ASIABIZBLOG

Among the more useful of the quasi-marketing documents put out by the big firms is one entitled "Franchising Opportunities in China, Japan and Singapore," prepared by PWC for the APEC Secretariat. Please don't spend the $60 APEC wants you to dole out for this study since it is available free of charge here. [UPDATE: THIS STUDY IS NO LONGER AVAILABLE AT THIS LINK.]

Many readers have found their way to the Asia Business Intelligence website by way of keyword searches at Google and Baidu for "franchise Asia" and the like, so this study is something to peruse that is directly applicable to that need.

That said, the Chinese section of the study appears to incorporate an odd amalgam of sources varying in trustworthiness from Euromonitor to the Chinese statistics bureau. Not all is new information -- some 3 years old -- and you'll find some of the grammar strange in places (a translation?). Nonetheless, the study is a beginning, at least for those who are just beginning to think about operating food and beverage franchises in China.

[Editor's note: Chinese approached me at different times last year, asking about reverse mergers and backdoor listings. These are legal methods whereby a private company merges with a listed shell company, thus becoming a listed company itself.

According to practitioners, Chinese salivate over the idea of going public in the U.S. and have been attaching themselves to the form like limpet mines on a U-Boat. This Wall Street Transcript panel entitled "China’s Obsession with Reverse Mergers" devoted a panel on just this topic last year. This Heller Ehrman white paper, "U.S. Listing Options for Hong Kong and Chinese Companies," dated August, 2003, shows dissemination of the idea that reverse mergers are possibilities for Chinese companies, but note the firm's distinct, well-reasoned hesitation in recommending the form.

I as well was not encouraging to my guests, not least because of the reputation traditionally attached to those who make use of the reverse merger. But the Chinese with whom I spoke noted with distinct relish what they believed was a faster and cheaper avenue by which they could be listed in the U.S, which assumpion is not necessarily the case. More importantly, they believed that the reverse merger would eliminate burdensome disclosure requirements the IPO process presented. Remember that many Chinese companies have serious financial difficulties which due diligence often exposes -- the Black Scrim of Death for many who lust to list.

Then the SEC issued rules last year compelling the production of additional financial documentation in the event of a reverse merger. One might think that would have stopped the show for Chinese companies, but, according to China Confidential's investigative reporting, it hasn't. With gratitude to its anonymous author who has kindly consented, we reproduce the post in full below.]

From China Confidential

More Chinese Firms Likely to Go Public in US

New rules governing Initial Public Offering (IPO) issuances could encourage more Chinese companies to go public in the United States through so-called reverse mergers with listed or over-the-counter (OTC) shell companies.

The rules, which the China Securities Regulatory Commission (CSRC) released in draft form before the week-long Labor day holidays, are aimed at upgrading the quality of listings.

The CSRC wants companies to have accumulated profit of at least 30 million yuan (approximately $3.7 million) and combined revenues of no less than 300 million yuan over the preceding three-year period prior to floating shares.

In contrast with China and most countries in the world, securities laws in the US are based on disclosure, not merit, though the nation's leading stock exchanges--the New York Stock Exchange, NASDAQ, and the American Stock Exchange--all have their own rules and requirements governing listings and related matters. The US Securities and Exchange Commission (SEC), the agency responsible for administering federal securities laws, has no profitability rule. It does not approve the prospectus, or registration statement, of a company--issuer in securities parlance--seeking to sell shares in an IPO or secondary public offering. Instead, the SEC clears a company's registration statement--an important distinction.

After clearing the Commission, as US securities lawyers say, the registration statement is "declared effective" and the issuer is then free to trade on an electronic trading system known as the OTC Bulletin Board, where the only meaningful listing requirements, apart from basic corporate governance rules, are the filing of quarterly and annual reports with the SEC, including audited financial statements, and timely disclosure of all materially important events and developments through special SEC filings and the preparation and dissemination of press releases.

"Disclosure is the operative word," says a New York-based US securities lawyer. "The US system is designed to provide a level playing field for all investors. Everyone is supposed to have access to the same information before making investment decisions."

For small to mid-cap domestic and foreign issuers, the reverse merger method--whereby a publicly traded shell issues so many shares to acquire an operating company that it becomes the surviving entity--has historically been a popular fast-track alternative to typically more time consuming, costlier IPOs. But because reverse mergers have also often been abused by shady penny stock promoters and brokerage firms, the SEC recently tightened rules for these deals, requiring merged companies to file audited financial statements within days of closing their transactions.

Despite predictions to the contrary, the new SEC rules have not been a significant deterrent to Chinese companies seeking to go public in the US by merging with shells.

"All the filing requirement did was weed out smaller, suspect companies," a veteran Wall Street investment banker tells China Confidential. "Companies that want to go public but are not large enough to qualify for traditional IPOs are still drawn to reverse mergers."

Securities lawyers who have represented Chinese and other foreign issuers report that their clients are usually surprised by the relative ease with which it is possible for virtually any company with more than a few hundred shareholders to go public in the US, though the country's ongoing reporting requirements--and civil and criminal penalties for misrepresentation and corporate mismanagement--seem severe to many overseas executives.

"It's the cost of going public that shocks them," says one high-priced New York lawyer. "Depending on the size of the company and the complexity and nature of its business and financial history, a reverse merger could easily exceed $300,000 in legal and accounting fees."

Last Friday, in a stunning turn of events, Ernst and Young announced the retraction of its May 3 report on China's NPL (non-performing loan) exposure. Claiming that the report had not gone through internal review, Ernst and Young further stated that the report "contained errors" requiring retraction of the study in toto. In doing so, E&Y has bowed lower than any western firm one can remember in recent times, offering in addition to the public shame of retraction, its profuse apology as well as sincere regrets.

And what errors, if errors they be. But are they? The global accounting firm had estimated NPLs for the four largest banks (CCB, ICBC, ABC, BOC) at US$358 billion. The press release notes that the "official level" of NPLs, that issued by the Central Bank, is but US$133 billion, a third of the E&Y figure. An error that large in official Chinese statistics is entirely believable -- the Chinese government recently revised upwards its GDP statistics by 16.4%. But when studied by professional economists at a respected global company?

Here's what Jack Rodman, a managing director at E&Y, said when the report was issued, before the retraction:

"I think the numbers will be a big surprise because China has been giving the impression (with its banks listing overseas) that the problem is behind us," said Jack Rodman, a managing director with E&Y. "China has not really resolved the issue - they have just moved it from one state enterprise to another."

Wow! It was refreshing to hear so bold a comment uttered by an executive representative of a major western business operating in China. (We have been writing in a similar vain for a number of years.) But then came the muzzling of those who felt it safe to speak in earnest. What happened?

Read the press release carefully, as it appears to have been drafted with great care. Within this work of fine draftsmanship (I heartily commend the writer), one finds an explanation to its global readership. May I paraphrase?

"We, a global leader in professional services committed to restoring the public's trust in financial accounting, told the world Chinese big four NPLs hit 358, but we were on the receiving end of some serious heat from the central bank the week it was issued, even though they characteristically didn't announce us by name. And, anyway, we're auditors for two of those banks, so what could we do? We haven't any choice but to kow-tow if we want to keep the business -- this is China and we're in it up to our double chins. Ok, here's the official number: $133 billion. We're not saying explicity that we avow the truth of that number, but it is the official version. Can you dig it?"

Sadly, none of the western press seems to have picked up on anything but the exact wording of the press release, making it appear as though E&Y was entirely at fault. At least, in the near term, their bold assertion may work to harm their reputation in the eyes of those who without China business experience. E&Y press relations people outside of China may wish to pitch the rest of the story, off the record, to their media contacts at some point.

[UPDATE (May 16, 2006): Bloomberg discusses why this is such a sensitive issue for the Chinese government here. A quote from the article:

"Chris Ruffle, a Shanghai-based fund manager, won't buy Bank of China shares when the nation's No. 2 lender goes public this month. As a Bank of China customer, he's all too familiar with the bank's failings...Banks are the weakest part of the Chinese economic system, so buying into them doesn't make sense to me.'"

Click the link to hear today's post.

In a story related to yesterday's post, as well as the HanXin （汉芯）chip scandal, the Christian Science Monitor reports on a Chinese government study of 180 Ph.D. candidates which found that fully 60% admitted to plagiarism and bribery. Can it be possible? Are Chinese academic standards really so very low, when Western instructors both in Chinese and American institutions of higher learning have generally viewed their Chinese students as upon the proverbial pedestal?

If true, American companies building R&D facilities in China, several of whom have been clients, need to pay heightened attention to the trustworthiness of the work their new hires purport to have performed as well as the reliability of results obtained in their own labs.

For modern-day mainland Chinese, does the goal and one's pursuit of it validate any means of obtaining it, including the purposeful obscuration of the truth?

On Wednesday, May 24, from 2 to 4 pm, I will speak at World Trade Week New York City. during the Expanding Markets in Eastern Asia: China, Japan and Korea panel. I'll focus on intellectual property issues relevant to that topic, and welcome readers to a chat after the panel.

Our podcasts are downloaded nearly 1,500 times each day. We get especially heavy usage through iTunes. A heartfelt thanks to all of our podcast listeners! To listen to the podcast archive, click this link.

[Editor’s note: The audience at the World Trade Week panel on Wednesday was populated by small and mid-sized American business owners in the New York City area, most of whom had just begun to contemplate entry into the China market. My remarks were aimed at providing them – as well as the internet audience -- with introductory information on intellectual property rights in China. More experienced readers may not find the following text suitable in its entirety, but the story at the top is kinda fun.

Here comes the disclaimer: this is general information not intended as legal advice specific to any individual’s particular situation. The use of “you” and “your” below does not refer to the reader personally, but reflects the choice of an informal substitute suitable for an oral presentation, rather than the stiffer “one.” That last sentence was totally pedantic, wasn’t it?]

Remarks by Rich Kuslan at World Trade Week, New York, May 24, 2006

Today, I’d like to speak to you about Intellectual Property (IP) Rights – what value, if any, does knowing what these rights are, have for you, when doing business in China? Let’s get to some possible answers by way of a story.

A Funny Thing Happened to Me on the Way to the Chinese Market

Recently in China, a friend introduced me to a medium-sized Chinese auto parts importer. Let’s call him Mr. Liu. Mr. Liu’s business was growing and he was looking internationally for sources of branded product to import. To be a bit clearer, he was looking for product with a popular international, i.e., non-Chinese, brand name on it. Chinese customers often are more likely to have confidence in and purchase foreign branded parts. What Mr. Liu wanted had to be imported, and not procured domestically, so that it would display unopened packaging that could genuinely say on it “original import packaging” or in Chinese 原装进口。

This sounded like it was going to be too easy. I introduced Mr. Liu to a major, well-respected American parts distributor, whom I knew well, let’s call him Bob, who quoted an excellent introductory price on product made in the manufacturer’s factory in the United States. I’d expected a favorable response to this offer, and yet the response was less than pleasant. Mr. Liu told me that he could purchase the same product (same model number and specifications) with the same company brand on it made in Korea at a significant discount. I approached Bob, who, after a pregnant pause, told me that none of the maker’s factories were located in Korea. In other words, the Korean product referred to by Mr. Liu was counterfeit.

Back to Mr. Liu. When he said he wanted foreign branded product, he didn’t mean that it had to be made by the company that actually owned or had been granted rights to manufacture the popular brand. The product had to appear to be correctly branded so that it would “persuade” the Chinese consumer that he was buying genuine parts. Mr. Liu told me straightforwardly that the Korean product was nearly 60% cheaper and almost as good as the American product. Best of all, it was branded with the very persuasive name and logo of the American maker. You can guess the outcome of this story. No sale. But the American company was now aware of counterfeiters stealing market share and not doing so by exporting counterfeits to the U.S., but to other nations and specifically posing a threat to future business potential in China. Bob and the parts maker were extremely interested in tracking the counterfeit product to the Korean factory.

Imagine the damage to your reputation and revenue potential when fakes of lesser quality invade a market you have high hopes for。

The more fascinating story I heard from Mr. Liu, was this. A Chinese auto parts maker exported product made in its Chinese factories to be re-packaged outside of China and then re-imported as so-called “genuine foreign-made” imported product. I have not been able to confirm this story, but I believe it. Such things happen.

Protection Against IP Infringement in China

If you have a product or a service you wish to sell into Asia, you have intellectual property that others can make use of to their commercial advantage while harming your interests. So, what can you do to protect yourself from intellectual property infringement in China? What are the challenges you might face? And what likelihood of achieving the results you set out to achieve?

Uh, oh!

Let me preface this discussion with the results of a recent American Chamber of Commerce study. According to their survey of U.S. companies in China, 55% said they were hurt by violations of intellectual property rights and 41% believed counterfeiting of their products increased in 2005. I note this despite 1) increased US and European pressure on the Chinese government to curtail IP infringement and 2) objective confirmation of increased Chinese government activity to do so. So you can see where I am going… You can assume that protection of your IP interests will be an uphill battle, but one that you must engage in for your own benefit, if you should wish to survive and even perhaps thrive in the Chinese business environment.

Click the little triangle to hear today's post.