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

I can now take a deep breath after the successful launch event for our new ZL London office on the 2 May.  We were overwhelmed with, and deeply gratified by, the extraordinary market response to our seminar. It is more than apparent that China is a hot topic in the UK at the moment.

Robert Lewis
Robert Lewis

Now with that safely and happily behind me, I can return to the discussion of outbound trade and investment from China, which is next in the planned order of discussion for this series of blogs on the China legal services market.

The happy coincidence is that my presentation at our seminar, handled in conjunction with my colleague Haibin Xue, managing partner of our new ZL London office, was on this precise topic – opportunities and obstacles in connection with Chinese outbound trade and investment.  Because our seminar was a bit of a parade of speakers run at a fairly quick trot in order to showcase our ZL London and China team, Haibin and I only had 10 minutes plus or minus to cover the high points of this very broad topic.  In this blog entry (and the next) I will follow the same general outline of our presentation at our launch event seminar, but can expand on the presentation here since I am not similarly constrained by space or time.  If you want to see the ppt slides that correspond to this blog entry, you can go to a landing page that PLC put together for our event.

With that introduction (and apology for the long delay since my last blog posting), let’s jump right into the subject.

Sometimes it seems as though the entire global legal profession is lined up to try to carve out a slice of the China outbound legal market, which all predict will produce the next wave of lucrative work for the top international law firms.  The reality, however, is that there is currently more hype and anticipation than actual substantial fee-generating work in this market segment, and few if any have looked at this in a clear-eyed way to see how the market is shaping up as a practical matter in order to identify where the opportunities are and who is best positioned to take advantage of each sub-category of China outbound work.  In this case, it is not a simple game of foreign firms versus Chinese firms: a much more complex matrix is emerging.

First, we need to define what we mean by outbound work for Chinese clients.  For the most part, everyone focuses on the outbound direct investment (ODI) figures, which have grown from $12.26bn in 2005 to just under $70bn in 2010.  This compares to inbound foreign direct investment (FDI) into China, which ranged between $60bn and a shade over $105bn over the same period. By 2015, China ODI is projected to reach $150bn and overtake FDI into China for the first time, which is expected to hit $140bn in 2015. 

Lawyers in the market have a general sense of how much legal work has been generated from FDI, including inbound M&A, over the years, so some may expect that China ODI will generate roughly commensurate levels of fee-generating legal work. That is proving not to be the case, principally because of the unique characteristics of Chinese clients and Chinese ODI to be discussed below. 

But first we will turn to examine another often overlooked market segment of the China outbound thrust. Both Chinese FDI and ODI figures are dwarfed by Chinese cross-border trade figures, which were in the range of $1.4tr and nearly $3tr over the same 2005 to 2010 period cited above.  By 2015, cross-border trade will amount to $5.4tr, or more than 35 times the value of projected ODI for that same year. 

Most people do not look at these trade figures as an indicator of potential legal work because it is often assumed that this is simple buy-sell trading of goods under standard form supply and procurement contracts.  That in fact may be the case for the vast majority of these transactions, but the era of low-cost, low-price manufacturing in China for export is coming to an end, and Chinese companies are already starting to move up the value chain, which will require investment in innovation, stronger brands, more extensive and efficient global supply chains and sales channels, as well as more sophisticated cross-border strategic partnering with leading MNCs.  All of this will require legal assistance – if (and that is a big IF) the Chinese clients recognise the need for and value of such legal services. 

If Chinese companies don’t get suitable legal support up front in respect of these commercial matters, then they will have problems at the back end, and in fact that is precisely the current situation faced by Chinese exporters. The China International Chamber of Commerce (CoC) and the CCPIT in an August 2010 report estimated that Chinese exporters had uncollected trade debts of a staggering $150bn.  To put this figure in context, that is nearly as much as China’s combined FDI and ODI for that same year, and represented approximately 5 per cent of that year’s total cross-border trade value. 

While the China International CoC and CCPIT did not explain their calculations (and, in fact, when I spoke to one CoC official he acknowledged that this was in part an exercise in voodoo economics – in other words, they didn’t have a solid basis for the figure), it actually does match up to my own back-of-the-envelope calculations based on typical bad debt rates (based on published figures) adjusted to include not just bad debts but delayed collections. Chinese companies are eternally hopeful that they will collect the cash someday, and if they are not a listed company they are not required to take a provision for potential write downs until a few years down the line, so the uncollected amount just sits in their accounts receivable (AR) for years at a time, making their financials look artificially robust. Taking all of this into account, the $150bn uncollected trade debt figure represents about a three-year backlog in the expected range of delayed collections, only some of which would in fact be written off or provisioned against under Chinese accounting practices.

However calculated, it is a sobering amount and represents a fundamental breakdown in the transaction management process on the part of Chinese companies. Of all the objectives of the parties to a transaction, the most fundamental is to ensure that each gets the benefit of the intended bargain.  For a supplier, goal number one is to get paid.  It is not that Chinese suppliers don’t want to get paid, they just have not connected the dots in all cases and understood that the sales contract is the key tool in the toolkit to cover this core risk. 

I have dealt with scores of top Chinese companies over the years, many of which have annual turnover of several billion US dollars, and I cannot count the number of times they have asked for advice on a problem that has arisen in connection with a supply or OEM transaction where they shipped on a bare PO and bill of lading with no contract, or with a contract that looked like it was made of Swiss cheese cobbled together by a blind mouse.  Many senior managers in otherwise respectable major Chinese companies often take the view that collection problems are like a force majeure event – in Chinese, ’meibanfa’, there’s nothing that can be done.  And accordingly, from what I have been able to discover, the manager who owns the profit and loss for the relevant business line is somehow not accountable for the ballooning AR or the eventual (but long delayed) writedown. It’s like an Act of God – “meibanfa”.  No one is responsible.  You just shrug your shoulders and eat the loss.

This is symptomatic of the overall transaction and contract management process in many Chinese companies.  One can easily imagine that if the fundamental objective of a supplier in a supply contract, namely getting paid in full and on time, is too often not realized, then there will be a host of other contract-related problems, and in fact that is the case.  Chinese companies too often have not understood that each clause affects either revenues or costs, either directly, indirectly or as a contingent matter.  Consequently, a substantial number of Chinese companies are bleeding cash at numerous steps along the transaction process management path, but no one is tracking the full cost of performance, so this financially debilitating condition goes undiagnosed.  And then when they run the final sums, they are scratching their heads, wondering why they weren’t able to achieve the headline profit margins.

I want to come to the defense of the in-house counsel in many of these Chinese companies.  They know what to do, but management often cuts them out of the process, and then points their fingers at the legal team if there is a problem.  At its core, this is a failure of management, and it is not going to get much better until they start tracking actual costs of contract performance and then recognise that they need to plug the holes in the process. 

Also, I wish to underscore that many of the top-flight Chinese companies have made substantial progress in terms of contracting and have closed the gap with the standard of international best practices, but these are still the exception and not the rule.  Similarly, it is true that whereas 10 to 15 years ago Chinese contracts were more like two-page letters of intent than full contracts, it is now more common to see something that looks more like a proper contract, but it is fair to say that the level of sophistication is still quite low – the form may be there but the substance is still lacking in many key respects.

International surveys tend to confirm this overall less-than favourable assessment of Chinese company contracting capability.  The International Association for Contract & Commercial Management (IACCM) in 2010 did a survey of international contract managers to rate the contracting environment in 45 countries.  Chinese came in ranked near the bottom at number 38 on the list.  What were the problems that the respondents identified?  Two-thirds cited differences in ethical standards and commercial culture, while plus or minus 50 per cent listed weak contact drafting/negotiation skills and sub-par English language skills. No matter how one slices the IACCM survey results, this core element of legal affairs management lags far behind the actual top-line financial performance of the Chinese economy, and represents a significant drag on bottom-line performance of Chinese companies.

This discussion of weaknesses in the contracting capability of Chinese companies may seem to be a bit a detour from our main discussion here, which is focused on opportunities in the China legal services market, but in fact this provides an essential backdrop to the core proposition, which is that Chinese companies have very high levels of unrecognised latent demand for legal services connected with cross-border trade activities. Chinese management is now facing an important watershed moment at this stage in the economic development cycle. The time when they can keep the economic engines running at a high level just by shipping dumb boxes of low cost, low price goods around the world is over. They have to move up the value chain, and this will require that they pay more attention to the rules of the game of international commerce, and demonstrate a more sophisticated understanding of how legal tools create value for them. 

This creates an opportunity to sell in higher levels of legal services to Chinese companies as they expand their operations around the world.  Key categories of commercial law services should include IP, dispute resolution, sales channel management and strategic alliances, as well as general regulatory, commercial and tax advice.  This should actually be a boom area for both Chinese and foreign law firms given the scope of Chinese cross-border trade and the increasing complexity of the nature of the related transactions as they move up the value chain.

But as a practical matter many of the legacy obstacles remain, and are stubbornly resistant to rapid change.  Chinese managers are still behind the curve in understanding the value proposition for commercial legal services for trade-related transactions. Many of the operating level managers will be more sensible on this front, but they have to seek instructions and approval from the top, which is slow to come.  In the context of offshore litigation the generally passive management style of Chinese companies is akin to paralysis – only the top management can make a decision but they don’t appreciate that delay if you lose.

Because senior management in many Chinese companies do not have a sufficiently fulsome appreciation for the value proposition for legal services up front, they generally choke on the fees proposed by outside counsel.  This is understandable in some respects: they have not incurred these legal costs previously and are already having to cover higher labour costs as well as commodity and component price volatility, so margins are already squeezed.  They are looking to save costs not take on new expenses for intangible services of (in their view) uncertain value.

One reason I moved from an international law firm to a top local law firm was to be able to leverage off a lower cost base to offer lower rack rates in order to address this market segment more effectively, but for many Chinese clients it is not a question of the rate but the fact that you are proposing to charge on a time basis at all.  Of course, it must be acknowledged that they are prone to turn white as a sheet when presented with top-end London rates, but they will also often be scared off by rates that represent a substantial discount against these top-end fee levels. 

In the end, they want a flat fee based on an agreed scope of works.  Of course, the problem is that it is easier to fix a flat fee than it is to ring-fence the work scope, and Chinese clients can be particularly liberal in their interpretation of what they understand falls within the ’agreed’ scope.  Sometimes you just have to adopt a Chinese approach – if the Chinese client abuses the work scope in one project, then you have to play on their sensibilities and sympathies to get an upward adjustment in the price in the next round.  It’s a relationship thing – and, of course, if you don’t know how to play, then you get played.

In sum, the main game in acting for Chinese companies will not be limited solely to the ’sexier’ outbound M&A and investment deals. Cross-border commercial transactions represent a very significant market opportunity for both Chinese and foreign law firms, even foreign law firms without a substantial presence in China. 

But it is still a muddy track for both, and as we will see in the next instalment in this series, just as there are obstacles to developing a cross-border commercial practice advising Chinese clients, there also is not a clear and clean shot at building a highly profitable business on the back of outbound M&A work for Chinese clients in the immediate near term. In fact, it appears that there is a natural segmentation in the legal services market for Chinese outbound M&A and investment, and there will be more than enough room for both the top local firms as well as the international firms in China. 

So the answer to the teaser at the end of my last blog entry (what pushed me over the edge to make the move from an international firm to a top Chinese law firm) will have to wait for one more instalment .  As hinted in my last blog posting, the answer may surprise you as it did me.  But what is even more interesting is that even in the last month I have gained a further appreciation for various additional layers of complexity in the assessment of this market opportunity.  We will have to leave it there for now; more to come.      

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