China Competition & Trade Review (Issue #4 - July 2020)

O’Melveny’s China Competition and Trade Reviews offer periodic updates about important antitrust, competition, and trade developments in China. The Reviews are intended to help companies navigate China’s rapidly evolving regulatory landscape with practical, on-the-ground insights into the country’s competitive conditions and the laws framing them.

This installment offers a brief overview of:

1. The continued fallout from the novel coronavirus (COVID-19) outbreak, which has resulted in new antitrust enforcement policies, new guidance regarding civil disputes, clarifications regarding antitrust fines, and at least one proposal that SAMR should target “killer acquisitions.”

2. The first-ever merger control review of a “Variable Interest Entity” structure, which has long been used by foreign companies to access sensitive industries in China, but has largely gone unregulated, until now;

3. Changes to China’s fair competition review system, which requires government bodies at all levels to assess whether their policies are compatible with fair, market-oriented competition;

4. A new decision on abuse of dominance, resulting in the highest damages award ever imposed in private antitrust litigation;

5. New penalties for abuse of collective dominance in the pharmaceutical industry, signaling a continued regulatory focus on the sector and the risk that companies in concentrated industries can collectively violate China’s antitrust laws without conspiring.

If you have questions about these developments, or any others pertaining to China, please contact the key contacts listed below.

1. The Continued Fallout of the Novel Coronavirus (COVID-19) Outbreak

While COVID-19 continues to ravage large parts of the world, cases have declined in China. Yet China continues to feel the fallout from the pandemic, including declines in China’s first quarter GDP, incomes, and exports. In response, the Chinese government has taken a number of measures to revive its economy while continuing to fight the pandemic. Important recent developments include:

• New Antitrust Enforcement Policies. On April 4, 2020, China’s antitrust authority—the State Administration for Market Regulation (SAMR)—announced new measures to fight the epidemic and spur economic recovery. The announcement included: (1) a pledge to expedite merger reviews for transactions in sectors closely related to the control of the pandemic, transactions touching on everyday necessities, and for sectors severely impacted by the pandemic; (2) a promise to grant exemptions to competitor collaborations related to the control of the pandemic or the promotion of small and mid-size businesses; and (3) a threat to impose heavier penalties on monopolistic conduct that impedes the fight against the pandemic or China’s economic recovery.
• New Guidance on COVID-19 Civil Disputes. On April 20, 2020, China’s Supreme Court issued a “Guiding Opinion” detailing how Chinese courts should approach civil litigation related to the COVID-19 pandemic. On the topic of contract performance, the opinion explains that a party seeking to be discharged must demonstrate that the pandemic caused the party’s failure to perform, that the party provided timely notice of its inability to perform, and that the party did not contribute to resulting loses. Courts are encouraged to excuse performance only if performance is impossible, although they can facilitate modifications to existing contract terms. The opinion also discusses (1) labor issues, including judicial support for flexible work hours and opposition to firing employees infected by or quarantining against the virus; (2) tolling of limitations periods that would have run during the past six months, so long as the pandemic prevented a party from asserting its claim; (3) the use of mediation to resolve disputes in order to relieve the burden on companies and the courts; and (4) the need for consistent application of Chinese law.
• Antitrust Fines. SAMR recently clarified that economic hardship caused by the COVID-19 epidemic will not reduce the fines imposed on antitrust violators, especially if violations occurred before the pandemic. Rather, fines are determined with reference to factors like the nature, extent, and duration of the violations as well as the offender’s efforts to self-report and cooperate during SAMR’s investigations.
• “Killer Acquisitions” in the Cross Hairs. A SAMR official recently suggested that companies should be required to report and receive merger clearance for potential “killer acquisitions,” transactions that fall under the current reporting thresholds but have anticompetitive implications, including the elimination of emerging and innovative competitors. According to the proposal, SAMR should require filings based on the value of the deal, even if the parties’ revenues are small or nonexistent. The proposal comes at a time when the COVID-19 outbreak has both exposed the negative consequences of past “killer acquisitions” around the world and created circumstances under which large, stable firms may look to acquire the increasing number of smaller, distressed firms. It should be noted that SAMR already has authority to investigate anticompetitive transactions below the reporting thresholds. It is also seeking authority to adjust the merger filing thresholds—they are currently a product of statute—to take into account economic development and industry scale, among other things.

2. The First Antitrust Merger Review of a “Variable Interest Entity” Structure

China closely controls market access by foreign investors, particularly in sensitive industries like media, telecommunications, and education. Foreign companies looking to operate in those industries have long used Variable Interest Entity structures (VIEs), while Chinese companies in those sectors use VIEs as a means to access foreign financing. At their most basic, VIEs are Chinese incorporated entities held by Chinese nominee shareholders, but controlled by a foreign entity through contractual arrangements. Despite their prevalence, the Chinese authorities have never sanctioned VIEs, leaving some to question their legality and long-term viability. Like other Chinese regulators, SAMR had also sought not to officially weigh in on VIEs or mergers involving a VIE structure. That recently changed, signaling a watershed moment for transactions involving VIEs.

• SAMR’s Exercise of Jurisdiction. On July 16, 2020, SAMR unconditionally cleared a transaction involving a VIE structure. The transaction involves the establishment of a joint venture between Shanghai Mingcha Zhegang Management Consulting Co., Ltd., which is controlled by a Cayman company through a VIE arrangement, and Huansheng Information Technology (Shanghai) Co., Ltd., part of Yum China. SAMR accepted the parties’ merger control filing and reviewed the transaction like any other transaction that exceeds the filing thresholds under China’s Antimonopoly Law (AML).
• The Prior Antitrust Approach. Before China created SAMR in early 2018, the Ministry of Commerce (MOFCOM) reviewed mergers. MOFCOM, however, consistently refused to review transactions involving VIE structures. MOFCOM was concerned that if it agreed to review VIE-related transactions, this would be seen as an implicit endorsement by MOFCOM—in its capacity as foreign investment gatekeeper—of VIEs. As a result, reportable transactions involving VIE arrangements were left unregulated under the AML for more than a decade. This included a number of high profile and controversial transactions.
• What Changed? The transfer of the merger review function from MOFCOM to SAMR decoupled traditional competition considerations from larger policy issues like foreign investment. SAMR has considered bringing transactions involving VIE structures under its purview for some time, and the review of the Mingcha/Huansheng JV confirms the policy change.
• The Implications. SAMR’s decision to review VIE transactions is not an endorsement of the VIE structure itself. Rather, SAMR assesses only the competitive effects of transactions; it is not authorized by the AML to assess the lawfulness of VIEs more generally. Still, parties to transactions involving VIE structures will now need to assess whether their transactions meet the filing thresholds under the AML, consider whether competition concerns exist, and factor in the implications of a China merger review on deal timing. They will also need to comply with the compulsory standstill obligation that prevents parties from closing transactions before receiving clearance by SAMR in cases where the deal is notifiable. It remains unclear how SAMR will address completed transactions involving VIE structures, although some reports suggest the deals could come under scrutiny for gun jumping.

3. Amendments to China’s Fair Competition Review System

China’s fair competition review system requires government bodies at all levels to assess whether their policies are compatible with fair, market-oriented competition. Offending behavior can include government restrictions on the free movement of goods, services, and investments, as well as exclusive licenses and exclusionary rules favoring local companies. China plans to integrate the fair competition review system into the AML as part of broader amendments to the competition law. To that end, on May 9, 2020, the SAMR, the National Development and Reform Commission (NDRC), the Ministry of Finance (MOF), and MOFCOM jointly announced how they plan to promote and develop fair competition. Key points include:

• Goals. The agencies pledge to improve the fair competition review system with a clear division of responsibilities, new rules, and efficient operations. The aim is to eliminate any government policy that restricts competition or establishes an administrative monopoly. The agencies emphasize that the fair competition review system exists to create a market-oriented, rule-of-law-based environment friendly to international business.
• Specific Steps. The agencies seek to broaden what falls under the umbrella of fair competition review, ensuring that the system evaluates any rules or regulations affecting market access, procurement, and bidding. Other changes include (1) refining the manner in which reviews are conducted to identify and avoid local protectionism; (2) unifying local review systems; and (3) inviting third parties to take part in reviews. The joint notice also indicates that authorities must carry out regular self-assessments of their current and past policies and amend any that restrict competition. Dedicated units will conduct yearly compliance spot checks, while mechanisms for tracing, reporting, and correcting unfair policies will be improved, including through the use of new technology.
• Timing and Scope. The joint notice lays out a three-year timeline to improve the fair competition review system. It also makes clear that the system is meant to apply to all regions and all government authorities, with better overall coordination—including sufficient local capabilities to carry out reviews and with appropriate supervision at the central level.

4. Groundbreaking Private Antitrust Damages

On March 18, 2020, the Nanjing Intermediate People’s Court awarded private antitrust plaintiffs RMB 68 million—approximately USD 9.5 million—as damages in an abuse of dominance case. The verdict in Yangtze River Pharmaceutical represents the largest award to date in private Chinese antitrust litigation and underscores the risk of monopolistic conduct in China.

• The Case. Yangtze River Pharmaceutical and its subsidiary Hairui Pharmaceutical (collectively, Yangtze) sued Hefei Yigong Medicine and one of its subsidiaries for abuse of dominance. Yangtze alleged that Hefei, which controls 100 percent of the market for the active pharmaceutical ingredient (API) used in desloratadine citrate disodium, refused to supply Yangtze—a pharmaceutical manufacturer—unless Yangtze agreed to long-term exclusive dealing provisions with volume and price commitments. Yangtze alleged that the move was to combat imminent entry of a competing API supplier. Yangtze also alleged that Hefei charged excessive prices for API, charged unreasonable royalties on Yangtze’s end product pharmaceuticals, and imposed other unfair trading terms.
• The Verdict. The Nanjing Intermediate People’s Court sided with Yangtze, awarding it RMB 68 million in damages to cover its economic losses. The Court also enjoined Hefei from abusing its dominant position and invalidated its contractual clauses imposing long-term exclusive purchase obligation and volume/price commitments. Hefei is appealing the ruling.
• Takeaways. The groundbreaking damage award in Yangtze River Pharmaceutical is likely to encourage other companies to raise abuse of dominance claims in Chinese courts. Together with SAMR’s own focus on alleged competition abuses by API suppliers, pharmaceutical companies and their contracts are under more scrutiny than ever.

5. New Collective Abuse of Dominance Penalties

It was a bad few months for active pharmaceutical ingredient suppliers. On April 14, 2020, SAMR concluded that three distributors of the API used in injectable calcium gluconate collectively abused their dominant market position. SAMR imposed a monetary penalty of RMB 325 million—approximately USD 46 million—its highest penalty against domestic firms since the AML took effect.

• Abuse of Collective Dominance. In China, companies can violate the AML by abusing “collective dominance.” The concept—which does not exist in the United States and is rarely applied in Europe—imposes a rebuttable presumption that firms are dominant if three companies have a combined market share of 75 percent or more. Those companies cannot act unfairly to exclude competition by abusing their collectively dominant position.
• The Investigation. SAMR investigated API distributors Shandong Kanghui Medicine (Kanghui), Weifang Puyunhui Pharmaceutical (Puyunhui), and Weifang Taiyangshen Pharmaceutical (Taiyangshen) for violations of the AML. The three distributors controlled between 87 and 94 percent of the API market for injectable calcium gluconate, which they achieved in part through exclusive supply agreements and bulk purchases of API.
• Structural Links Between the Parties. SAMR found that the three distributors were closely related, with Kanghui controlling Puyunhui and Taiyangshen through the exchange of management-level personnel, business agreements, and linked financial systems. SAMR also found evidence that Kanghui transferred business to Puyunhui and Taiyangshen to avoid antitrust investigations. Thus, while the companies officially operated independently, they effectively acted under Kanghui’s instructions. These types of structural links may indicate the types of entities most likely to fall within the reach of a collective dominance investigation.
• SAMR’s Ruling. SAMR concluded that the three API distributors abused their dominant market position by selling API at unfair prices, rapidly raising rates, securing margins of nearly 30 percent, breaking from past pricing practices in the same geographic market, and imposing “double margins”—Kanghui would purchase API and resell it to Puyunhui and Taiyangshen, who then sold it to drug manufacturers. The API distributors also imposed unfair trading conditions on their customers, including requirements that drug manufacturers sell the finished product back to the distributors. SAMR fined Kanghui RMB 143 million, which represented 10 percent of its 2018 revenue in China, the maximum penalty allowed under the AML. SAMR fined Puyunhui and Taiyangshen 9 and 7 percent of their annual revenues, respectively. SAMR also confiscated roughly RMB 120 million in illegal gains and issued administrative penalties for failure to cooperate (between RMB 20,000-100,000, which is approximately USD 2,800-14,000).
• Implications. SAMR’s ruling is the latest example of enforcement against perceived abuses in the pharmaceutical industry. In both 2017 and 2019, China’s antitrust agency fined API suppliers for abuse of collective dominance. In each instance, the antitrust enforcers reacted to prices that they perceived to be unnaturally high and trading conditions that they deemed unfair. And while SAMR generally has looked for structural links between parties before imposing penalties for abuse of collective dominance, its rules do not require them. Companies in concentrated industries would do well to review pricing strategies and business arrangements to ensure compliance with the AML.

O'Melveny & Myers LLP is a foreign law firm registered with the Ministry of Justice of the People's Republic of China. Under current Chinese regulations, we are allowed to provide information concerning the effects of the Chinese legal environment, but we are not authorized to practice Chinese law or to render legal opinions in respect of Chinese law. We work in cooperation with a number of Chinese law firms. Should you require a legal opinion in respect of any Chinese law matter, we would be happy to assist you in obtaining one from a Chinese firm.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Philip Monaghan, an O'Melveny partner licensed to practice law in England & Wales, Ireland, and Hong Kong, Charles Paillard, an O'Melveny counsel licensed to practice law in France and a registered foreign lawyer in Hong Kong, Scott Schaeffer, an O'Melveny counsel licensed to practice law in California and the District of Columbia, and Lining Shan, an O'Melveny counsel in the firm's Beijing office, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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