China Competition & Trade Review (Issue #2 - November 2019)

O’Melveny’s China Competition and Trade Review offers periodic updates on important antitrust, competition, and trade developments in China. The Review is 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 second installment offers a brief overview of:

1. China’s new Social Credit System, which seeks comprehensively to monitor companies’ compliance with the law and makes it more important than ever to ensure strong internal compliance systems;
2. Draft regulations from China’s national antitrust enforcer, which seek to increase the consequences of serious anticompetitive behavior;
3. Recent changes in China’s foreign investment and competition landscape, which are meant to increase protections for foreign entities, ease market access, and create a fairer, more predictable business environment;
4. The Chinese Supreme Court’s landmark decision on resale price maintenance (RPM), which frees China’s antitrust enforcers from proving anticompetitive harm and requires great caution before adopting RPM policies in the China market; and
5. Trends in Chinese merger clearance, which continues to play an important role in global transactions.

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

1. China’s New Social Credit System

For years, China has been working toward the implementation of a Social Credit System (SCS), through which it intends to monitor, influence, and publicly report companies’ compliance with laws and other government requirements. Low ratings can lead to severe sanctions, curtailing a company’s ability to operate effectively in the country. This possibility is noteworthy today because China is aiming for a complete rollout of the SCS by the end of 2020 and has already launched certain elements. When it is fully operational, the SCS is likely to increase the importance (and burdens) of compliance and reporting efforts.

• Objective. The SCS is intended to promote integrity and credibility in the Chinese economy, but also to enhance China’s soft power, international influence, and control over market behavior. The rollout of the SCS coincides with a relative opening up of the Chinese market, including eased joint venture and investment requirements, as discussed more below. Some observers suggest that the SCS is the reason for the shift, providing the government with another means to influence market behavior.
• Operation. The SCS aims to centralize every company’s compliance with Chinese laws, regulations, and government requirements, no matter which Chinese agency is responsible for monitoring and enforcing the relevant provision. To simplify a bit, government authorities set topic-specific requirements—generally market rules and regulations—that firms must satisfy in order to receive a good rating. Companies are then monitored for compliance through self-reported data, traditional government inspections, next-generation technologies related to big data and artificial intelligence, and third-party input from companies like Alibaba and Tencent. Based on that information, companies are rated for compliance with each set of topic-specific requirements, and the collection of ratings is centralized and accessible across agencies.
• Joint Sanctions. Companies who breach a government requirement will receive a rating downgrade and, over time, will experience greater restrictions on their business activities. If negative ratings accumulate or in the event of serious misbehavior, a firm can even be blacklisted. In that situation, the SCS imposes joint sanctions. This means that a company that violates China’s Antimonopoly Law may not only be subject to sanctions from the State Administration for Market Regulation (SAMR), but could also be subject to restrictions and negative treatment from all other government agencies, including, for example, a loss of preferential tax treatment, loss of financial subsidies, restrictions on government procurement and bidding activities, and more frequent government inspections, audits, and supervision, among other things. There are currently over 50 memorandums of understanding between government authorities intended to facilitate topic-specific joint sanctions.
• Implications. While the SCS is principally intended to help implement and enforce Chinese laws—underscoring the importance of robust compliance and reporting mechanisms—it can also impose requirements that reach beyond existing regulations. Companies may, for example, be negatively impacted by the behavior of business partners, requiring careful selection and monitoring of suppliers and distributors. Requirements related to continuing supply to Chinese customers during the US-China trade dispute may also play a role, potentially putting multinational companies in a tough situation.

2. Proposed Regulations Increase the Stakes of Anticompetitive Behavior

The State Administration for Market Regulation, China’s national antitrust enforcer, recently issued draft regulations regarding the creation of Lists of Parties with Seriously Illegal and Dishonest Acts. Much like the Social Credit System—which these regulations are meant to support—the measures are intended to enhance social supervision, increase the consequences for unlawful actions, and publicize misbehavior. Key considerations include:

• Qualifying Offenses. The regulations contain a lengthy list of actions that result in inclusion on the serious offender list, ranging from failure to execute an administrative sanction to repeat trademark infringement. Notably, companies that engage in unfair competition or monopolistic practices—and that cause serious harm as a result—will be included. So will companies that are found to endanger China’s national interests or those of Chinese consumers by engaging in collusion, fraud, compulsory trading, or the use of standard terms. Such provisions arguably could be used as a lever in the ongoing trade dispute between China and the US.
• Consequences. Inclusion on SAMR’s serious offender list will carry several important consequences. Companies will be impacted when seeking to register and secure licenses or certifications. They will be considered a high credit risk under the Social Credit System, becoming the object of increased regulatory attention, additional supervision, and more frequent inspections. And listed entities may also experience harsher administrative punishments.
• Duration. If an entity voluntarily corrects its illegal behavior and eliminates any adverse impacts from its actions, it can apply for removal after one year. Alternatively, if the listed entity does not commit any further acts that would qualify for listing, it can apply for removal after three years. A party included on the serious offender list can seek administrative reconsideration or institute administrative proceedings.

3. Recent Changes in China’s Foreign Investment and Competition Landscape

Against the backdrop of the still-simmering US-China trade dispute, China has promised a more open market, a more level playing field, and a more predictable business environment. A number of new measures reflect this commitment:

• New Business Environment Regulations. On October 22, China issued regulations intended to create a “stable, fair, transparent, and predictable” business environment. The regulations, which come into effect on January 1, 2020, reiterate China’s commitment to equal treatment for foreign-invested firms, increased protection for intellectual property rights, streamlined administrative approvals, and enhanced antitrust enforcement against all types of anticompetitive conduct, among other things. While the regulations generally do not offer detail about how these principles will be achieved—calling on governments at all levels to improve or establish policies and mechanisms—they do indicate that firms can submit complaints directly to China’s State Council, the country’s chief administrative authority, if a set of government rules does not comply with standards of fair competition.
• New Foreign Investment Law. The new Foreign Investment Law, which will take effect on January 1, 2020, streamlines and consolidates the country’s foreign investment regime and attempts to make China a more welcoming investment destination with better protections for foreign entities and standardized management of their investments. In many industries, foreign-invested enterprises will be treated just like domestic entities when it comes to market access, standard setting, government procurement projects, and technological cooperation, among other things. The law also aims to protect foreign investors from forced technology transfers, the exploitation of trade secrets, and the expropriation of investments.
• Changes to Foreign Investment Restrictions. Each year, China issues two lists. One identifies sectors in which foreign investment is prohibited or heavily restricted, referred to as the “negative list.” The second is a list of sectors in which foreign investment is encouraged, often through tax, tariff, or land use incentives. The 2019 versions of these lists reflect an easing on foreign investments in several industries, including the agriculture, mining, oil and gas, infrastructure, transportation, entertainment, telecommunications, and manufacturing industries, all of which saw restrictions come off the negative list. That list now covers 40 sectors, down from 48 in 2018. At the same time, the encouraged industries list added dozens of new sectors in which China hopes to bolster foreign investment. Many of those sectors relate to manufacturing, with a particular emphasis on high-technology industries like 5G components, cloud computing, aerospace materials, and artificial intelligence.
• Joint Ventures. Traditionally, foreign firms looking to operate in China had to form a joint venture, often with a local partner owning a majority of the enterprise. In some respects, these requirements are easing. According to reports, South Korean carmaker Hyundai may soon acquire full ownership of one of its car making operations in China, buying the shares of its Chinese partner. JP Morgan won a bid that will allow it to take a majority stake in its asset management joint venture. And PayPal recently secured approval to acquire 70 percent of GoPay, making GoPay the first foreign-invested payment platform in China.
• Other Opening Up Measures. China has announced a number of other measures to support the “opening up” of its financial sector. Among other things, the measures allow (1) wholly foreign-owned futures, mutual fund, and securities companies by the end of 2020; (2) wholly foreign-owned life insurance companies by the end of 2020; (3) foreign-invested rating agencies that can rate bonds traded on the interbank market; (4) foreign control of asset management companies; (5) the establishment of wholly foreign-owned currency brokers; and (6) foreign owned or invested pension fund management companies.

4. A Groundbreaking Decision on Resale Price Maintenance

The Chinese Supreme Court recently published a groundbreaking ruling on resale price maintenance (RPM), a practice through which a manufacturer and a distributor agree on the prices at which the distributor will resell the manufacturer’s products. The Court ruled in Yutai v. Hainan Provincial Price Bureau that China’s antitrust enforcers need not prove anticompetitive impact in RPM cases, establishing a presumption that the practice is unlawful. The ruling vindicates the government’s position in the only antitrust case to date that it has lost. Key takeaways from the Supreme Court’s decision include:

• Enforcers’ Burden. While the Chinese Supreme Court acknowledged that RPM can have both procompetitive and anticompetitive effects, it concluded that Chinese antitrust enforcers are entitled to a presumption of anticompetitive impact. It explained that because China’s markets are not fully developed—and market forces cannot correct anticompetitive behavior—China’s antitrust enforcers must be able to target potential anticompetitive effects. Requiring the agencies to conduct comprehensive investigations with sophisticated economic analysis in every RPM case would greatly increase costs and undermine the efficiency of agency enforcement.
• Rebuttal Possible. Importantly, RPM is not per se unlawful. Companies targeted by regulatory enforcement actions are entitled to rebut the presumption of harm in two ways. First, they can demonstrate that the RPM agreement does not actually harm competition. Second, they can prove that the challenged conduct falls under an exemption to the Antimonopoly Law, which exempts things like promoting public interests, protecting the interests of international trade or foreign economic cooperation, and enhancing the competitiveness of small enterprises. The opinion, however, does not explain what types of evidence are sufficient to satisfy either rebuttal option. Companies should approach RPM in the China market with great caution.
• Private Litigation. The presumption of unlawfulness in RPM cases extends only to China’s antitrust enforcers. Private plaintiffs bringing RPM claims must still prove anticompetitive impact because, in order to recover monetary damages, they must prove that they actually suffered harm.

5. Trends in Chinese Merger Clearance

China’s rise to antitrust prominence has given it leverage in merger reviews on par with the US and Europe, rendering China a critical hurdle in global merger clearance. With the Antimonopoly Law now in its eleventh year, certain trends in Chinese merger clearance are apparent. Together, they underscore that unconditional clearance in other jurisdictions does not mean easy success in China. Key trends include:

• Length of Review. Chinese merger clearance generally takes longer than in other jurisdictions, especially when potential competition concerns exist. It can be months before SAMR even “accepts” a merger filing, after which a single round of agency review can run for six months. In the ASE/SPIL case (2017), for example, MOFCOM—the relevant antitrust regulator at the time—accepted the case roughly four months after the parties filed their notification. It then took almost a year for MOFCOM to complete its review and approve the transaction. Other cases in which SAMR required remedies are similarly lengthy. Indeed, each conditional clearance in 2019 took well over six months. Parties should factor the Chinese review process into deal terms.
• Behavioral Remedies. While regulators in the US and EU have expressed a desire to utilize structural remedies, which require the parties to divest or otherwise modify their assets before the transaction is cleared, China regularly utilizes behavioral remedies, which can influence the parties post-transaction operations. Examples of Chinese behavioral remedies include (1) supply and price commitments for Chinese markets; (2) continued product interoperability; (3) licensing of standard essential patents at fair, reasonable and non-discriminatory terms; (4) bundling prohibitions; and (5) guaranteed access to and use of technology or digital platforms. The attraction to behavioral remedies is to a large extent explained by their potential to achieve industrial policy objectives.
• Hold Separates. The “hold separate” is a quasi-behavioral remedy that is unique to China and employed with some regularity, even when no other regulator imposes conditions. Hold separates prohibit operational integration of certain business units until years after the deal closes, thereby aiming to ensure continued competition in the relevant product market. In some instances, SAMR must approve integration at the end of the hold-separate term. Recent examples include hold separates in Cargotec/TTS (2019) and II-VI/Finisar (2019).
• Stakeholder Interests. Perhaps even more than regulators in the US and EU, SAMR turns to and relies on the input of stakeholders, which can include customers, competitors, trade associations, and a range of government agencies and decision makers. While merging parties can attempt to anticipate and preempt negative feedback by engaging with customers and trade associations, and by arguing there are no anticompetitive effects, SAMR often sides with stakeholder feedback and looks for remedies that satisfy their concerns.

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, Scott Schaeffer, an O'Melveny counsel licensed to practice law in California and the District of Columbia, Lining Shan, an O'Melveny senior legal consultant in the firm's Beijing office, and Charles Paillard, an O'Melveny associate licensed to practice law in France and a registered foreign lawyer in Hong Kong, 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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