal profession is to view it through the prism of client demand for legal services.  This, in turn, is connected to the remarkable sustained growth of the Chinese economy (albeit from what originally was a very low base) and the legal reforms of the past two to three decades, which have attracted extraordinary levels of foreign direct investment (FDI).  At the same time, in this new environment, Chinese enterprises have also flourished, and now we see many of the Chinese champions of industry, and even more second- and third-tier Chinese companies, leading the growth of Chinese outward direct investment (ODI).

As is the case in any jurisdiction around the world, the Chinese legal market is driven by both the nature of the clients and their activities that require legal services support.  A simple construct through which to view the legal services market in China is to divide the overall market for legal services into three sub-markets: inbound, domestic and outbound.

An even simpler approach would be to divide the work into two categories: acting for foreign clients and working for Chinese clients, as each client category has its own characteristics.  There are further sub-divisions with each of these groupings, and it is important to assess demand for legal services in the context of both the nature and background of the client and the type of work to be undertaken, but these groupings provide a suitable starting point for our discussion. 

In this blog entry and the one to follow I will focus on the legal services market for foreign clients and their subsidiaries in China and then will move on to address the Chinese client market in the following blog postings. 

When we look at the foreign client part of the Chinese legal market, it becomes clear that it is the nature and background of the foreign clients that has driven much of the demand for legal services.  In the early days, the legal framework in China was rudimentary at best and generally ignored in practice, particularly by Chinese parties.  But while Chinese companies looked first to government policy and relied almost exclusively on government relationships or ’guanxi’, foreign companies coming to China, principally from North America and Europe, started from the remarkable proposition that black letter law – and contracts – actually meant something. 

One foreign lawyer colleague in these early days wryly – and astutely – remarked that were it not for foreign corporates investing in China, there would have been no one in China, including government regulators, who really paid attention to or cared about the specific terms of Chinese law.  If no one cares about the law, the business prospects for lawyers generally are not very promising.   Legal business at the top end of the market is driven by sophisticated deal making, increasingly complex regulatory schemes and the credible threat of enforcement by regulators and courts.  In the early days in China, none of those factors was present, at least not in the same manner as in more developed jurisdictions, so the demand for legal services was driven primarily by the fact that multi-national corporations (MNCs) were hard-wired to comply with even incomplete and often internally inconsistent regulatory requirements and to try to create deal structures, which, at least facially, made sense. 

A lot of the work of lawyers advising MNCs in those early days was comprised of reading the tea leaves of how the law likely would be applied – which only sometimes matched up to what the law actually said – and adapting international deal structures and contract terms to the Chinese legal environment, which in practice called for the dumbing down of contracts and the flaying out of deal structures to accommodate the sometimes bizarre requirements of local practice.  We provided the ’how to’ manual on a bespoke basis for each client because nothing was standardised and the policy sands were constantly shifting, and we had to provide comfort to the board of directors back home that the arrangements were in fact not illegal even if not fully compliant with black-letter law.  In short, we were legal risk managers as much as we were lawyers in the traditional sense.

As a result, in the 1990s even if the local firms had been more robust and competitive, the bulk of the legal work likely would still have gone to the foreign law firms because they were the ones who were familiar with the expectations and requirements of the MNC clients and could more effectively relate the circumstances on the ground in China back to the home legal environments of the foreign clients.  In addition, by way of legal training and the western legal practice model, the foreign lawyers historically have tended to be better problem-solvers and better equipped to perform comparative law analyses.

Predictably, however, over time a certain level of standardisation gradually began to develop in the market, at least surrounding the key elements of the most common FDI vehicles.  Through the mid’ to late 1990s manufacturing joint ventures were the primary door through which foreign investors were permitted to enter China, but once wholly foreign-owned enterprises (WFOEs – endearingly pronounced “woofies” in local parlance) were permitted across more industry sectors, that quickly became the investment vehicle of choice for MNCs.  With the advent of China’s entry (actually, to be hyper-correct, re-entry) into the World Trade Organisation in late 2001, more service sectors were opened up to foreign investment (at least nominally), and in some cases WFOEs were permitted but in many other industry segments JVs, sometimes with majority local ownership control, were still required. 

These two entity forms for foreign-invested enterprises (FIEs) thus came to dominate the FDI market.  In fact, even though other FIE corporate vehicles have been introduced over the years, none have displaced the JV and WFOE to any meaningful degree, and in connection with inbound M&A projects the target company is to be converted into a JV or WFOE on a post-acquisition basis, further enshrining these two FIE entity forms as the default foreign investment vehicles of choice.  As all parties became more familiar with these FIE forms, the original mystery surrounding them began to diminish, on the part of not only the MNC clients but also on the part of Chinese counterparties, the government officials administering the related regulatory schemes and also the local Chinese law firms, which were able to mark up base transaction documents from the foreign law firms that were floating around from the scores and even hundreds of FDI projects on which they had worked as local co-counsel with their foreign law firm counterparts.  

Thus, the latter part of the 1990s through to the beginning of the new millennium marked a key inflection point in the development of the local Chinese legal profession.  While Chinese deals can never be fully commoditised and entity set up in China is still not as simple or efficient (or inexpensive) as in most other jurisdictions, by the turn of the millennium the basic framework for FIEs was increasingly well settled and familiar, and a lot of the accompanying regulatory running around fell right in the sweet spot of the leading Chinese law firms, who knew the system and how to work it. 

The foreign firms continued to have some important advantages in terms of problem solving and deal structuring overall, and often also in terms of negotiating corporate governance provisions, but over time for many projects the fundamental problems and the solutions became more familiar and uniform in nature.  It is also to be expected that with time and experience the top local lawyers would start to become more adept at thinking outside the box and creative deal structuring, and in fact they have continued to march up that learning curve, with some being further advanced along this path than others.

At that same time, more and more foreign SMEs made their way to China to follow their key manufacturing customers and to fill out the rest of the supply chain in China.  Many of these SME clients did not think that they needed to pay premium rates for what had by that time in many cases become non-premium work, and many SMEs had a higher risk tolerance than many of their major MNC counterparts.  A similar observation could be made about the expectations and risk appetites of new foreign investors coming from outside the US, Europe and the Commonwealth countries – they all tended to opt first for local law firms. 

For example, while at Lovells we had several opportunities to pitch for work for Singaporean clients introduced by our colleagues in the Lovells Singapore office, but it was very difficult to persuade these Singaporean clients to pay the higher foreign law firm rates in China, and in most cases this work would end up with a top local law firm, based principally on price.  As a side note, it is remarkable to observe that the rates of lawyers in the Beijing and Shanghai offices of the international firms were always significantly higher than the rates charged by colleagues in the Singaporean offices of the same firms.  This is a historical anomaly, reflecting the difference in the pricing of legal services in Hong Kong (which has migrated to the China offices of the international firms) as compared with Singapore.  Making this even more ironic was the fact that the overall level of quality and experience in sophisticated deal making was clearly higher in Singapore than in Beijing or Shanghai, even within the same international firm, making the price differential all that more jarring for Singaporean clients.

Not surprisingly, an increasing number of such foreign clients began to go direct to local law firms for what they perceived to be better value, with an emphasis not only on lower fees but also based on a sense that the local firms knew better how to get things done in the local environment.  Not long after I resigned as Asia general counsel for Nortel Networks (may it rest in peace) and joined Lovells to head its Beijing office in 2001, I attended a seminar presentation by one of the Big Four accounting firms in which they presented their most recent survey results on FDI in China.  Even at that time, more than half of the respondents expressed a preference to go direct to local Chinese law firms.

I have been predicting and planning for the end of FDI work for foreign law firms in China ever since, which has in some respects made me the Jeremiah of the foreign legal profession in China, and in some cases just as (un)welcome!  The writing has been on the wall for more than 10 years now (apologies for mixing my Biblical metaphors), and I remain confident in the accuracy of my reading of the overall trend lines, but I must confess that I have probably been wrong to suggest that the well of FDI work for foreign firms would dry up completely, and I certainly have been completely off the mark in terms of the projected timing.  I had expected the end of FDI for the foreign firms to have come much sooner, but we still have a lot of foreign law firms feeding at the FDI trough and there seems to be enough room to go around – for now and probably, but perhaps to some further diminishing degree, for some time to come.

There are two key factors contributing to my revised conclusion: 1) the evolving nature of FDI in China, and 2) the non-uniform subjective preferences of clients.

In the early days, FDI consisted primarily of manufacturing JVs and WFOEs that were light on technology transfer, but over time, either as the result of government “encouragement” or changing market imperatives, MNCs began to increase the level of technological inputs into their China operations, and eventually moved important elements of the R&D to China.  MNCs relied heavily, almost exclusively, on the foreign law firms to design overall translation structures that would provide the necessary protections. At the same time, in the newly opened service sectors, new business models were introduced for which there was no existing stable regulatory framework.  Again, the MNCs relied upon the foreign law firms to understand how the imported business model was intended to work and how to fit it into the incomplete legal infrastructure in China.  As new specialist industries moved more of their operations into China, and more onshore/offshore structuring was utilized, it was always the international law firms that led the way in laying the groundwork for new forms of FDI.

But the same cycle noted above with respect to basic FIE structures has been repeated in connection with each such new iteration, and the cycle time from market innovation to commoditization – with corresponding migration of market share to the local law firms – has shortened dramatically with each repetition of the cycle. Consequently, a clear pattern has emerged in which the foreign law firms inexorably move up the value chain with the local firms chasing closely behind to take up increasing market share in the broadly-defined FDI space.  However, because there is not sufficient super-premium work in the China market to support all the foreign firms that are here, and (as will be discussed more in a subsequent blog) because the staffing of foreign law firm offices here is still rooted more in the historical law firm business model from the late 1990s and early 2000s, there are still a substantial number of foreign law firm offices in China which continue to rely quite heavily on more plain-vanilla FDI work.

This creates some obvious overlap in terms of market coverage between many foreign firms and the top domestic law firms, which leads to more choices for foreign clients, which brings us to the second factor: client preference.  The stubborn fact is that foreign clients make their own decisions about outside counsel, and while the trend lines indicate that an increasing percentage of foreign companies start with a clear preference to use local Chinese legal counsel, it is also abundantly clear that a significant percentage of foreign clients coming to China will always prefer to work with a trusted law firm from their home jurisdiction.  Thus we now see flourishing (albeit small and not necessarily profitable) China practices of smaller foreign firms from jurisdictions from across continental Europe as well as second- and third-tier US firms, in each case feeding off of China FDI work of their home client base and whatever other table scraps they can pick up once they are on the ground. 

The top-tier international firms with more substantial presences in China will also continue to have a certain level of mid-cap FDI work for their own clients (as we will see in the next blog entry, the China aspects of global M&A deals also falls in this category) and for others who need the assurances and comfort attached to their brand or simply because of their trust in the individual practitioners at the foreign firm.  The simple truth is that when there are several hundred practitioners in the market who are all capable of delivering acceptable levels of service for basic FDI projects, it is increasingly challenging to differentiate yourself from the crowd.  It becomes an exercise in getting in front of the client and making the sale in terms of experience, competence and legal/business judgment, and that is where so many of the senior lawyers at the foreign law firms still have a really good story to sell.  That formula is likely to remain unchanged in respect of China FDI work for the foreseeable future, so there will always be a role for the foreign law firms in this market segment, even if the local firms continue to eat up market share by sheer volume.  

As with any service industry, the assessment of relative comparative advantages of law firms in China, and the related segmentation of the market, is always client driven.  I have found it interesting that since leaving Lovells to ’go local’ I have very seldom been pitching head-to-head against the China offices of the major international law firms for work from major MNCs; it is much more common to be competing against other top-tier Chinese law firms for the work.  The nature of the clients and the work are exactly the same as what I had over the years at Lovells – a mixture of M&A, infrastructure projects, telecoms/high-tech, clean energy and even plain-vanilla FDI for MNC operating companies – but the clients (including Fortune 50 MNCs) had already made up their minds before coming in the door that they were going to hire a local Chinese law firm, so the China offices of the foreign law firms were already out of the frame.  On the other hand, I have old friends who are in-house with major MNCs who can’t give me work because the global general counsel back at HQ insists on using only top-shelf New York or London firms on their panel.  It’s a mixed bag. 

In any event, I was not predicting the end of the world for foreign law firms in China, just the end of the world as we knew it in the 1990s.  As noted above, the nature of transactions and deal structures are no longer as simple as they once were, and more and more China deals are inextricably integrated into the global business of the participating foreign MNCs.  Such cross-border linkages create more opportunities for foreign law firms, but this does require some retooling so the China offices of these international firms so that they can move up the value chain.  It is not clear that the traditional staffing of China offices of foreign law firms (which, as alluded to above, is something we will address in a subsequent blog in this series) will support this natural evolution – in fact, I am not shy to say that I made the move to a Chinese law firm in part so I could avoid becoming a dinosaur at some point and instead possibly be considered to be a market innovator (or at least a maverick)!    As the foreign firms necessarily move up-market to provide services more commensurate with their fee levels, this will leave an ever larger vacuum for the local Chinese law firms to fill.  This is actually a sensible direction for the China legal services market to continue to take.

So what are the current points of intersection of the shifting tectonic plates in the China legal services market where there is movement between foreign and local law firms?  M&A heads this list, and that will be our lead focus in the next blog as we finish off this discussion of working for foreign clients in China. 

Robert Lewis is international managing partner at Zhong Lun Law Firm, based in Beijing